Becoming Decentralized Enough: The Case For DAOs

Friday, 9th of August 2019 · by

A major critique of Decentralized Finance (DeFi) is around how decentralized it really is. Critics assert that we cannot label protocols such a Maker, 0x , Compound, and others as "decentralized" if they have a centralized company that can exercise control over the protocol's smart contract, disable, or kill the contract at any time. They suggest that these protocols should be described as non-custodial financial services at best.

Though the argument is valid, there are a number of strong counterarguments that defend the need for such controls. The most sound argument in this regard is to account for a temporal dimension: DeFi protocols cannot start 100% decentralized from day 1 but can become less centralized overtime. There should be some mechanisms, such as the emergency kill switch, to halt operations if necessary to protect user funds.

Another strong argument is that all these protocols are open source and auditable. If the developing company decided to kill/quit the project, the code is available for other companies/individuals to use.

Regardless of the camp you're in, we can all agree there is room for improvement when it comes to DeFi decentralization. And DAOs or Decentralized Autonomous Organizations may be prime tools to further improve decentralization of a DeFi product. DAOs allow DeFi users to decide on major decisions such as adding features or deploying a new version of a DeFi protocol. Moreover, users can vote on who activates an emergency switch - or even create a child-DAO - to handle such a critical task.

In this article, I discuss why DeFi protocols will eventually need to decide between delegating control to a DAO to become truly decentralized or clearly forming into a centralized business that facilitates non-custodial financial services on public blockchains. Each of the two options could be a valid and sustainable model with different trade-offs and goals.

Though the concept of the DAO is a cornerstone in enforcing the decentralization of DeFi projects, this doesn't mean projects like Maker or Uniswap are already 100% decentralized. Instead, these projects have set themselves on a path towards decentralization and there's a long road ahead towards realizing that goal.

Why DAOs Are Essential For DeFi Decentralization

First, a working definition of a DAO for our purposes:

  1. DAO membership is open and is not limited to a specific group.
  2. DAO members /shareholders can propose/vote on changes and their decisions cannot be blocked or modified by a central authority.
  3. The DAO members receive direct or indirect financial incentives from participation to guarantee alignment of incentives.

These characteristics are essential for effective decentralization. In that sense, we can consider Bitcoin as the most successful DAO. In Bitcoin anyone can participate by running a node or just owning bitcoins, anyone can propose, support or criticize BIPs, and finally, every participant benefits, at least indirectly, from participation and keeping the system functioning according to the rules.

Similarly, these characteristics are what makes DAOs great governance mechanisms for DeFi products to become truly decentralized.

Another benefit of utilizing DAOs in DeFi protocols is that, if done right, they may help alleviate some regulatory risks for developers of such protocols. In fact, this is a complex and nuanced legal topic that requires a separate post in its own right. While many developers think that if they don't have control over the smart contracts they shouldn't be liable for how they are used, regulatory bodies like the SEC think otherwise.

MakerDAO and Where It Falls Short

MakerDAO was one of the earliest DeFi projects to recognize the need for a DAO to govern many of the critical parameters needed for the operation of the Maker project. The most notable of these is the stability fee which is simply the interest rate charged on CDPs. The voting of MKR token holders for successive increases of the stability fee during March and April of this year was the main reason it was possible to bring DAI price back to $1 after trading 3–4% percent below the peg value.

Maker stability fee changes. Source: mkr.tools and DAI/USD price source: Messari

Another important decision that MKR holders need to vote on soon is the selection of the ERC-20 tokens to be used as collateral for the multi-collateral DAI (MCD). The Maker community would select between REP, BAT, DGD, 0x, GNT or OMG to use as collateral in addition to ETH.

Although Maker's DAO structure gives MKR holders multiple governance rights, Maker utilization of the DAO is not perfect. While, theoretically, almost any decision related to Maker can be voted upon as a governance proposal, many decisions are decided without a vote such as the hiring of executive team members and the spending of the project funds. Another limitation of MakerDAO is the current distribution of the MKR tokens which allows a few entities to decide the outcome of most votes if they decide to participate.

Decentralized Exchanges and DAOs

Decentralized Exchanges or DEXs were the first products of what we call today as DeFi. While the goal is to allow users to trade and exchange tokens in a noncustodial and decentralized way, DEXs are the hardest systems to decentralize without sacrificing significant functionality and performance. To explain why let's consider the core operations of any DEX. These operations include

  1. Deciding on what tokens to list.
  2. Organizing order books, facilitating trade execution and order matching
  3. Capturing trading fees as the DEX revenue

Of the three operations, the second one is the hardest to decentralize. While accepting limit orders to create order books can be done using on-chain transactions, it is costly and suffers from significant performance bottlenecks. Even in such a scenario, centralized servers and websites are needed to read the blockchain data and display the order books to users. Improving performance usually means adding more centralization by utilizing centralized off-chain order books and trade-matching engines. DAOs have been long considered as a mechanism to resolve this centralization issues as we have seen in IDEX, 0x, and even Uniswap.

Uniswap's Invisible DAO

It may be strange that I have included Uniswap in the DAO category even when the project team is not marketing it as one. However, a closer look under the hood of how Uniswap operates shows it perfectly fits the definition of a DAO.

Of the three operations required by any DEX, Uniswap elegantly automates the second and hardest operation and performs the first and third operations in a DAO-like fashion. The hardest piece of the DEX puzzle, which is the market making and order matching, was solved using an automated market-making technique and creating a single trading price decided automatically by the smart contract.

How Uniswap works as a DAO

For the token listing decisions, Uniswap allows any DEX participant to "list" any ERC-20 token for trading by allowing them to create a liquidity pool for this token against ETH, DAI or any other token. By providing liquidity to the created pool, participants own shares in the pool entitling them to the pool revenue. Participants can "delist" a token by withdrawing the liquidity and burning their pool shares. Through that process, the DEX participants have all the authority to list or delist any tokens. In addition, all of the Uniswap fee revenue (0.3% of every trade) goes back to the liquidity pool shareholders. This way, Participants benefit directly from the operation of the system.

Given this architecture, Uniswap nicely fits the DAO definition ; 1) It is an open organization where anyone can obtain shares by providing liquidity, 2) participants effectively decide what tokens to list/delist by allocating capital to their selected pools, Uniswap team cannot block the participants decisions, and 3) participants directly benefit from owning the organization shares.

Still, Uniswap can benefit from a formal DAO governing the system that may make decisions such as changing the fee structure, upgrading the automated market-making techniques, or adding features to the Uniswap DEX.

Why Cannot Other DeFi Projects be considered as DAOS

Many interesting DeFi projects and protocols implement elements of a DAO such as voting or earning benefits by participating in the protocols. However, they cannot be classified as DAOs if they don't fit the three main requirements. For example, the lending protocol Compound is open for participation for anyone and participants in the protocol benefit of participation in the form of earned interest. In addition, the platform users can vote for what coins to offer for lending or use for collateral similar to what happened with WBTC listing. However, such votes are not binding and the project team can ignore the voting results. This comes in contrast to MakerDAO's voting which is performed using a smart contract where the voting results cannot be overturned by the project team.

Similarly, the decentralized exchange IDEX is adopting a gradual approach to decentralizing the platform by allowing the platform users to run elements of the DEX infrastructure via staking the project's token. Users who help with running infrastructure nodes earn a percentage of the platform trading fees, currently 25% of the trading fees. However, IDEX doesn't fit the definition of a DAO as users have no say on what tokens to be listed on the exchange.

Other Areas Where DAOs Can Benefit DeFi

In addition to improving the distribution of control of the current DeFi products on Ethereum, DAOs can play a significant role in bringing DeFi to Bitcoin. Many of the viable approaches to utilize Bitcoin in DeFi depend on creating a sidechain, such as Blockstream's Liquid, or creating a Bitcoin peg zone on other blockchains such as Ethereum, e.g., WBTC, or Cosmos. The fundamental issue with such solutions is the selection of the validators who maintain the pegging process. For example, in Liquid sidechain, 35 trusted entities were selected by Blockstream to act as members of Liquid Federation that oversees the peg to the Bitcoin blockchain. The problem with this approach is the centralization on the peg validator selection. This issue can be significantly improved by using a DAO where participants can decide on who would act as a validator. DAO participants could be also rewarded by the fees generated in the peg zone to incentivize them to operate honestly.

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Author

Mohamed Fouda
Cryptocurrency Researcher and Investor. TD research | PhD Northwestern University https://medium.com/@fouda