Recently, with the launch of yEarn/YFI and COMP, people have been getting really excited about decentralized governance systems again – well, more excited than they have been with all the DAO activity happening lately. In today’s piece, I’m going to explore the different kinds of governance systems out there in the context of blockchains.
Just a note: I’m not going to cover yEarn/YFI in detail in today’s piece so if you want to learn more about it then you can read this excellent piece from Daryl Lau. You can also check out information about Yield Farming both YFI and other tokens here.
When it comes to governance in the context of blockchains, there are two core types – binding on-chain governance and off-chain governance. “Binding on-chain governance” is when a blockchains rules can be changed by token holders (such as in Polkadot) and off-chain governance is when those rules cannot be directly changed by token holders – rather, they are changed by an off-chain process (that can also use on-chain processes as a signal).
The Ethereum blockchain itself does not have any form of binding on-chain governance so ETH holders cannot directly change the protocol rules by all banding together to vote with their coins. For the protocol’s rules to change, it has to go through an off-chain governance process (via Ethereum Improvement Proposals) that involves a number of diverse parties (developers, ETH holders, community members, ecosystem spokes/projects, and miners/other network participants). Ethereum Improvement Proposals (EIPs) are changes that can be proposed by anyone and follow a defined process that eventually ends in the EIP moving to an ‘Accepted’ state. Once an EIP is in the ‘Accepted’ state, Ethereum client developers will code up an implementation of it for inclusion in a future network upgrade (hard fork). A network upgrade date is typically set based on a block number sometime in the future. Once that block is mined (and if everything went well with the upgrade) then that EIP will be live on the network.
Projects built on top of Ethereum can use either an on-chain, off-chain governance mechanism or no governance mechanism at all. For example, Uniswap v1 does not have any governance built in – the smart contracts will simply live on Ethereum forever and cannot be altered (unless someone was able to gain control of the entire Ethereum network of course). On the flip-side, all parameters for projects like yEarn can be changed by YFI token holders through a binding on-chain governance process. Other examples include MakerDAO where MKR holders can change parameters such as the stability fee and add new collateral types as well as Compound where COMP holders can alter things like collateral ratios for assets.
Personally, I’m not a big fan of on-chain governance for layer 1 (aka the blockchain itself). I won’t dive into every reason as to why I’m bearish on the idea but the main reason is basically that I believe on-chain governance systems are just plutocracies dressed up in fancy tech. You can just look at the token distribution of these new on-chain governance chains for proof – the distribution is typically centralized in a few big players hands. Additionally, if the base layer is at the mercy of a small set of token holders then that means every app built on top is also at the mercy of those same token holders.
Speaking of token holders – getting a “fair distribution” of tokens among a wide and diverse set of people is also incredibly hard. What’s even harder is incentivizing these same people to actually participate in the governance process and using their tokens to vote (instead of just speculating). This isn’t even taking into account how difficult it is to get a bunch of people to actually agree on something! The best token distribution that I’ve seen so far was the recent YFI yield farming event that basically launched with no founder or team allocation, no pre-mine, no investor/VC tokens – just a simple fair launch for everyone to participate in. This has actually resulted in an amazing distribution of token holders so far (note that there are currently only 30,000 YFI tokens in existence).
In saying all of this, with different apps on Ethereum now becoming so intertwined, it begs the question: can one app that is governed by token holders be compromised to bring down the majority of the network? Well, we can take Maker as a simple example here. Dai is used in basically every app on Ethereum as it’s a core building block of DeFi so what happens if the Maker platform is messed with in some way by token holders? In theory, MKR token holders could vote to do things like change the oracles so that they reflect a price of $0 (causing liquidations) or directly drain the vault of ETH. Though, in Maker’s case, there is a delay of 12 hours on changes going through once approved by governance. Though do note that this delay can also be changed by Maker governance!
Obviously governance isn’t exclusive to crypto-networks/blockchains – these are issues that humanity has been dealing with since we came into existence. What blockchains do enable are new ways to coordinate using both cryptoeconomic and social incentives in a globally distributed way. Which way is best? Only one way to find out!
Have a great day everyone,
All information presented above is for educational purposes only and should not be taken as investment advice.