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DeFi Governance in Action

Crypto users playing a decision-making role normally reserved for executives? That’s just one effect of DeFi governance.

By Cryptopedia Staff

Updated March 10, 20225 min read

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Many popular decentralized finance (DeFi) platforms like Uniswap, Compound, and Yearn.finance have made decentralization a guiding priority. In the management of their respective protocols, the creators of these DeFi platforms have transferred decision-making power from a small team of founding members to global, distributed communities of stakeholders through the creation of governance tokens. Decentralized governance remains in an experimental stage, but key processes have already been standardized and implemented across the industry so that protocols can be governed in a sustainable and equitable manner.

Overview: What is DeFi Governance’s Role in Crypto? 

Decentralized finance (DeFi) platforms achieved tremendous growth in 2020, propelling the sector to the forefront of blockchain and financial technology (FinTech) by combining peer-to-peer (P2P) networks, algorithmic automation, and community incentive structures to enhance existing — and create wholly new — financial products. DeFi’s decentralization extends beyond the technical aspects of peer-to-peer trading or blockchain nodal structure, as it pursues the development of more equitable and decentralized organizations and industries via tokenized governance mechanisms.

Many DeFi platforms are redoubling the blockchain community’s steadfast commitment to decentralization by widely releasing governance tokens to users. These governance tokens transfer agency, responsibility, and control of platform management from a project’s small group of founders, employees, and insiders to the globally distributed and decentralized community of stakeholders that uses the platform and engages with the wider DeFi ecosystem.

DeFi projects rely on governance mechanisms to make crucial decisions about protocol changes, hiring developers, and even changing governance frameworks. For example, a borrowing and lending platform may use its governance process to determine the amount of collateral required to borrow money or to make changes to its interest rate model. Similarly, a decentralized exchange (DEX) platform could use its governance mechanism to allocate funds for the platform’s development or to change the way its liquidity pools are managed. Or, a yield farming platform could use its governance process to hire someone to audit its code.

Types of Blockchain Governance

Blockchain governance first emerged as an off-chain process in which stakeholders coordinated and determined the direction of a protocol through conferences, mailing lists, online forums, and other means. However, off-chain systems often result in situations where some stakeholders are more powerful than others. In the Bitcoin ecosystem, for example, core developers and miners wield the most power because more casual users lack the formal means to register their input.

On-chain governance, a mechanism that enables stakeholders to vote for protocol changes directly on the blockchain, was developed to provide individual users with more influence in the governance process. In this system, governance proposals are often coded into smart contracts and are executed if they receive the required amount of votes to be ratified. DeFi platforms largely use on-chain governance mechanisms. To earn the right to vote or to make a proposal, you typically must hold a governance token. Though on-chain governance has proven to be significantly user-inclusive, it has also been criticized as plutocratic, because the amount of tokens you hold often determines the weight of your vote.

Governance Tokens

Governance tokens are typically based on the ERC-20 token standard, and usually they must be staked — or held as collateral — to provide holders with the right to vote or to make a proposal. Governance tokens are typically distributed to platform users as a reward for using the protocol, and cannot be initially purchased, though they may eventually trade on exchanges after distribution. DeFi platforms have relied on governance token awards to attract liquidity and users to their projects, and the tokens have often become objects of speculation. However, in theory, the more successful the protocol, the more valuable the governance token should be, as it gives protocol users the power to control, direct, and organize more resources by changing incentives and capital flows.

DeFi Governance Processes

Once governance tokens have been distributed, the hard work of actually governing a platform begins. The most popular DeFi governance structures all follow the same general process:

Discussion: Discussion is the first step of DeFi governance, as stakeholders attempt to gauge the sentiments of the community around specific issues and potential changes. Discussions happen across a platform’s official governance forum and informal communication channels. Ideas and policies are ideally the center of conversation, but politicking often occurs as users try to convince others in the community to support their ideas or proposals.

Improvement proposal: Improvement proposals are an attempt to systematically and transparently put forward new changes to the system by using a generalized template consisting of the proposal’s context, description, and potential code change. For now, most improvement proposals are technical, quantitative, and mainly submitted by developers. Once a code change is proposed, it can be discussed and reviewed by the community — then changed further if necessary. For example, using Ethereum Improvement Proposals (EIPs), Ethereum stakeholders can direct the course of the project, its governance, and its underlying blockchain.

Quorum: A quorum is the minimum amount of participation required to pass a vote. For example, a proposal may have 100% support from voters, but if the number of token holders who vote fails to meet the minimum percentage required, then the vote is often automatically canceled. One of the biggest problems in DeFi governance is low participation. People often want to hold tokens for speculative purposes and may not want to participate in governance because it is time-consuming and/or they do not have a strong view — or any view at all — on the proposed change to the protocol.

On-chain vote: For most DeFi protocols, one token equals one vote, and a simple majority of more than 50% is enough to execute a new proposal. The more tokens an entity holds, the more weight their vote carries. If a token holder does not want to vote directly, their voting power can be delegated to another address. Once a vote is passed, the proposal can be executed.

Implementation: Since proposals are usually software changes, the final step in the decentralized governance process is changing the code.

Fair Launches: The Yearn.Finance Example

As DeFi governance tokens have become popular, issuers have been under increasing pressure to release the tokens via “fair launches.” This term implies a standard that no one entity should have an advantage in obtaining the governance token, meaning that there should be no private pre-sale of the token and no tokens set aside for the protocol’s creators.

One example of a fair launch is Yearn.finance. At the launch of the protocol’s YFI token, no tokens were reserved for the founding team. All YFI tokens had to be earned the same way: by participating as a liquidity provider to designated liquidity pools. Without investors or even founders receiving special treatment, YFI holders could trust that Yearn’s community was sufficiently decentralized, thus catalyzing an enthusiastic and dedicated group of stakeholders to organically improve and promote the Yearn platform.

What Is Yield Farming? The Compound Example

Compound was one of the first DeFi protocols to launch a governance token. The release of its COMP token in June 2020 initiated the phenomenon of DeFi “yield farming,” which is essentially a trading strategy intended to maximize DeFi platform incentive structures. Yield farmers are those who provide crypto assets to various DeFi protocols to earn governance tokens as a reward. Those governance tokens are then deposited in other DeFi dApps to accrue interest or earn access to other kinds of digital assets and financial instruments. The effectiveness of yield farming in bringing in new capital to a protocol — and the explosive value of governance tokens — convinced other DeFi platforms to follow Compound’s lead.

DeFi solutions and platforms are on the cutting edge of blockchain governance and have demonstrated that efficient governance need not come at the expense of decentralization. Though DeFi governance is still in an experimental stage, the popularity of governance tokens and fair launches indicates that its key processes will likely have a lasting impact on the blockchain ecosystem.

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