The Pain of DeFi Governance: How to Avoid Being Co-opted by Oligarchy?

Author: Zaheer Ebtikar

Compiled by: Hu Tao

DeFi governance is one of the hottest topics in recent discussions within the DeFi industry, from Uniswap's proposal to fund a DeFi education fund with 1 million UNI, to Sushiswap's proposal to sell tokens at a discount to certain investment institutions, and most recently, the proposal to list the BOND token on Aave was rejected by a few whale addresses with a 99% opposition rate, raising public concerns about the abuse of governance power by certain DeFi oligarchs.

Zaheer Ebtikar, a partner at Immutable Capital, recently analyzed the issues exposed in the DeFi governance process on the Deribit blog. He believes that the participation rate in governance for most DeFi protocols is generally too low, due to reasons such as high participation costs and an overwhelming number of proposals. Additionally, there is an issue of governance power being overly tilted towards token holders rather than the main contributors of the community, and he also proposed corresponding solutions.

It's that time of year again when that annoying kid in school is everywhere, asking you to vote. You read the list of promises on the campaign flyer and wonder why anyone would bother with these student government positions (I know, because I used to be that kid in school).

The game opposes any form of governance work: no one really cares about the decisions made, except for a few; real power is held by a small number of people—teachers and administrators.

Like school government, DeFi governance is largely seen as a ruse to make participants believe the process is democratic. In reality, many decisions are often made by the higher-ups at the expense of the end users. A system that forces the elite to become "angels" often lacks the feasibility of long-term decentralized governance.

1. Why Most Users Do Not Participate

Staring at the campaign speeches outside, you realize that most people really aren't bothered by what's happening around campus. Too many town halls happen because you don't really care or don't have enough bandwidth to participate. In its simplest form, cryptocurrency faces the same issues as other areas of the world, primarily stemming from small governments. The vast majority of people simply do not participate, and the following data can confirm this:

The most obvious problem with current protocol governance is the interests of the final voters—why would they spend time voting? Generally speaking, whether for economic or moral reasons, most people have motivations to participate in governance. Similarly, protocols that want better governance outcomes should start considering proactive ways to incentivize good governance. Simple solutions include using a small token treasury to incentivize dedicated members of the protocol to vote on key issues and help find meaningful ways to understand new proposals.

One of the main issues with protocol resolutions comes from the ineffective execution of a large number of proposals. Anyone participating in governance can propose changes to the core functions of the protocol. The resulting problem is that meaningless and interesting proposals are mixed in with an endless stream of governance proposals, ultimately leading to too many proposals for most people to care about. Instead, allowing incentivized members to reach the quorum for new proposals and filter the resolution list may be beneficial.

Finally, there is the issue of gas costs and smaller users. Generally, token founders and DAOs should minimize the entry barriers for the smallest participants as much as possible, including gas transaction costs. At a fundamental level, founders can incentivize good governance by using part of the token funds to subsidize gas fees for delegators below a certain threshold.

2. Oligarchy

The form of governance by oligarchs and elites seems to be one of the most common natural forms of primitive government. The idea that commoners should transfer their voices to elites and knowledgeable individuals is an attractive notion in any society (for the wealthy), but it rarely brings better outcomes for the majority. DeFi is no exception.

Like any new field, early DeFi was largely initiated by venture capitalists hoping to support new forms of financial technology. However, with the growth and development of DeFi, some structural issues regarding the true decentralization of protocols have emerged, primarily because they cannot conduct coherent governance and ultimately do not operate like a cartel.

In DeFi, governance typically occurs through voting, and proposals must meet a certain voting threshold to pass. These votes are usually allocated based on token ownership. The more tokens an entity holds, the more votes it has, thus wielding greater influence. On paper, this seems like standard democracy. But this simple mechanism contains the seeds of stagnation in DeFi governance.

The token and development process is as follows:

Now, this does not apply to all tokens (fair distribution, airdrops, etc.), but generally, tokens tend to shift to entities with the most resources. The problem is that this process often stifles the smallest users, even if they might find the protocol or project most useful.

A simple solution to this problem is what Compound has done with their voting delegation to governance politicians. The idea here is that the community can delegate their votes to certain politicians who act on their behalf for governance, allowing smaller users to concentrate their votes. The issue is that in today's world, Compound's governance still largely reflects a very heavy voter class, with four out of the top five holders being venture capitalists.

The problem is that this measure still does not actively make it easy for small protocol users to unite behind a few users, and it still leads to a small number of users holding a large amount of voting power. Interestingly, in some governance structures, large token holders still do not participate in governance forums, rendering a significant number of votes useless or easily swayed by other users in contentious proposals. Overall, this process alienates the majority of users while sacrificing those who are "in."

3. Proof of Contribution

Protocols should not focus on the largest token holders but should seek what is known as proof of contribution, though this term should not be used as a consensus mechanism but should apply to governance weight.

In theory, the structure of governance should focus on both the primary users with the highest community participation and the largest token holders. A simple mechanism could be to split governance through token distribution, issuing it like multiple classes of stock, where ownership and voting rights are not evenly distributed.

This process can be accomplished by restricting voting rights to dilute large inactive participants and prioritizing the minimum for smaller voting groups for new proposals. Additionally, protocols can leverage their longest holders/stakeholders to gain more or less voting tokens/credits to incentivize long-term participants to take governance issues more seriously.

4. Conclusion

DeFi is still in its infancy, being just a part of our ecosystem that has only recently begun to meet most of its demands and uses. In this process, challenges such as governance and people's participation are to be expected and are significant indicators of growth.

If the industry can take sufficient measures to create a streamlined proposal and change process, lower the entry barriers for small participants, and incentivize a broader ecosystem to participate in the governance of its protocols, then we are likely to see a fully transformed system achieve decentralized autonomous decision-making.