Defi Has a Governance Problem: How to Fix It
DeFI-focused DApps appear to be crypto’s new catalyst for a greater bull market. Still, are they as fair to the user as they are cracked up to be? Yes, the DeFi market is currently valued at over $1.5 billion, but it has a major governance problem.
Through the example of the Compound ecosystem, it is easy to understand how this works out.
Similarly to Defi Protocols such as Maker, Compound has taken staking and attempted to use it as a key part of a decentralized lending system. When users send supported cryptocurrencies to its smart contracts, they receive what are called cTokens that give them(in theory) more interest, the more tokens they own. The crypto they’ve locked in for these cTokens then gets lent out to interested parties.
Holders of cTokens are also entitled to receive COMP, which is Compound’s governance token. If you’re not familiar with what a governance token is, think of it as a vote.
As with Maker’s MKR token, the majority of COMP are either controlled by its development team or powerful investors like A16z(Andreesen-Horowitz) and Coinbase. Some sources put this number at 58%, versus 42% that are currently available to the public.
According to DeFi Rate, unlike the one coin, one vote system that some stake-based systems use, the weight of a COMP holder’s vote is determined by interest earned, together with interest paid. Therefore, to truly make your vote count, it is not enough to just buy up COMP. You’d also have to be a frequent lender and borrower in as high volume amounts as possible, which actually leads to further centralization.
Just as in the fiat system, those with the deepest pockets, which in this case are rich investors and cryptocurrency exchanges win. Until that changes, the future of Compound and other DeFi systems will continue to be decided by a plutocracy.
How to Make Things Right: Skin in the Game
If you find yourself feeling now that DeFi is nothing more than the traditional finance system on the blockchain, then you’re not alone. Skewed governance leads to centralization and a perpetuation of the status quo.
This can and has to be fixed, which leads to the heart of the argument here.
“Skin in the game” provides a better way.
In the cryptocurrency context, this refers to buying-in, in order to be one of the leaders of a protocol or DApp. Compound, for example, applies “skin-in-the-game” through its method weighting votes. Still, as previously mentioned, this mechanism is flawed because it allows those with the most currency in the ecosystem to control it.
Cryptocurrency firms like Numerai are already working on changing governance systems like this one for the better.
This year, their blockchain protocol called Erasure went live via its first application called Erasure Bay.
Overall, Erasure Bay is a decentralized marketplace for information with a simple, yet fair application of “skin-in-the-game.”
Anyone can request any information from anyone, but to do so, they have to stake DAI as payment(reward) in advance. The “fulfiller” of their request then needs to satisfy what is called a griefing ratio, which is a percentage of the DAI reward that the requester sets in advance. According to Numerai’s team, in most cases, 10% of the reward seems to be the norm. To satisfy this ratio, a fulfiller needs to stake DAI that’s equivalent to it before working on the request involved.
In practice, all of this would mean that a $200 reward could have a 10%($20) griefing ratio and therefore require a $20 stake from an interested fulfiller.
The key benefit for the requester in such a scheme is that if the fulfiller provides inaccurate or low quality information, their stake can be destroyed. This falls in line with one the central ideas involved with skin in the game that people tend to act more fairly if they truly have something on the line.
In other words, monetary risk engenders further accountability.
How can Erasure be applied to governance systems like Compound’s?
Surprisingly, this idea of “skin-in-the-game” or recourse for both sides of any platform has not been widely adopted yet. Lending credence to its massive potential, however, is that implementing the Erasure protocol on any DApp or service is extremely simple.
All of these actions that occur on Erasure Bay are facilitated behind the scenes by the Erasure smart contracts. Since the Numerai team’s ultimate goal is for Erasure to underpin every aspect of the internet, they’ve made its smart contracts fully open-source and easily composable for any interested team using what is called a clone-factory. Generally, this is a system in which one team’s Ethereum-based smart contracts can be used by others with mere hashes of them. These hashes, in turn are called “minimal proxy contracts” because they allow multiple services to run the same smart contracts with only a few lines of code.
Because of this, MPCs make it easier than ever for protocols to rapidly increase their value through widespread usage as per the popular “fat protocol” theory. Essentially, in Erasure’s case, it’s “plug-and-play.”
Compound could create Erasure MPCs, then develop its own system that puts the power of governance back into the hands of the user without changing the core of their voting system. Consider, for example, delegated proof-of-stake systems like Tezos.
Average users send Tezos to “bakers,” who vote for them because they meet the threshold of having 10,000 or more XTZ. Despite how this may look, Tezos’ governance system may still be considered as decentralized because users can pull their stake if the baker they are affiliated with, votes against their wishes.
Since services like Defi Rate have already begun acting as delegators for COMP holders, it is reasonable to expect that Compound might turn out similarly over the long term.
If we were to imagine Compound as a fully dPoS system, then it is easy to see where the Erasure protocol comes in.
Through the principle of “recourse,” which is the center of what happens on Erasure Bay, both delegators and average COMP holders could be better protected. Delegators could be required to lock their stake into an escrow, which could then be lost any time that the system determines they have acted against the interests of the average user.
This loss could be driven by Erasure’s MPCs but triggered by something like a community review that has to reach a 51% or more to be considered valid.
The average COMP holder, in turn, could be allowed to pull their stake when they disagree with a delegator’s track record, though to keep the system as equal as possible, this could be limited to a 7-day grace period and done with a 10% griefing ratio.
All in all, Erasure’s MPCs are fully composable so these specifics can vary widely and give the team involved a wide array of options. If Compound really does shift to a dPoS governance system, then Erasure could serve it well. If not, then it may continue to favor centralized governance akin to a plutocracy.
Since Compound is the leading DeFi protocol by value, it is reasonable to expect that future projects will follow its example, which increases the importance of it getting its governance “right.”
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