Builders ask whether they should give governance rights to tokenholders, and, if so, when they should do so. At the same time, policymakers want to understand the nature of crypto governance and, for network tokens in particular, to determine whether the blockchain systems to which they relate are controlled by any person or group of persons acting under common control.
To aid in this conversation, this piece explains the core purposes of governance in crypto and provides clarity on which kinds of tokens should and shouldn’t have governance powers based on these purposes. It should help both builders and policymakers understand the issues around governance, decentralization, and control.
Governance: What and why
By governance, I mean the process by which a community or organization sets its rules and makes decisions.
Good governance matters. It creates trust among important stakeholders — leading to more investment, collaboration, innovation, and growth. It promotes decentralization and prevents power from concentrating unduly. It improves decisions by leveraging the wisdom of the crowds, and it leaves the community feeling better about the way decisions are made even in instances where they disagree with the decision itself.
Governance specifies who makes which decisions, and how. On an online platform, governance could include how community standards are written, enforced, and appealed; the manner in which fees are set or changed; the way a ranking algorithm works; when the platform can use user data to target ads; and other similar issues.
There are many possible ways to make each of these decisions. Imagine a publicly traded company. The CEO can make some decisions unilaterally, or in coordination with the board of directors. The company can also ask its users or customers to make decisions through a democratic process (e.g., corporate shareholder votes); or an algorithm could make them with user or customer feedback (e.g., feed ranking based on user signals). When a user disagrees with a decision that affects them personally (e.g., an account suspension), company employees could adjudicate appeals, or an independent body could hear them instead (e.g., Meta’s Oversight Board).
Where decisions are made collectively, there are also many ways to allocate proposal-making power, voting power, and veto power, and each has tradeoffs.
Tokens and governance rights in crypto
Governance is as much a major focus in crypto as it is with traditional institutions like corporations and non-profits. But crypto comes with differences. Tokens enable true digital ownership, and sometimes they confer governance powers, too — that is, some tokenholders could have decision-making rights directly over how the protocol operates. Some decisions are made once and enshrined forever in smart contracts on the blockchain or in the blockchain’s protocol itself; others might be made by the founding team, by developers building on top of the protocol, by validators at the consensus layer, or elsewhere. And some decisions may be reserved for the tokenholders to make via a democratic process.
In such cases, tokenholders have the right to make collective decisions that bind the underlying network or product. What decisions tokenholders have the right to make, and how, is programmed into the underlying blockchain network at its inception.
But this all raises the question of when a token should provide governance rights, and why. There are two particularly important reasons that projects choose to use token voting in crypto: to maintain network decentralization, and to make binding decisions that are informed by the community.
Decentralization beyond programmability for network tokens
The first motivation for token governance is to maintain network decentralization and avoid human control when future decisions can’t be pre-programmed into code. This applies specifically to network tokens — tokens that help create and keep a blockchain network running, paying for security, transactions, voting, and the like.
Avoiding centralized control is a fundamental goal of blockchains, and, in parallel, is a key legal test for determining whether a token should be subject to securities laws or not. The more a network token and its underlying blockchain system functions programmatically — that is, based on smart contract code pre-committed to the blockchain, or based on the blockchain’s protocol itself — the less scope there is for founders or other humans to control the system and its token.
In some cases, this programmability may be sufficient to make a token fully decentralized and outside the control of any person or group of people (known as “ossification”). In other cases, however, future decisions and changes will arise that could not be anticipated when the original smart contracts or blockchain protocol were written.
In these cases, tokens require decentralized governance that allows tokenholders rather than founders or other groups of people — like a board of directors or a group of managers — to make collective decisions. Preventing control by a small group of individuals avoids the third prong of the so-called Howey test (where a reasonable expectation of profits is primarily derived from the managerial efforts of a third party or the promoter).
Decentralization is also essential for a project to be deemed “mature” as laid out in the CLARITY Act that the U.S. House of Representatives passed earlier this year. Being deemed mature is desirable because it reduces regulatory uncertainty and makes it easier for projects to sell tokens and be listed on exchanges, among other things. Projects are deemed mature if, along with a number of other conditions, “No person or group of persons under common control has the unilateral authority, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise, to control or materially alter the functionality, operation, or rules of consensus or agreement of the blockchain system or its related digital commodity.”
Imagine a DeFi project that has pre-committed how its protocol works using smart contracts on the blockchain. But the world has changed and the project now wants to upgrade the core smart contracts to implement new functionality. If this protocol upgrade is decided via decentralized governance, then it should ensure that “no person or group of persons under common control” had the unilateral authority to make these changes. In contrast, in the absence of effective decentralized governance, the project must either not make these changes, or let the founders drive them forward at the risk of not gaining maturity status.
There are many examples of decentralized governance for these kinds of decisions which cannot be locked-in in advance, including UNI holders’ governance power regarding the fee switch or protocol upgrade votes on Optimism.
Voting
For core network tokens like AAVE or UNI, the decentralization motive looms large: protocol fees, upgrades, and other strategic decisions have to be made in response to difficult-to-anticipate scenarios as the world changes, as new tokens emerge, new technologies are developed, and new business opportunities arise. Token voting offers one possible way to keep humans in the loop without recentralizing control in the founding team. Hence, network tokens may want to provide governance rights whenever the network needs to rely on ongoing decisions that can’t be programmed in advance.
At the same time, these tokens often power ecosystems with many builders and users. Allocating proposal and voting power to these stakeholders can also serve to make the protocol credibly neutral, alleviating fears of expropriation (or “rugging”) and encouraging deeper investment and engagement. Therefore, network tokens should especially provide governance rights to stakeholders whose ongoing trust is essential to the success of the network.
Rough consensus
Onchain token voting is not the only way to govern a network in a decentralized fashion, though. Consider Ethereum. The ETH token does not provide voting rights, yet the network is decentralized because core governance decisions are made via a democratic, deliberative process that seeks to arrive at a “rough consensus.” While final proposals are “voted” on by staked validators when they participate in the underlying consensus protocol, there is no token voting per se. Solana is somewhat similar, with validators only casting token-based votes on non-binding recommendations similar to off-chain “temperature checks” in other DAOs.
Therefore, network tokens may provide voting rights, but they do not always need to. Whether they should do so is likely to depend on how important it is for a network’s governance process to be fully explicit; how effectively the community is able to deliberate and achieve rough consensus; how concerned people are about the vulnerability of token voting to potential governance attacks or takeovers; and other related factors.
While successfully decentralizing governance is necessary in these cases, it is not sufficient to achieve full decentralization, as there are many ways in which a project needs to be decentralized.
Crowdsourced engagement
A second motivation for token governance, which can apply to all the seven main types of tokens, is to make decisions that are more informed by the community and that encourage a sense of ownership and engagement.
Leveraging the wisdom of the crowd
Providing governance rights via tokens can sometimes help to make better decisions, regardless of how it affects decentralization. As Condorcet, the eighteenth-century French philosophe, famously established, under certain conditions, a majority vote can aggregate “the wisdom of the crowd,” coming to a more-informed decision than experts.
In crypto, there are many examples of this kind of voting. DeFi protocols often vote over key parameters — for example, risk parameters or the listing of new tokens. This has been the case with Aave and MakerDAO. While these votes may primarily serve to maintain decentralization, it is possible that the tokenholders as a crowd know more about the right rate than centralized decision-makers would.
Other projects — like Arbitrum and Optimism — often leverage the crowd to vote on how to distribute grants. Here, again, the hope is that the community as a whole may have more information about which projects have done a good job or are worthwhile for the community to support.
Because the goal here is to help inform decisions, rather than to decentralize, any kind of token could include voting rights. A company-backed token, an arcade token, or even a memecoin could harness the wisdom of the crowd to make decisions over the direction of the project in ways that improve outcomes.
Even if voting doesn’t lead to more-informed decisions, it can still be valuable for creating a meaningful sense of community buy-in and generating fan engagement. Outside of crypto, this is a common marketing strategy — think for example of fan votes to choose K-pop contestant winners or to choose Major League Baseball’s All-Star team.
In crypto we’ve seen a number of interesting experiments in this direction. NounsDAO sold NFTs with the promise that each owner would be able to vote on what the DAO should do next. Other DAOs have held quirky votes on less monetarily significant decisions that people might care about — ApeCoin holders have voted on potential artistic collaborations, and LinksDAO pooled money and voted to purchase a golf course, to pick two examples.
While this kind of voting can certainly apply to network tokens, it can also apply to other types. Arcade tokens might want to let users vote on decisions related to how a game works or how a loyalty program functions. Collectible tokens might want to let fans vote on artistic choices or as a way to engage more deeply with a creator — similar to how the fantasy author Brandon Sanderson has fans submit potential questions for voting, so that he can answer the questions that get the most votes.
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Crypto tokens are growing and evolving, and so too is the policy and regulatory environment around them. As the industry matures and the policy environment becomes clearer, it’s important to understand two motivations for governance in crypto — maintaining decentralization where programmability isn’t possible, and crowdsourcing engagement. These two motivations can help guide governance rights across different kinds of tokens, and it should provide a useful starting point for people building or seeking to guide policy around tokens and governance in crypto.
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Andrew Hall is the Davies Family Professor of Political Economy in the Graduate School of Business at Stanford University and a Senior Fellow at the Hoover Institution. He works with the a16z research lab and is an advisor to tech companies, startups, and blockchain protocols on issues at the intersection of technology, governance, and society.
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