Decentralized governance in DeFi: Examples and pitfalls



A paper by Monday Capital and DappRadar

Over the past 6 months, DeFi has become the leading moniker in the blockchain industry. The sector has shown huge growth both in terms of development, investment, and on-chain activity. 

Much of the growth was propelled by the trend in governance token mining that arguably started with Compound, but was quickly picked up by other projects.

The trend worked off several key themes: the need for projects to incentivize liquidity growth on their platforms and the need for decentralization and community ownership.

It seemed that by rewarding liquidity providers and users with governance tokens projects could stimulate interest and activity with high yields. TVL numbers responded, but as the report on decentralized governance in DeFi by DappRadar and Monday Capital details the current execution of decentralized governance may leave projects and the ecosystem vulnerable.

The decentralization of the DAO

It has often been pointed out that yield farming is a whale game. Projects may have intended to foster community ownership with the governance token distribution, but whale activity and distributions to investors and team members may have negated much of that.

The report shows how centralized token holdings have become for key projects. This goes to show that while blockchain technology and the DAO concept may provide the tools for decentralization, they alone do not guarantee it. There needs to be a proper alignment of incentives.

The risks of improper decentralization

Decentralized and centralized each have their benefits and their downsides. However, improper decentralization can lead to the project suffering from the negatives of both. The report outlines a number of key threats to such projects including:

  1. Hostile takeover and capital loss;
  2. Conflicts of interest;
  3. Domino effect collapses;
  4. Activist investors;
  5. Legal uncertainty.

DeFi has been a major catalyst for the industry. Moreover, the gaming and collectibles sector has started to look at the governance token model as well. So, it is important that the community does not overlook the inefficiencies highlighted in the report and properly address them. The bigger these dapps become the harder it may be to correct fundamental flaws.

The sector periodically experiences the pain of protocols being exploited. As the industry becomes more and more interconnected the risk and the associated downside of governance inefficiencies will only increase. So, it is imperative that the industry acknowledges these issues and properly address them.

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