Governance Tokens: A Guide to DAOs

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The world of cryptocurrencies is constantly changing and new concepts are constantly emerging. It is normal to get lost among so many definitions. One of the key concepts of recent years in the cryptocurrency and blockchain technology space is governance tokens and DAOs. Don't miss this article if you don't want to be outdated.

Governance tokens are a tool used by DAOs. But governance tokens are not limited to DAOs, but are a tool also used in other types of platforms. Therefore, we will first explain what governance tokens are before defining what a DAO is.

What is a governance token

A governance token is a type of cryptographic token that is used to allow token holders to participate in governance and decision-making on a blockchain platform. This type of token allows its holders to influence the development, decisions, and direction of the blockchain platform.

Governance token holders may have different levels of influence in decision-making, depending on the amount of tokens they own. In some blockchain platforms, governance token holders can even propose changes and improvements to the platform.

Applications of governance tokens

Some examples of applications of a governance token can be the following:

  • Decision making: Governance token holders can vote on important issues related to the management and development of the project or protocol in which they are used. For example, they can vote on changes in the organizational structure, fund allocation, and other important aspects.
  • Incentives and rewards: Governance token holders can also receive incentives and rewards for participating in decision making and contributing to the project's development. For example, they can receive additional tokens or discounts on transaction fees.
  • Promoting community participation: Governance tokens encourage community participation in project management and development, which can improve transparency and decision making.
  • Inflation control: Governance tokens can also be used to control the inflation of the total token supply, which can improve currency stability and protect the value of token holders' assets.
  • Decentralization: The use of governance tokens can promote decentralization and community participation in the management of projects and digital assets.

This type of token has become an essential tool in the management of decentralized projects and protocols.

Examples of governance tokens

Some examples of governance tokens, along with the platform they govern, are:

What is a DAO

A DAO (Decentralized Autonomous Organization) is a decentralized and fully autonomous organization that operates on a blockchain network, and whose decisions are made by voting by governance token holders through governance mechanisms.

What is a governance mechanism

A governance mechanism is a set of rules, procedures, and structures that govern decision-making in an organization, platform, or project. A governance mechanism can include aspects such as the election of leaders or representatives, the allocation of responsibilities, conflict management, decision-making, supervision, and control.

In the context of cryptocurrencies and blockchain, governance mechanisms are often designed to be completely decentralized and autonomous, allowing the community to make important decisions transparently and fairly, without the intervention of a centralized third party.

How governance works in blockchain

In a DAO, rules and decisions are established by smart contracts programmed in the blockchain network, which means that there is no central entity making decisions or controlling funds. Governance token holders have the right to vote and can propose and vote on changes and improvements within the organization.

DAOs can be used for different purposes, such as creating cryptocurrencies, funding projects, managing digital assets, and much more. Because decisions are made by the community of governance token holders, DAOs can be more transparent and democratic than centralized organizations.

In summary, DAOs emerge to offer more decentralization to cryptocurrency projects. That is, to have no central entity controlling it, but rather be governed democratically by all users who use the project's platform. Essentially, it is a group of people organizing to collaborate on a project or a common goal, using a decentralized and transparent voting system.

DAO Examples

Here are some examples of DAOs that are being used in different sectors and areas:

  • MakerDAO: It is one of the most popular and successful DAOs. It uses a DAO to manage and issue its stable cryptocurrency (DAI).
  • Aragon: It is a platform that allows organizations to create and manage their own DAOs.
  • MolochDAO: It is a DAO that funds open-source projects related to Ethereum.
  • Kyber Network: It is a decentralized exchange that uses a DAO to make decisions and manage its funds.
  • GnosisDAO: It is a DAO that focuses on the development of blockchain technologies and dApps.
  • DAOstack: It is a platform that allows users to create and manage their own DAOs, and also provides tools for project management and decision-making.
  • Molten: A DAO that focuses on the development of blockchain technology for the gaming sector.
  • Yield Guild Games (YGG): A DAO that invests in NFTs (non-fungible tokens) of video games to earn future profits.
  • Friends With Benefits (FWB): A DAO focused on the arts and culture sector, aiming to support artists and creators through investments and collaboration opportunities.
  • Unslashed Finance: A DAO that offers decentralized insurance to protect users from potential risks and losses.
  • Curve Labs: A DAO that works on the development of decentralized applications (dApps) and blockchain solutions for personal finance management.

If you notice, we have shown you a series of governance tokens, but not all of them correspond to a DAO. This is because there are platforms that are not organized as a DAO, but have issued governance tokens so that platform users can participate in certain decision-making processes. In other words, they are platforms with some centralization that want to decentralize some of their processes.

An example of this is Uniswap. Uniswap is not a DAO strictly speaking because, although it uses a governance token system, its organizational structure and decision-making are not completely decentralized. Although the UNI governance token allows token holders to vote on important decisions related to the platform, Uniswap still has a centralized development team that has some control over the decision-making and development of the platform.

Another example of this hybrid system that uses governance tokens without being a DAO is the AAVE lending platform.

Distinguishing between a DAO and a centralized platform with governance tokens is not always easy. Many of them try to show that they are 100% decentralized through a DAO when, in reality, they are not. If you are curious and want to know what governance a platform has, you should study the project well, analyze its whitepaper, and participate in its community.

Advantages and disadvantages of governance tokens and DAOs

DAOs and governance tokens have advantages and disadvantages. Here are some of them:

Advantages

  • Decentralization: DAOs and governance tokens promote decentralization, as they allow community members to make important decisions and participate in the management and development of projects and digital assets.
  • Transparency: DAOs and governance tokens foster transparency and accountability, as important decisions are made through a public and transparent voting process.
  • Community participation: DAOs and governance tokens encourage community participation in project management and development, which can improve efficiency and decision-making.
  • Flexibility: DAOs and governance tokens are highly flexible, allowing community members to adapt decisions and management to their needs and desires.

Disadvantages

  • Complexity: DAOs and governance tokens can be complex to understand and use for some users.
  • Fraud and manipulation risk: Governance tokens can be subject to fraud and manipulation, which can negatively affect decision-making and project management.
  • Conflicts of interest: Holders of governance tokens may have different interests and goals, which can lead to conflicts of interest and make decision-making difficult.
  • Security risk: DAOs and governance tokens can be vulnerable to cyber attacks and other security risks, which can affect the integrity of the platform and decision-making.

One of the disadvantages of governance tokens that is much discussed in the cryptocurrency space is closely related to conflicts of interest. And it is that although some governance tokens, such as the mentioned UNI or AAVE, seem to have a huge market capitalization. However, that money can be ridiculous for institutional investors managing a large amount of funds.

These types of investors can acquire a very important percentage with the governance tokens of a project and influence its decision-making. This practice is more dangerous in new projects that are emerging and whose market capitalization is still small.

But as we say, the cryptocurrency space is new and although it may seem that a lot of money is being moved in this world, it is actually ridiculous compared to what is being moved in stocks, the FOREX market, or futures and options.

And so, the governance token with the highest market capitalization, UNI from Uniswap, encountered this problem in early 2023.

It turns out that Uniswap wanted to add a new blockchain to its ecosystem and the community decided it to be the Binance Smart Chain. However, in subsequent votes, a16z, one of the largest cryptocurrency funds and major investors in Uniswap, rejected the proposal, as they owned 15 million UNI, a very high percentage of the token's supply.

It turned out that the vote proposed the Wormhole bridge for the implementation of the new blockchain. However, a16z did not agree, as they wanted LayerZero bridge to be used. And this protocol was part of the a16z venture's portfolio.

As we say, conflicts of interest are one of the big problems of DAOs and governance tokens and they represent one of the challenges they must face in order to achieve success.

This article is part of our guide on Bitcoin and cryptocurrencies. Specifically, of the guide on types of cryptocurrencies. Find more related articles in the following list:

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