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Magnify #15: Decentralized Governance Sounds ScintillatingšŸ˜

Oct 11 2022
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We may have used (and even abused) the term decentralized governance without understanding what it is and asking the right questions.

The need to look for decentralized ways of governing a protocol has never been greater. As protocols have developed, there has been a need to govern/control them, so they keep functioning without needing any meddling by any centralized authority. In the pursuit of ensuring that, we have attempted to establish decentralized governance.

In a nutshell, it can be defined as governance that needs no external single, centralized institution to influence and/or control the development of a set project/protocol/network it aims to govern. Instead, this power is reserved for the hundreds of thousands of members who hold the projectsā€™ native currency. This is both a definition and an end goal. And below, Iā€™ll explain why itā€™s more of a latter than the former

Decentralized governance is marred with challenges, and as we have seen in the past, some significant questions have bugged us.

Is incentivizing good behavior enough to dissuade malicious activity on the network while ensuring that the governance power on the network is evenly distributed?

That's a mouthful. Let's break it down.

Decentralized governance takes pride in rewarding good behavior and punishing bad one. This approach is no different from the one we see in our world now. Governments exist because good behavior can be recognized and rewarded and bad behavior punished. But as we see with corrupt governments, colloquial policies, and a nonchalant attitude towards the bigger problems, that incentive hasnā€™t worked very well.

Another key point to note here is that this makes incentives the only driver of any type of behavior in the market. And not all incentive-inspired behaviors are positive/for the greater good. Just take Lido, for example. Upon being criticized for perpetuating a stake centralization problem (Lido currently has 30% of all staked-ETH staked via its protocol), the governance on the protocol decided to ask its members if they agreed to self-limiting the amount of ETH that could be staked via the protocol. Here are its results.

Can we measure the communityā€™s behavior on a moral compass in this case?

No major LDO token holders would want the protocol to cut its growing branches of profit and self-limit itself. And in this case, the community is acting without bothering about the impact of their long-term actions. This leads us to more critical questions, such as

  • what happens when impacts on profitability outweigh the significance of making the right decision in decentralized governance (esp. for members who have a large influence over the protocolā€™s governance because of their large holdings)?
  • can we trust thousands, if not hundreds of thousands, of members otherwise to make a well-informed decision to counterbalance the profit-seeking attitudes of those mentioned above?

To further explain this, letā€™s take an example. Suppose you and I are part of the protocol governance where you have 100x more tokens than I do. Now, if a governance decision needs to be made that has the power to impact the profitability of the protocol by (negative) 5%, you are more likely to vote against it. Even though I might want to counterbalance your stance, I canā€™t because you have much more influence.

Add to that, why do you think I would care? If Iā€™m simply a retail user, then Iā€™m not concerned with where the profit of the protocol goes as long as:

  • I get my airdrop, and
  • I can make a profit from the market fluctuations in the token.

What Iā€™m trying to say here is that:

  • we canā€™t fully trust an entity that has a large holding of the protocolā€™s tokens because a rational thirst for perpetual profit would drive them,
  • we canā€™t fully trust the thousands of community members because they donā€™t have enough incentive to make a strategic and well-thought decision.

In decentralized governance, who assumes more responsibility?

This would be a simple and direct answer: the protocolā€™s core team members and early ambassadors are more likely to assume a higher responsibility than the speculators or even part-believers (people who like the protocol but are still here for speculation). And by responsibility, I mean an ability to sidestep from a profit-driven pursuit to influence the changes in the protocol. However, the core teamā€™s changing structure (such as some members leaving) can influence how governance is managed.

But what about other members whose primary objective may not be aligned with the long-term vision of the protocol? The only way would be to train/educate them to start thinking similarly.

With governance token holdings come responsibility. And that responsibility can either be self-assumed and/or learned. The latter would only come from the core members.

That is not to say that the core members and ambassadors are the only individuals who would assume responsibility for the protocol. What I am implying, however, is that that is where the inspiration to assume responsibility will come from.

The right governance structure

To be honest, when it comes to the rules of a DAO being encoded into the blockchainā€™s smart contracts ā€“ it is the same as rules written in a constitution. True, the additional implementation/execution layer comes with the latter, but with significant token holdings, the rules of any DAO can be changed.

And this is where private organizational structures also come into play in a DAO. If two dominant players in the governance of a single protocol battle it out over which improvement proposal gets implemented, then that entity which has more leverage over the protocol (such as locked/unvested token holdings) or over the community (such as having more social influence) will have a greater influence. Moreover, in an alternative environment, the two entities could coalesce to form a union and influence the implementation of that proposal that best suits their combined needs.

In such a case, the governance would dwindle to a few members in the board room changing the rules of the company without thousands, if not hundreds of thousands, of employees not being aware of why the implementation took place at all.

Cost of exit

Another factor that plays a crucial role is the cost of exit. If the cost of exit for an entity from any network is too high, then the entity in question is more likely to pay closer attention to the impact that they have on the protocolā€™s governance. This will be true for entities with a greater number of token holdings. On the contrary, for individuals with a handful of governance tokens of a network - all they need is the right time to dump their tokens in the market.

Thus the cost of exit is directly proportional to the amount of effort an entity is going to put in to influence the governance of the platform.

Closing Thoughts

Decentralized governance sounds scintillating in connection to cryptoeconomics - but the truth is that it is not too far from the models that already have in existence today. We should both:

  • be wary of the similarities between decentralized governance and traditional constitutional governance, and
  • be aware of the challenges those similarities would bring over to this side.

As protocol founders, developers, researchers, and general crypto enthusiasts, we must continue researching and finding stronger governance models where all types of users have some incentive to aid in the protocol's governance. Else, we might be left facing the same problems as we see with current government structures.

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