Governance Tokens Simply Explained

Governance tokens represent voting power in the decision-making of a DeFi project. These kinds of tokens are crucial to keep a protocol decentralized and well-governed.

What Are Governance Tokens?

Governance tokens are tokens, with which holders can influence the future of a specific DeFi protocol. A project’s community can create governance proposals. The tokens holders can then vote accordingly whether or not to approve the proposal. The changes can be anything from small projects to changing the governance structure itself.

We call these organizations “Decentralized Autonomous Organizations” (DAOs). Most DeFi protocols have such a governance structure to remain decentralized. Proponents of these tokens argue that the bottom-up structure of the decision-making process bootstraps innovation. Because anyone can join a DAO, the protocols cannot exclude anybody from the decision-making process. Anyone can buy a token and contribute to the project!

The success of governance tokens speaks for itself. One of the best-known examples is MKR, which is also one of the oldest DeFi tokens. MKR holders vote on governance proposals aiming to provide value to the Maker protocol. For example, MKR holders can vote to add another token as collateral to mint DAI.

Disadvantages of Governance Tokens

Critics claim that these tokens aren’t necessarily the best way to establish consensus among the community. Some argue that these tokens are actually counterproductive because we can also make decisions without a voting mechanism. They claim that most token supply is in the hands of very few parties. While some parties (usually the team behind the project) enrich themselves after the distribution, others get left behind. That’s how a few big token holders could collude and easily decide about the future of the protocol. That’s why critics claim that governance tokens don’t really decentralize a protocol, but rather make it more centralized.

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