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What is DeFi Governance?

Decentralized Finance (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.

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.

See you next week. Onward and Upward!

Team Gemini

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