PYMNTS DeFi Series: Unpacking DeFi and DAO

Welcome to the seventh installment of PYMNTS’ eight-part series on decentralized finance (DeFi).

Over the coming days, we’ll be looking at every part of DeFi — the biggest, hottest, most rewarding and risky part of the blockchain revolution. At the end of it, you’ll know what DeFi is, how it works, and the risks and rewards of investing in it.

See Part 1: What is DeFi?

See Part 2: What Are the Top DeFi Platforms?

See Part 3: What Is a Smart Contract?

See Part 4: What is Yield Farming and Liquidity Mining?

See Part 5: What Is Staking?

See Part 6: What Are DeFi’s Top 10 Uses?

“Democracy is the worst form of government except for all those other forms that have been tried.”

—Winston Churchill

So, with that in mind, how is DeFi governed?

To answer that question, we need to frame it a little: How do you govern something that by its very nature does not, and cannot, have any central control? By voting.

Enter the DAO, or decentralized autonomous organization.

Think of DeFi governance as small-d, small-town democracy at its purest. Everyone who has a vote can step up to the front of town hall and cast a ballot — except that instead of a town secretary, it’s computer code calling the meeting to order, collecting and counting the ballots, and announcing the winner.

That is, of course, an oversimplification. For one thing, the townsfolk are scattered around the globe and don’t speak the same language.

Like everything in DeFi, DAOs are designed to make two things unnecessary: central authority and trust.

Uncontrolled

DAOs are established by central authorities, specifically the developers that built whatever protocol they created, whether that’s a decentralized exchange, marketplace, lending/borrowing platform, video game or something else. In most DeFi projects, the goal is to turn control over to a DAO once the project is up and running.

See also: PYMNTS DeFi Series: What Are DeFi’s Top 10 Uses?

All DAOs are governed by smart contracts that provide the hierarchical control. Once the rules of the platform are established and put up on the blockchain — Ethereum, in most cases — the smart contract’s code automatically executes them.

Read also: PYMNTS DeFi Series: What Is a Smart Contract?

So, in a lending/borrowing platform like Aave — the second largest DAO token, boasting a market capitalization of $2.38 billion — the smart contract oversees the lending pools in which investors lock their funds, controlling everything from the interest rate they receive to the rules of how long they must wait to cash out and withdraw funds.

The smart contract also sets the interest rates borrowers must pay, custodies their collateral and, if the value of that collateral drops too far, will sell it off, usually at a big loss, to repay the loan before the lender takes a haircut.

Built on immutable blockchains, it’s not possible for anyone to go back and change any of a DAO’s rules. But, new transaction — new rules, in this case — can be added to the blockchain.

So, if the Aave shareholders — the owners of the AAVE governance tokens — want to raise the interest rate for borrowers from 3% to 4%, or add a new type of loan, they can vote to update the rules the smart contract enforces. The same thing applies to updating code, changing the look of the user interface or even changing the voting rules.

Trusting

Like any public blockchain, the open-source code is viewable by the public. Since there is no human being in control, users can be certain the code will execute according to the rules it contains. As the industry saying goes, “code is law.”

DAOs are controlled by a type of cryptocurrency called governance tokens, and these give token holders a vote on the project. The investment is based on the idea that as the platform attracts more users and the funds are deposited into its lending pools, the total value locked (TVL) increases and the more valuable its tokens will become.

Aave has nearly $14 billion TVL, but the AAVE token is not loaned out. The Aave protocol’s voters have allowed lenders to lock 30 different cryptocurrencies, each of which has interest rates for lenders and borrowers set by the smart contract rules.

Different protocols have different voting rules, but almost all come down to this: Token holders can propose a rule change. If it gets enough support, a vote is scheduled; if enough voters support it, the proposal passes, the code is updated, and the protocol’s rules are updated. There is a set schedule for this process, but generally at least a week is required to get through it once a proposal gets enough support to bring it to a vote.

Are DAOs the Worst?

The biggest pro of DAOs is that they work without human control. However, there are a number of potential drawbacks.

For one thing, if enough of the governance tokens are concentrated in too few hands, or too many token holders don’t bother to vote, the protocol becomes de facto centralized, at least to some extent.

Then, there’s the problem of bad code in an industry in which scammers and hackers stole $7.7 billion in 2021.

Read more: 2021 Crypto Scams Top $7.7B, Fueled by DeFi-Friendly ‘Rug Pulls’

The term DAO came from a 2016 project called The DAO, which was essentially a decentralized venture capital firm. A token sale raised $150 million, and investments would be crowdsourced and token-holder approved. Unfortunately, the code had a flaw that promptly let a hacker drain 3.6 million ether, worth about $50 million.

However, that’s only half the problem. In late September, the Compound lending protocol made a code upgrade that introduced a bug that exploited a way to get the DAO to give out vast numbers of new COMP tokens from a reward system that was only supposed to give out a few. All told, $90 million was drained, and while no users lost funds, a fundamental DAO flaw was displayed — the DAO voting protocol took a minimum of two weeks to permit code updates.

There was also the MakerDAO flash crash in September 2020, and a flaw in the lending/borrowing protocol’s code was revealed when borrowers’ collateral was liquidated after a big drop in ether’s price. People were able to “buy” the collateral for $0 bids. In all, borrowers lost $8.33 million. After initially agreeing to compensate the victims by minting more MKR tokens — which wouldn’t cost anything — the Maker community ultimately voted not to.

Remember what Churchill said about democracy being the worst form of government? Centralized controllers can be shamed into doing the right thing — a distributed community of voters, not so much.

Next Up: What Is the Best DeFi Blockchain?

Most of DeFi is built on Ethereum, the No. 2 blockchain by market cap. However, Ethereum is badly overtaxed and is unable to handle the flood of transactions, caused in large part by DeFi. The result is that transactions can be delayed and the gas — the transaction fees paid to miners — have skyrocketed to unsustainable levels.

Which is why a whole slew of new blockchain called “Ethereum Killers” have emerged, with several rocketing into the list of the Top 10 cryptocurrencies this year by promising faster and cheaper transactions. But are they really better and will actually win? We’ll take a look.