Dragonfly Research
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Dragonfly Research

Decentralized Governance: Innovation or Imitation?

By Ashwin Ramachandran and Haseeb Qureshi

It was early 2016, and the time was ripe for change. The Ethereum community believed that DAOs would revolutionize governance, and were ready to put money on it. The DAO had only just launched, and it had already amassed 10% of the circulating Eth supply. Soon it would be responsible for over 1.5% of all transactions on Ethereum.

Vitalik introducing DAOs in early 2016

Ethereum users packed into auditoriums to listen to speeches on how DAOs represented the future of governance. It was claimed that DAOs would make governance radically transparent, unlike conventional, closed-door companies. DAOs represented a step function improvement over traditional governance systems. By placing “automation at the center, humans at the edges”, DAOs would make the world more coordinated and efficient. They would pull us, whether we liked it or not, into the future.

It’s been 4 years since then — so what’s the verdict? Have DAOs revolutionized governance?

DAOs today are tangible, but pedestrian. Users can design and deploy DAOs in a few mouse clicks, and over 1.9k DAOs have been deployed to-date. The story was supposed to be that decentralized governance would eliminate the need for firms, and that application governance would rise above the antiquated forms of traditional public company governance.

But so far, application governance looks almost identical to traditional firm governance.

DAOs started as quests for autonomy — decentralized, democratic organizations controlled by the swarm. But DAOs today aren’t all that decentralized, nor democratic. Just last week, 5–6 parties voted to make sweeping changes to two of the largest DeFi protocols. DAOs don’t really look like decentralized democracies, much less a revolution in governance.

DAOs certainly improve organizational efficiency when they can replace humans with code. But DAOs promised much more than that. They claimed to usher in a democratic future that would empower all stakeholders. If this is the case today, why does the average DeFi user have about as much influence over DeFi as the average Robinhood user has over its namesake company?

When we originally started down this track of thinking, we were planning to write an article explaining how decentralized governance had failed to live up to its revolutionary expectations.

But then we thought: maybe that’s the wrong conclusion.

Maybe what’s going on here is not a story of decentralized governance failing to innovate. Maybe the real story is: decentralized governance evolved to converge with forms of centralized governance. Instead of being a failure, maybe that’s a sign of a deeper truth: that centralized governance structures, having evolved over thousands of years, are actually the optimal way to govern organizations?

How does governance work in most crypto projects?

There are three major forms of governance that all crypto projects follow.

The first is founder controlled. Much like private companies, early-stage crypto projects are often controlled by their founders. The founders are responsible for guiding the product strategy, roadmap, and direction of the company. Founder-led companies often resemble dictatorships (in software governance, this is often lovingly referred to as a BDFL), and many application-level token startups begin their life under this form of governance.

And with good reason! At an organization’s earliest stages, the only thing that matters is avoiding death. Concentrating organizational power in the hands of founders results in a faster moving, incisive organization. While there’s nothing inherently wrong with founder-led companies, token projects that rely on this form of governance are pretty much like normal startups.

The second major form of governance used by many token projects is council controlled. Most Layer-1 blockchains and early stage token projects rely on a small group of “enlightened elite” to make policy, define product roadmaps/strategic direction, and propose system-wide changes. Examples of this type of governance include Bitcoin, Ethereum, Grin, Monero, and more. In crypto, these councils are almost always composed of core developers.

Council controlled governance decentralizes protocol control away from founders and towards core developers. But this form of governance is also not new. Many organizations have used this form of governance for decades, including The Linux Foundation, W3C, International Science Council, CERN, and IETF. It’s a tried and true approach to governing complex, highly technical projects.

The third major form of governance used by many crypto projects is an explicit representative or liquid democracy. Representative democracies allow individuals to elect a group of officials to make decisions and form policy on their behalf. Liquid democracies are a more general form of governance in which people can either vote directly or delegate their vote to a representative to vote on their behalf.

Visual representation of Direct, Representative, and Liquid Democracy. Source: Dominik Schiener

“Fully decentralized” blockchain applications frequently use representative or liquid democracies (and occasionally proxy voting) in governance. Voting power is determined by ownership of a governance token, which confers governance rights. For example, Maker (MKR) governance is akin to a direct shareholder democracy. Compound (COMP) takes a liquid democracy approach, whereby anyone is free to either vote directly, or delegate their voting power to someone else.

But we’ve seen these forms of governance before as well! Most western countries are governed by representative democracies. Similarly, most public companies are governed by something resembling liquid democracy. For example, public company shareholders can delegate their votes to other shareholders who vote on their behalf. This is called proxy voting, as it allows for single vote delegation (although true liquid democracies allow arbitrarily long delegation chains). Blockchains improve the efficiency and coordination of these forms of governance, but blockchains did not invent them. These governance structures still mirror the forms of shareholder governance used by most public corporations.

Let’s take a step back and examine this parallel further.

How are public companies governed?

To understand the parallels between DAO governance and public company governance, it’s worth establishing a bit of background.

There are two tiers of governance in the modern public corporation: management and the board of directors. Management oversees day-to-day company operations, while the board provides strategic oversight and keeps management in check. Boards consist of many different types of directors, including large shareholders and shareholder elected members.

DAOs substitute shareholders with tokenholders, allowing the largest tokenholders to effectively act as the protocol’s board of directors. This de facto board helps guide protocol direction by proposing or voting on upgrades and directing future development.

Management, however, is replaced completely with code. This is one way blockchains improve governance: they substitute humans with automation.

But that’s not the only reason why traditional shareholder governance is inefficient.

More than 80% of the S&P 500 is owned by institutional investors, and a small number of shareholders hold majority stakes in most large-cap public companies (eg. Vanguard Index Funds). These investors, due to the sheer number of companies they represent, require special entities to advise them on all board/shareholder decisions. These entities are called proxy advisors.

Index Funds such as BlackRock rely on proxy advisory services such as Glass Lewis or ISS to advise them. While the proxy advisor industry emerged to improve shareholder voting efficiency, it hasn’t fundamentally improved this process. Proxy advisors are incentivized to grow their businesses and don’t directly bear the cost of bad decisions. Thus, they have little incentive to improve the efficiency of the underlying shareholder voting process.

Proxy advisor services are misaligned with increasing shareholder voting efficiency. Source: George Mason

This is where Blockchains offer an advantage. Blockchains fundamentally improve the efficiency of liquid democractic/proxy voting governance. They allow for instantaneous vote delegation, which democratizes proxy advisory services and allows the best analysts to influence major votes and acquire additional voting power. This is a significant improvement over the proxy voting process.

Crypto Co-opts Co-ops

But not all cryptonetworks reflect the system used by most public companies. Compound distributes governance tokens directly to users and early investors in the protocol. With this, the team has handed off control to a decentralized liquid democracy.

Compound Token Distribution. Credit: Robert Leshner

This form of token distribution mirrors a co-op. Co-ops are corporations in which shares are sold to users, creators, or customers of the company. Imagine an Uber where drivers and riders own the company rather than outside shareholders. Fundamentally, co-ops align incentives by placing users/consumers directly in control of a company’s future.

REI is perhaps the best known example of a consumer co-op. When REI performs well, consumers earn an annual 10% dividend based on the eligible purchases they made that year. While traditional companies aim to increase payouts to shareholders via dividends or buybacks, co-ops benefit consumers/users and incentivize participation to drive further value creation.

Co-ops are an old idea, dating back to the mid-1700s. So why don’t we see more co-ops out there? Mostly because co-ops are both capital and operationally inefficient — organizing, coordinating, and incentivizing millions of equal shareholders is difficult! Co-ops tend to get out-competed by leaner, traditional companies with better access to capital.

Blockchains can improve the operational efficiency of co-ops, making them attractive models to port onto a decentralized substrate. But again, the governance innovation here is mostly in efficiency and automation, not in fundamental design.

Convergent Evolution or Lack of Innovation?

Given all this, we’re brought back to the original question. This convergence between centralized and decentralized governance — what does it mean? Is it a sign that we’ve failed to innovate? Or is it that centuries of evolution and competition has already led us to the optimal ways to govern organizations?

We don’t know for certain. But it seems that mirroring traditional company governance is the right path forward, at least for now.

So far, decentralized governance has been more translation than innovation. You could say blockchain governance is currently in its imitation phase. With new governance tokens being launched daily, entrepreneurs will need to wander the governance idea maze before they can discover the best governance mechanisms. We’re hopeful that this is a product of being early days, and over time, better structures will emerge. At Dragonfly, we’re excited to work with the best entrepreneurs innovating in decentralized governance. If you’re doing something genuinely new here, come talk to us. We’d love to hear from you.

Thanks to Ivan Bogatyy, Tom Schmidt, and Jesse Walden for their comments and feedback on this piece. For more of our writing, follow us on Twitter at @ashwinrz and @hosseeb.



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Ashwin Ramachandran

Ashwin Ramachandran

Researcher at Dragonfly Capital. Previously Engineer/Researcher @ThunderCore, CS @DukeU