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How Do Governance Tokens Work?

The primary tool for achieving decentralized governance in DAO, DeFi, and decentralized application (DApp) initiatives is the use of governance tokens. Active users frequently receive these in appreciation for their dedication and community service. To ensure the projects’ strong development, token holders vote on important topics in turn. Smart contracts are typically used for voting, and the outcomes are then automatically carried out.

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Compound, a DeFi system that enables users to lend and borrow cryptocurrency, is another illustration. To empower its user base to vote on important choices, it distributes a governance token called COMP. According to users’ on-chain behavior, the tokens are distributed. In other words, you earn more COMP tokens on Compound if you lend and borrow more. One COMP token represents one vote, similar to MakerDAO. Users can also authorize others to cast votes using their tokens on their behalf. Notably, Compound released the admin key for the network in 2020. It means that without the use of any alternative governance mechanisms, the project becomes entirely governed by its token holders.

Each project establishes its own rules for how its governance tokens operate. According to various computation models, tokens are allocated among stakeholders, such as the founding team, investors, and users. While some governance tokens only vote on a select group of governance problems, others cast ballots on a wide range of subjects. Different governance tokens have different financial dividend potential.

The creation of governance tokens is still in its infancy. Many DeFi and DAO initiatives have benefited from their help as they have grown rapidly. These coins are the foundation of decentralization since they have the ability to vote on how the projects are managed. As long as the tokens are distributed fairly among the community members, the one token, one vote approach puts users and the community at the center. Future growth of governance tokens is possible. To create more dynamic decentralized ecosystems, user-owned networks, Web3 initiatives, and games may embrace governance tokens.

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