DeFi Governance Models

Decentralized Finance has unquestionably been one of the most rapidly-expanding sectors in the world of Blockchain. Since its inception, DeFi has gradually been replacing the single authority control and third-party interference in financial transactions with the help of Smart Contracts powered by Blockchain. Truth be told, the decentralized and permissionless nature of DeFi is the core pillar of this entire DeFi ecosystem, helping it expand its boundaries exponentially.

“However, the longevity of any technology in the modern world is subject to the evolution of its functional and operational aspects. “

For instance, a DeFi protocol might need some crucial changes in their interest rate mechanism or implement a new feature to face the exploding expectations

Since DeFi does not entertain third party control, an interesting question that arises is, who will take the important decisions for the protocol?

Well, this is where the DeFi governance models come into play.

The Governance model of Decentralized finance aims to shift the control of the protocol from a third party to the users who actively participate in the protocol.

Although a particular DeFi protocol is developed by a small group of developers and investors, the ability to engage and impact the choices made for the protocol is not controlled by them after the protocol is in effect.

This depicts the significance of the Governance model in DeFi as it makes it more decentralized, transparent as well as reliable.

Different governance models

Founder control

To begin with, the majority of the DeFi projects are controlled by the founders. They share a resemblance with the early age startups in their infancy. This can result in faster growth of the organization since the decisions are taken solely by an individual.

Council control

As the name signifies, the power rests with a group of people who devise strategies and lay roadmaps. Bitcoin and Ethereum are noteworthy examples of this type of governance where the core developers are the council.

Liquid democracy

Proclaimed as an explicit representative, this model allows the representatives to be elected by vote. Also known as delegated or proxy voting, this mechanism follows parallelism with the method followed by corporate, where dignitaries and stakeholders vote. Every network that follows this governance has a minimum requirement for getting a right to vote. For instance, you must have a minimum of 1% of the tokens in that network to partake in voting. These tokens are generally known as Governance tokens.

They reserve the right to participate in all the decisions regarding changes in the protocol. It allows for on-chain governance and has demonstrated to give strong returns. Typically each token is equal to one vote. Therefore, if you have more token, you have more votes. The investors are also more intrigued in making huge investments in DeFi projects managed by governance protocols.

At the heart of this concept lies the Governance Tokens. These tokens allow DeFi to ensure an adequate decentralized governance mechanism of any particular protocol.

Understanding Governance Token

Governance tokens play a remarkable role in establishing a democratic governance model in any DeFi platform. This allows the holders of the governance token to participate as well as influence the decision-making process within that particular platform.

The governance tokens are primarily used for an effectual voting mechanism that provides the holders with an option to vote for or against a particular proposal. While the community can predetermine the minimum response needed for allowing any decision to be accepted, the outcome of the voting procedure decides whether or not a proposal should be implemented in the platform.

As far as the distribution of governance tokens is concerned, most of the protocols follow a popular distribution model that allows users to earn governance tokens whenever they participate in the protocol. For instance, Compound distributes around 2890 COMP tokens every day to its users who either provide liquidity to the protocol or act as a borrower.

Hurdles in the path of the DeFi Governance Models

Keeping in mind the fact that the entire DeFi community is still in its nascent stage, the DeFi governance model is riddled with some flaws as well.

The first challenge that this model faces is the accumulation of governance tokens within a few hands.

Let’s understand this through an example

During the distribution of COMP tokens of Compound protocol, around 46% of the total governance tokens(COMP) were owned by the founders, shareholders as well as the Compound team. It quite clearly depicts how the preponderance of the voting power and capability of influencing the proposal is controlled by the developers of Compound protocol themselves.

On the other hand, 24% of Maker Dao’s governance tokens(MKR) are primarily owned by the top 20 addresses, thus allocating most of the power down to a few users.

Another obstacle in the governance model is the excessive practice of yield farming.

Higher yield farming activities blur the true value of the crypto assets associated with it. This is because, such activities immensely boost the demand for a particular asset, more often than not, for a very short period.

This leads to a potentially troublesome scenario where the borrowers find it extremely difficult to pay back the loan. While this can cause a significant loss of value in a particular governance token, it can also adversely affect the stability of the platform.

So, What’s next?

With the inevitable growth of DeFi, the need and demand for governance tokens are progressing at a very rapid pace as well.

The governance model in DeFi is capable of resolving any internal conflict as well as simplifying the decision-making process within the blockchain network in a very democratic fashion.

Therefore, it can be said that the inclusion of a governance model is what allows a DeFi protocol to accommodate the needs of modern customers for transparency, trust, and an unbiased mechanism.

However, the incentive mechanism of providing liquidity to get governance tokens has led to an extremely competitive behaviour among the users. Since users with more liquidity can technically get access to more governance tokens, the entire governance model might gradually go back from a decentralized to a centralized model with powers concentrated in the hands of a few.

This quite clearly illustrates that the current governance model of defi does need some imperative modifications and alternatives that address these issues adequately.

That said, the evolution of governance models may hold the utmost influence over shaping the future of DeFi.