Confusing Decentralized Governance: Is it Innovation or Imagination?

*Authors: Ashwin Ramachandran and Haseeb Qureshi, * respectively a junior partner and managing partner at the blockchain venture capital firm Dragonfly Capital

*Compiled by: * Perry Wang

The timeline traces back to early 2016, when the timing for transformation was ripe. The Ethereum community firmly believed that decentralized organizations (DAOs) would revolutionize governance and was ready to invest heavily in it. The DAO project emerged, gathering 10% of the circulating ETH at the time. Soon, it accounted for 1.5% of the total transactions on the Ethereum network.

Ethereum founder Vitalik introducing DAO at a conference in early 2016

Ethereum users flocked to the auditorium to hear how the DAO would represent the future governance model. The presentation claimed that unlike traditional closed companies, the DAO would make governance highly transparent, representing a gradual functional improvement over traditional governance structures. The DAO also proclaimed, "Automation at the center, people at the periphery," claiming to make the world more coordinated and efficient. Whether we liked it or not, we were being dragged into the future by the DAO.

Then four years passed, and what did we get? Did the DAO achieve a governance revolution?

Current DAOs are tangible, but their presence feels very "ordinary." Users can design and deploy a DAO with just a few clicks, and a total of over 1,900 DAOs have been deployed. The story was originally thought to be that decentralized governance would take center stage, eliminating the need for corporate structures, and governance of applications would surpass the outdated forms of traditional public company governance.

But so far, reality is stark; application governance looks almost identical to traditional corporate governance.

What DAOs initially shouted was "pursuing autonomy"—decentralized, democratized organizations controlled by the community. But current DAOs are neither decentralized nor democratized.

Just last week, two leading decentralized finance (DeFi) protocols made comprehensive changes to governance rules through a vote by 5-6 parties.

DAOs do not seem to have realized decentralized popular democracy, let alone bring a revolution to governance.

When DAOs replace people with code, they can certainly improve organizational efficiency. But the initial promises of DAOs were much more than that. They claimed to bring a democratic future that empowers all stakeholders. If that was the vision, why do ordinary DeFi users have no more influence over DeFi than users of stock and crypto trading platform Robinhood have over Robinhood?

When we initially discussed this issue, we intended to write an article explaining why decentralized governance failed to deliver its revolutionary expectations.

But at that time, I thought perhaps that conclusion was wrong.

Maybe this is not a story of decentralized governance failing to innovate. Perhaps the real story is that decentralized governance is gradually evolving to integrate with centralized governance forms.

Maybe this is not a failure, but a deeper truth: that after thousands of years of evolution, centralized governance structures are actually the best way to govern organizations?

1. How does governance work in most crypto projects?

All crypto projects follow three forms of governance.

The first is founder control. Similar to private companies, early-stage crypto projects are often controlled by their founders. Founders are responsible for guiding product strategy and the direction of company development. Companies led by founders often resemble autocratic regimes (in the realm of software governance, this is often jokingly referred to as benevolent dictator for life, BDFL), and many application-layer token startups begin their entrepreneurial journey under this governance model.

This makes a lot of sense! In the early stages of an organization, the only thing that matters is to survive. Centralized organizations with power in the hands of the founder greatly enhance the speed of decision-making and action. There is nothing inherently wrong with founder-led companies, but token projects relying on this governance form look no different from ordinary startups.

The second major governance form adopted by many token projects is "group control." Most L1 blockchains and early-stage token projects rely on a small group of "enlightened elites" to set policies, determine product roadmaps and strategic directions, and propose systemic changes. Typical representatives of this governance type include Bitcoin, Ethereum, Grin, Monero, and others. In the crypto space, these small groups are almost entirely composed of core developers.

The small group governance model allows decentralized protocols to achieve a certain degree of decentralization, transferring control from the founders to core developers. However, this form of governance is not a new creation. Many organizations have implemented this governance form over the past few decades, including The Linux Foundation, W3C, International Science Council, CERN, and IETF. This is an attempt and a feasible method for managing complex, highly technical projects.

The third governance form adopted by many crypto projects is "representative democracy" or "liquid democracy." Representative democracy allows individual users to elect a group of officials to make decisions and set policies on their behalf. Liquid democracy is more common, where people vote directly or delegate their votes to representatives.

Virtual demonstration of direct, representative, and liquid democracy, source: Dominik Schiener

"Fully decentralized" blockchain applications often adopt representative or liquid democracy in governance (occasionally proxy voting). Governance tokens grant governance rights, and voting weight is determined by ownership of governance tokens. For example, Maker (MKR) governance is close to shareholder direct democracy. Compound (COMP) adopts a liquid democracy approach, allowing anyone to vote directly or delegate their voting rights to others.

But these forms of governance existed before! Most Western countries adopt representative democratic systems. Similarly, most public companies are governed by a form resembling liquid democracy. For example, shareholders of public companies can delegate their voting rights to other shareholders to vote on their behalf. This is called proxy voting, allowing single-vote delegation (although true liquid democracy allows for arbitrarily long delegation chains—others can delegate to others).

Blockchain improves the efficiency and coordination of these governance forms, but they were not invented by blockchain. These governance structures still map to the governance structures of most public company shareholders today.

Let's take a step back and examine this parallel relationship more seriously.

2. How do public companies govern?

To understand the direct parallel relationship between DAO governance and public company governance, it is worth explaining the background knowledge in detail.

Modern public companies have two layers of governance: management and the board of directors. Management oversees the daily operations of the company, while the board provides strategic oversight and reviews management. The board consists of various types of directors, including major shareholders and directors elected by shareholders.

In DAOs, token holders replace shareholders, allowing the largest token holders to effectively serve as the board of directors for the protocol. This de facto board upgrades and guides future development through proposals or votes, helping to steer the direction of the protocol.

However, management is completely replaced by code. This is one way blockchain improves governance: replacing humans with automation.

But that is not the only reason for the inefficiency of traditional shareholder governance.

More than 80% of companies in the S&P 500 are owned by institutional investors, and the majority of large public companies' equity is held by a few shareholders (e.g., Vanguard index funds). These investors, due to the large number of companies they represent, require special entities to provide advice on all board/shareholder decisions. These entities are called proxy advisory firms.

Index funds like BlackRock rely on proxy advisory firms like Glass Lewis or ISS to provide opinions on their corporate governance. Although these proxy advisory firms have rapidly risen to improve shareholder voting efficiency, they have not truly improved the process. Expanding their business brings more profits, but they do not directly bear the costs of poor decision-making, so they have no incentive to improve the efficiency of the underlying shareholder voting process.

Proxy advisory firms are not linked to improving shareholder voting efficiency, source: George Mason

Blockchain can bring advantages in this area. Blockchain can fundamentally improve the efficiency of liquid democracy or proxy voting governance. Blockchain allows for instant voting delegation, democratizing proxy advisory services and enabling the best analysts to influence major voters and gain additional voting rights. This is a significant improvement in the proxy voting process.

3. Cooperatives in the Crypto World

But not all crypto networks parallel the systems used by most public companies. Compound directly distributes governance tokens to users and early investors in the protocol. With this approach, the team has handed over control to a decentralized liquid democracy.

Compound token distribution, source: Robert Leshner

This form of token distribution reflects a cooperative model. Cooperatives are companies that sell shares to users, creators, or customers of the company. Imagine if Uber belonged to its drivers and couriers, rather than external shareholders. Fundamentally, cooperatives coordinate incentive mechanisms by allowing users/consumers to directly control the future of the company.

The American outdoor brand REI is perhaps the most well-known consumer cooperative. When REI profits well, consumers share in 10% of the annual profits based on their eligible spending. While traditional companies increase returns to shareholders through dividends or buybacks, cooperatives benefit consumers/users by creating additional value through rewarding consumption.

Cooperatives are an ancient concept that can be traced back to the mid-18th century. But why haven't we seen more cooperative-type enterprises? Mainly because cooperatives are relatively inefficient in both capital and operation—organizing, coordinating, and incentivizing millions of equally invested shareholders is very challenging! Cooperatives can easily be outcompeted by traditional companies that have more streamlined structures and easier access to capital.

Blockchain can improve the operational efficiency of cooperatives, allowing cooperatives to create more attractive models embedded in decentralized templates. But the governance innovation here still primarily manifests in efficiency and automation, rather than in its underlying design.

4. Fusion or Lack of Innovation?

Considering all the above factors, let's return to the original question. What does this amalgamation of centralized and decentralized governance mean? Is it a signal of our failure to innovate? Or have centuries of evolution and competition led us to find the best way to govern corporate entities?

We do not have a definitive answer. But reality seems to confirm that traditional corporate governance is the way forward, at least for now.

So far, decentralized governance is merely a decentralized version of traditional methods, rather than an innovation. You could say that blockchain governance is currently in an imitation phase. With new governance tokens being launched every day, entrepreneurs need to navigate the maze of governance ideas before discovering the best governance mechanisms.

We hope this is just a product of the nascent stage, and over time, better governance structures will emerge.