Decentralized finance, or DeFi, is a system that uses blockchain technology to conduct peer-to-peer financial transactions using smart contracts. This allows users to conduct transactions without any centralized third-parties, making the financial world more democratic.
DeFi is growing rapidly in the crypto space, in part because it promotes transparency, accessibility and decentralization in an otherwise highly centralized industry. But as its popularity grows and more crypto enthusiasts use DeFi protocols, so do questions about how some of these platforms are run. One area that DeFi advocates have increasingly looked to for guidance is the decentralized autonomous organization. At first glance, DAOs and DeFi may look like unrelated concepts. But there are key similarities between the two and some DeFi protocols have started incorporating DAO governance models.
Let's explore the ways in which DAOs and DeFi could intersect.
What are the Types of Decentralized Autonomous Organizations (DAOs)?
First, we need to understand what a DAO is. The main element in how DAOs operate is that they have no central authority. They are effectively autonomous digital entities who use blockchain-based voting to govern and have smart contracts in place to facilitate those decisions. DAOs promote many principles that decentralization advocates endorse, including openness, inclusivity and democracy.
A DAO can be organized for many purposes – investments, socializing, governance and more. Because they make it easier to establish open, decentralized systems, they have significant potential for altering the way businesses run in the future.
There are various kinds of governance models associated with DAOs. Typically, the primary question when discussing DAO governance is what voting structure it utilizes. Some of the most common include:
- Token-Weighted Voting: In a token-weighted DAO system, the amount of voting power an individual has is directly tied to how many tokens they hold. This puts more power in the hands of the biggest stakeholders. While this promotes transparency and participation from token holders, it can also create some risk for centralization if large token holders have complete power over decision-making.
- Quadratic Voting: This system attempts to balance out the influence of majority and minority stakeholders. Although participants can allocate their votes toward more than one proposal, the cost of each vote increases quadratically. This helps promote different opinions and fairness among the group.
- Futarchy: In a Futarchy model, prediction markets are used to make decisions. The participants will bet on their expected outcomes for a proposal, and the one that receives the highest rate of predicted success is the one that’s chosen. This is because the model assumes that collective wisdom will lead to the best result.
- Liquid Democracy: This model is a hybrid system between direct and representative democracies. In a liquid democracy, participants have the option to vote directly on proposals or delegate their votes if they feel they do not have enough expertise or interest in an issue to make an informed choice. This helps incentivize participation while also promoting speed, efficiency and educated decision-making.
- Reputation-Based Systems: In a reputation-based governance model, voting power is distributed based on community reputation, a score that can be raised by activity within the group. You could earn toward your reputation for participating in projects or discussions, among other things. In this type of system, users are rewarded with more decision-making power for more participation, ensuring that active users have the most say. This system promotes democracy and activity.
What Challenges Does DeFi Face? The Case for Governance Structures
But why would DeFi protocols need DAO governance structures? While DeFi presents revolutionary opportunities, it also has its share of challenges. One of the biggest is that many DeFi platforms aren’t really decentralized at all. Often, DeFi protocols have centralized data feeds or can be influenced by small numbers of powerful administrators.
Then there’s the question of governance itself. The crypto space at-large has been repeatedly plagued by these issues, and that includes DeFi and DAOs. One example is the first DAO (which was called The DAO). Despite raising more than $150 million, it was later delisted after facing significant issues with its governance.
This is a problem some DeFi protocols have tried to address. For example, Arkadiko is an open-source protocol for minting stablecoins, earning interest and borrowing assets on the Stacks Bitcoin layer. They’ve instituted a governance voting policy in which members who hold their governance token (DIKO) can vote on proposals for the future direction of the platform.
How DAO Governance Can Help
Implementing a governance structure could address some of these concerns. In particular, it can help with standardizing the rules that DeFi protocols operate under and in implementing fair voting methods that incentivize participation.
But the real draw of a DAO system is its emphasis on decentralization. Because their entire governance system is implemented by smart contracts – rather than just their transactions – there isn’t the same concentration of power or centralization that can plague DeFi. The DAO system allows users to assume real power and be included in the decision-making process, which simultaneously supports the underlying ethos of decentralization and helps each platform’s users have a real say in how it works for the community.
There are plenty of examples of DeFi projects that have taken the next steps toward decentralization by using a DAO governance model. For example:
- Compound: Compound has moved toward a truly decentralized system in which a governance system has replaced their administrator. This allows users to interact with or make changes to Compound without needing to rely on their internal team.
- AAVE: The Aave protocol is another that’s taken concrete steps toward true autonomy. They have implemented a multilevel governance structure that “creates economic incentives that keep the voting pool active.”
- Uniswap: Then there’s Uniswap, which simplified its own governance processes late last year. Uniswap has a straightforward process for how they’ve given power to a globally distributed community of stakeholders.
- MakerDAO: Arguably one of the most well-known examples of a DeFi project with a DAO governance model. MakerDAO is a peer-to-peer protocol on the Ethereum network that facilitates borrowing, lending and saving via their stablecoin Dai. The MKR token is the governance token used by the Maker protocol.
The Growing Overlap between DeFi and DAOs
While there may be expanded opportunities for interoperability in the future, we don’t need to completely guess how DAO models could interact with DeFi.
One easy example is the use of smart contracts, which are already an element of both DAOs and DeFi platforms. While smart contracts are mainly used to execute trades in DeFi, they have much broader uses in DAOs and are one of the most common existing integrations between the two of them today. In addition to promoting decentralization, smart contracts can help create immutable decisions for governance.
DeFi platforms can also select what style of voting process they want to employ for their users, whether it’s based on tokens held or one-person-one-vote. This is an easy – if high-stakes – way to integrate governance into a protocol.
The Challenges of Mixing DAOs & DeFi
Despite its opportunities, integrating DAO governance structures with DeFi protocols isn’t a one-size-fits-all solution. There are several challenges facing the DeFi movement that a new governance structure alone may not be enough to overcome.
For example, the openness of a DAO model is a double-edged sword. While the transparency of running on a public blockchain is valuable to those who want to verify transactions, it does raise some privacy concerns in the financial sector. Having such immutability could also make DeFi deeply vulnerable to smart contract programming errors.
On a broader level, critics can also point to historical security issues with DeFi. Past hacks – while more indicative of rushed technology than a fundamentally unsafe system – have undercut some people’s trust in decentralization. While this is not inherently a problem with DAOs in the DeFi ecosystem, it is an obstacle to be overcome in the court of public opinion.
Finally, there’s apathy to contend with. Many DAO users don’t actively vote – a recent study on DAO governance suggested an average of just 20 percent participation. There are various explanations for the low overall numbers, but the underlying consistency seems to center on stakeholders feeling like their vote is not individually powerful enough, which suggests that both DeFi and DAO platforms need to work harder at implementing governance structures that decentralize power.
We’re still in relatively early days when it comes to the intersection between DAOs and DeFi protocols. Over time, more theories about how the two can interoperate may come to light, particularly with regards to Bitcoin DeFi, which is still in its early days.
What is clear is that the DeFi protocols that have embraced some form of decentralized governance have seen success from this relationship. Because governance remains an active issue in DeFi, it’s likely that more and more platforms will utilize the principles of how DAOs operate to combat it.