Web3 projects are—in theory—democracies. The Platonic ideal of a Web3 offering is not run by a tiny episcopate of developers or executives, but by its community of users, who are encouraged to mull over and eventually vote on every aspect of a project’s business model—from its treasury management to the granularities of its tech. 

One of the core technologies that allows this universal participation is the “governance token.” Unlike other tradeable crypto assets, governance tokens confer something akin to rights to holders, affording them votes, veto power, and a powerful financial incentive to work for the good of the project. 

There are, nevertheless, debates over how to value and allocate governance tokens—and how the unique “rights” they confer can be protected. A number of governance tokens have been manipulated by bad actors, for instance, and US regulators have questioned whether they are illegal securities. 

Below is an overview of how governance tokens work and the challenges they face. 

Examples of Rights Afforded by Governance Tokens 

So, what do governance tokens actually let a holder do? The powers they vest range from the trivial—like adding support for a particular token on a decentralized exchange—to the incredibly significant, e.g., treasury management or altering fee models. 

Some offer basic rewards schemes as well as access to a platform’s decision-making process. For instance, CRV, the governance token for the decentralized exchange Curve Finance, allows holders to stake their holdings in return for trading fees taken from users. It also lets them lock their CRV up—that is, agree to not trade it for a certain period of time—to vote in governance proposals and earn rewards. 

The same goes for MKR, the governance token of MakerDAO, a DAI stablecoin issuance protocol. MRK lets holders decide the parameters for the DAI stablecoin peg and oversee the addition of new collateral types. Meanwhile, STG, the governance token of cross-chain protocol Stargate Finance, allows holders to vote on governance decisions that reward emissions and pool-rebalancing parameters.

There are other, more complex kinds of rights conferred by governance tokens. In decentralized autonomous organizations (DAOs) with more elaborate structures, governance tokens play a vital role in coordinating members and stopping them from, say, stabbing one another in the back. 

One example is MolochDAO, which was conceived as a game-theoretical approach to decentralized decision-making. The DAO’s governance token (described by the DAO’s developers as a “share”) is deliberately non-transferrable, and can only be withdrawn by quitting (“rage quitting”) the DAO altogether, which results in loss of the vote. That encourages shareholders to either exit swiftly or contribute to maximize the value of their share. 

Voting

There are different ways in which governance tokens represent voting power within a Web3 project. Voting often takes place on platforms like Snapshot, where proposals can be discussed at length. Some projects limit voting to “one token, one vote,” while others allow “weighted” voting favoring large holders. 

There are also safeguards to ensure no single actor or clique accumulates too many votes. With Uniswap, for instance, a certain portion of the governance tokens were allocated to the principal developers and then “locked up” for a number of years—offering an incentive while ensuring that developers didn’t abscond with the funds at the first opportunity, or misuse their outsized voting power. 

Governance Tokens vs. Utility Tokens 

You might confuse governance tokens with utility tokens, another kind of crypto token that is primarily (theoretically) not used for speculation. But they are not quite the same. 

The difference between utility and governance tokens is akin to the difference between buying a movie ticket to watch a show versus buying a ticket that allows you to vote on which shows will be broadcast.

Utility in blockchains is any product or service rendered using smart contracts to an on-chain address. Blockchain applications use utility token ownership to offer exclusive access to their services. “Utility” is an umbrella term that encompasses many use cases, including staking, token swaps, minting NFTs, wrapping assets, and governance.

Governance tokens, on the other hand, offer the right to implement protocol-level changes and steer the direction of an on-chain application or a decentralized community as its utility. All governance tokens are utility tokens, but not all utility tokens are governance tokens.

Governance Tokens in Context 

Here are a few cases where governance tokens played a central role.

In September 2022, Cosmos, the ‘internet of blockchains,’ was undergoing a major transformation when a group of key contributors of the Cosmos community released a white paper popularly dubbed ATOM 2.0. The white paper proposed revamped tokenomics for ATOM to give it a more central role, as well as many new ideas for the Cosmos Hub. Though the proposal had a lot of support, it lost to a slew of ‘NoWithVeto votes—a specific vote established by the Cosmos community to show stronger disagreement than a ‘No’ vote—citing concerns over ATOM’s new monetary policy.

The ConstitutionDAO stands out as an interesting experiment in DAO governance. A group of crypto enthusiasts sought to buy one of the original copies of the U.S. Constitution, auctioned by Sotheby’s in November 2021. They formed a DAO to crowdfund this operation and offered $PEOPLE tokens to contributors. Ultimately, the DAO lost the auction to a higher bidder.

Had the DAO been successful, each “We The People” token holder would have become the de facto owner of a proportional share of the Constitution.

Lido DAO, a liquid staking solution for Ethereum, vetoed a proposal in July 2022 to sell 1% of LDO’s total supply to Dragonfly Capital. The proposal sought to diversify Lido treasury, which relied heavily on volatile assets like LDO and ETH. Community members ultimately suggested a similar proposal—but with a lock-up period for LDO tokens to safeguard against potential selling pressure. Arguably, that made management of the treasury more transparent. 

How Different Are Governance Tokens From Regular Crypto Assets?

In many ways, governance tokens act like regular crypto assets. Their prices increase as the value of the project grows (though this can be problematic from a regulatory point of view). As with every crypto token, there are flourishing secondary markets for governance tokens, and they can be traded and staked to earn income, or even burned to deflate their supply. 

For some projects, governance tokens can be used to  generate income. Some decentralized finance (DeFi) projects, for instance, allocate a portion of the proceeds taken from transaction fees to holders of these tokens, who can vote to decide their share. Furthermore, token holders often farm—that is, deposit with crypto lenders to generate interest—their tokens to multiply their income.

However, this financialization of governance tokens has its risks. 

The Risks of Investing in Governance Tokens 

Since the introduction of governance tokens, Web3 has grown exponentially in value. Governance tokens were ostensibly built to preserve decentralization and resist censorship, but various legal challenges have emerged from the traditional financial world. 

The U.S. Securities and Exchange Commission (SEC), for instance, has released guidance that defines some governance tokens as securities. According to the SEC, if a digital asset represents an investment in a “common enterprise” with “a reasonable expectation of profit gained through the effort of others,” it ought to be regulated as a security. 

How to interpret these rules, and which governance tokens are actually securities, is the topic of ongoing legal debate. We do know that the SEC has specifically called out some governance tokens as securities and will potentially continue to do so. Despite their theoretically narrow focus, they are, after all, bought and sold on secondary markets just like other crypto assets. That also leaves them open to standard manipulation. One recent example was the $MANGO token, whose price was artificially inflated by the trader Avraham Eisenberg—who has since been sued by the SEC. 

There are also concerns that governance tokens are too centralized. Given that these tokens confer holders both riches and voting power, early adopters and institutional investors risk becoming overmighty as the price increases. 

A number of innovations in decentralized governance have been developed to address this centralization. “Quadratic voting” makes accumulating voting power progressively difficult as investors accumulate governance tokens. ”Vote-escrowed governance,” meanwhile, uses time-locked contracts to escrow users’ funds, ensuring only honest contributors participate in governance. 

What Lies Ahead for Governance Tokens

In an attempt to address many of the legal concerns, some DAO communities are now trying to circumvent the regulatory headwinds by decoupling governance and their token’s monetary value. 

For instance, some DAOs are issuing Soulbound” tokens that quantify parameters such as member contribution, traits, and achievements to measure their voting power. Other DAOs are tackling centralization by making it difficult to accumulate voting power with the aforementioned new technologies of quadratic voting and vote-escrowed governance tokens.