Learn on SubDAO: DAO Governance Matters for DeFi

At the Ethereal Summit and the Ethereum Community (EthCC) 2021 conference, Ethereum creator Vitalik Buterin shared his views on DAOs (decentralized autonomous organizations), NFTs (non-fungible tokens), and DeFi’ s (decentralized finance), although he addresses the future utility of the Etherum, it still shows that these three things are weighed in the whole industry.

Booming of DeFi and DAO

Since DeFi has boomed in 2020, it has been no strange for us anymore. However, at the very beginning of the DeFi, it really brings an influx in this crypto sphere. The total value locked in DeFi contracts is more than $204.5 billion, as of October 9th, 2021. The total value locked is calculated by multiplying the number of tokens in the protocol and their value in USD. Though the total figure for DeFi may sound substantial, it is still in the very state of evolution.

At the same time, the development of DAO also is a big part. The DAO development history is legendary in which the huge amount of funds has been related in the very beginning. The DAO was initially seen as a revolutionary project and raised $150 million in Ether (ETH], one of the greatest crowdfunding efforts of the time. We all know the story, the DAO is attacked and the funds have been stolen. Although the setback occurred in the very early stage, it never hinged the steps that people continued to explore the new field.

Now we can see that the organizations that initially launched these DAOs slowly give away control of the project to one day become irrelevant. Token holders can actively vote on governance proposals to hire new contributors, add new tokens as collateral for their coins, or adjust other parameters. Now, the list of DAOs is extensive. Over time, it has become a clear concept that has been gaining traction.

In 2020, a DeFi lending protocol launched its own governance token and distributed it through a liquidity mining process. Essentially, anyone who interacted with the protocol would receive tokens as a reward.

Development oF DeFi Needs the DAO Governance

Decentralized finance, or DeFi, is a system by which financial products become available on a public decentralized blockchain network. That makes them open to anyone to use, rather than going through middlemen like banks or brokerages. Unlike a bank or brokerage account, a government-issued ID, Social Security number, or proof of address are not necessary to use DeFi. More specifically, DeFi refers to a system by which software written on blockchains makes it possible for buyers, sellers, lenders, and borrowers to interact peer to peer or with a strictly software-based middleman rather than a company or institution facilitating a transaction.

As to realize the final aims of DeFi, there will be multiple technologies and protocols are used. DAO is one of them.

DAOs are “non-hierarchical organizations that perform and record routine tasks on a peer-to-peer, cryptographically secure, public network, and rely on the voluntary contributions of their internal stakeholders to operate, manage, and evolve the organization through a democratic consultation process”. DAOs are in common use for DeFi and conservatively oversee more than $543 million. DeFi DAOs help users transfer cryptocurrencies across different blockchains and serve popular DeFi use cases such as crypto lending or yield farming.

DAOs are open-source, thus transparent, and, in theory, incorruptible but depending on the governance rules, there are different levels of decentralization. While the network might be geographically decentralized and have many independent but equal network actors, the governance rules written in the smart contract or blockchain protocol will always be a point of centralization and loss of direct autonomy. DAOs can be architecturally decentralized (independent actors run different nodes), and are geographically decentralized (subject to different jurisdictions), but they are logically centralized (the protocol).

DAOs have both internal and external governance components. Internal governance is characterized by non-hierarchical modes of governance and has quasi-democratic features. External governance is the reliance on clusters of servers and individual nodes for the functioning of the network and decision-making. Notably, those who control nodes and server capacity can exert undue influence on decision-making, and in a stronger way than other actors.

The key blockchain-based governance tools are:

  1. Tokenization: the process of transforming the rights to perform an action on an asset into a transferable data element, a token, on the blockchain.
  2. Self-enforcement and formalization of rules: the process of embedding organizational rules in the form of smart contracts.
  3. Autonomous automatization: the process of defining complex sets of smart contracts as DAOs, which may enable multiple parties to interact with each other, even without human interaction.
  4. Decentralization of power over the infrastructure: the ownership and control of the technological tools employed by the community through the decentralization of the infrastructure they rely on, such as the collaboration platforms (and their servers) employed for coordination.
  5. Increasing transparency: the process of opening the organizational processes and the associated data by relying on the persistence and immutability properties of blockchain technologies.
  6. Codification of trust: codifying a certain degree of trust into systems that facilitate agreements between agents without requiring a third party.

The Utility of the DAO and DeFi

Uniswap is one of the latest successful DAOs in the DeFi space. After a successful launch of its decentralized automated market-making protocol in 2018, the team moved to launch a governance token that would transition Uniswap into a decentralized community governed by its users. Now, Uniswap users are not only able to supply liquidity to the decentralized exchange but also submit governance proposals to the platform.

The problem in the DeFi and DAO

Governance in decentralized systems can be compromised because most DAOs raise money in one way or another and in return, investors get back governance tokens. This creates a high degree of centralization at the start of token distribution. Users see tokens as yield, not voting rights, leading to a very individualist approach to collaboration. Furthermore, there are no minimum numbers for participation in order to kickstart the governance. In order for a system to be considered sufficiently decentralized, there needs to be a high minimum number of token holders/participants. In many DeFi projects, these economic incentives are offered for providing liquidity, via governance tokens, and encourage competitive and speculative behavior which leads back to a centralized governance structure, since tokens slowly concentrate in a few hands.

Why is this a problem? Projects can become vulnerable to attacks because of excessive centralization and parties with a conflict of interest can push through proposals, and activist investors can acquire a significant enough amount of governance tokens to help push through proposals profitable to them.

The vulnerabilities of DAOs also lie in automation. The organization is governed and operated by smart contracts, the smart contracts which form the governance are written and executed as computer code. The monitoring and enforcement of smart contracts are by computer algorithms, and there are weak or non-existent mechanisms for dispute resolution, since the “code is law,” and all participants have agreed in advance to abide by the code of the smart contract.

Future growth and trends

While each DAO works a little differently from others, they generally function through holders of governance tokens voting on proposals for actions.

DAOs embody some of the core benefits that come with operating on the blockchain, including co-ownership, co-governance, and more, generally speaking, models that are designed around participation and consensus. This time around, DAO best practices are evolving and aspects like tooling are getting better.

Given the growth of DeFi (a sector that includes decentralized exchanges), it’s little surprise that people are becoming more willing to launch and use DAOs.

In terms of the near future, one trend we’re already seeing and will see more of is that DAOs will become more complex and multifunctional. At the same time, they’re also streamlining and simplifying their user experience.

The application layer has become a lot easier and cheaper to operate and best practice procedures have been established, acting as a key driver for the success and use of DAOs. Examples include Aragon, which has improved its DAO stack, and SubDAO, which has created a cheaper and more inclusive way to operate DAO decision making.

The new tools are being introduced for creating new capabilities to help run DAOs more efficiently like SubDAO, and even extend decentralized governance to smaller use cases. For example, SubDAO has established multi-signature secured vaults and a treasury management suite, also uses an off-chain voting system.

More generally, we expect a significant increase in DAOs and in the use of “autonomous financial instruments,” particularly in the DeFi sector. These will set the tone and trend for further mass adoption in other areas. Usually, tech needs a sector to lead the way and we believe with DAOs it will be the DeFi sector that is quickly crossing over to the financial sector. Given the growth of DeFi (a sector that includes decentralized exchanges), it’s little surprise that people are becoming more willing to launch and use DAOs.

DeFi is still in its infancy as an industry and the concept of DAOs is still relatively young, so we will continue to see a greater number of players entering the market and making improvements. As with all emerging and unregulated technologies, DeFi and DAO continue to be a case for “caveat emptor”.

About SubDAO

SubDAO is a DAO infrastructure based on Polkadot, where any decentralized organization is allowed to conveniently create and manage a DAO. SubDAO does not only connect DAO with DApps to realize DAO’s cross-chain management but also bridges Web 2.0 and Web 3.0.

The founding team of SubDAO is composed of the former Technical Team leader of the IBM Group and many early well-known developers from Polkadot. All team members own rich experiences in Internet companies such as IBM, Tencent, and Alibaba. Jack Platts, former Director of External Cooperation of the Web3 Foundation and Partner of Hypersphere Ventures, serves as a strategic contributor to SubDAO. So far SubDAO has completed multi-million dollar financing including Hypersphere, Huobi Ventures, and other institutions.

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SubDAO is a DAO infrastructure based on Polkadot. It allows any decentralized organization to swiftly create and manage DAOs.