Decentralized Finance, or DeFi, requires Decentralized Autonomous Organizations, or DAOs, in order to keep the governance of its projects and platforms as decentralized as possible.
In fact, simply uploading any smart contract to Ethereum’s decentralized network is not enough to guarantee that it cannot be managed in a non-decentralized manner.
Furthermore, DeFi’s greatest innovation is decentralization, i.e. the fact that there is no single-point-of-failure, not only for the execution of smart contracts, or on-chain transactions, but also for the governance of projects and platforms.
Indeed, decentralization is not only a fundamental, critical and basic point. In the absence of decentralization, probably no DeFi instrument would be revolutionary, and since it is only with decentralization that DeFi projects and platforms can aspire to achieve truly revolutionary results, this is why a more decentralized governance becomes an essential element to truly pursue these ambitions.
However, the fact is that it is not obvious whether the governance of a DeFi project is decentralized. Take Maker DAO for example: in theory, it would have been possible to create a similar project with centralized governance. In fact, the creators themselves admit that the project cannot be said to be 100% decentralized yet, although the goal is to achieve that result.
So when a new project, or a new platform, of decentralized finance, is born, it is not at all certain that it is actually a decentralized project or platform. DAOs aim precisely to try to solve this problem, or at least to reduce it to such an extent that it becomes irrelevant. That’s why many DeFi projects are managed through DAOs, to the extent that the vast majority of DeFi protocols are either already managed by a DAO or envisage implementing one in their roadmap.
Central operating authority? Not anymore
This type of governance requires that the protocol is not managed by a company, an association, or a foundation, but by an autonomous decentralized organization that operates following the programming integrated directly in the smart contract, usually registered on the Ethereum blockchain, and publicly verifiable by anyone.
In this way, it is possible to completely eliminate the need for a central operating authority, because all the management rules are written in the public code of the smart contract, which is virtually unchangeable.
DAOs often use this system to manage their funds and issue their own tokens. These tokens, in turn, often represent users’ voting rights or ownership of the DAO itself.
Token owners can usually vote on governance issues related to the DAO, or how its services work. This, for example, is a similar feature to public limited companies, although DAOs often involve much more voting and direct decisions. Ultimately, it is in the interest of token owners themselves that the protocol works best, without problems, thereby creating additional demand for tokens.
So, even if with different characteristics in some ways similar to those of normal companies, associations, or foundations, the big difference lies in the application of operational decision-making processes, which a DAO can make only and exclusively according to what is allowed and permissible by the public smart contract, practically immutable.
This considerably increases the degree of certainty, despite the fact that other processes that are not always decentralized may intervene upstream of the implementation of these processes, such as, for example, a concentration of tokens in the hands of a few subjects, or even just one.
There is also another critical point, which is destined to remain critical probably forever: the quality of smart contracts.
Quality of Smart Contracts
Already in the past, it has happened several times that a smart contract contained bugs or was vulnerable to attacks. This actually reduces the certainty, however, for some time now it has become customary to have smart contracts examined in depth by expert and independent third parties before they are finally published on the blockchain. This doesn’t eliminate the risk, but at least theoretically it reduces it a lot.
As can be easily understood, in this scenario a DAO is not a simple and trivial structure, if anything, it is a structure that is often much more complex than traditional centralized structures, especially those of small size. However, regardless of all these problems, it currently remains the only real solution to make DeFi projects as least centralized as possible. It should be added that, unlike an association or foundation, a DAO is not necessarily a non-profit organization. In other words, it is possible for a DAO to generate profits, and perhaps distribute them to token holders, for example.
Indeed, since they are still financial instruments, profit-driven DAOs are numerous, and this makes the risks even higher because when profits are involved they have a considerable capacity to attract hackers, fraudsters and malicious criminals of various kinds. For now, we’re actually still in an experimental phase, since even the main DAO, that of Maker, hasn’t yet completely fulfilled its roadmap.
“DAOs will rise from the ashes”
However, it is already clear that there are very few alternatives to DAOs, in order to guarantee a high degree of decentralization to DeFi projects. At this stage, it is quite common that, every now and then, a DAO is found to be faulty, or badly designed, or with serious bugs that undermine its success, but it is only by continuing to experiment with these solutions as often as possible that it will be possible to bring to light all the main problems.
For example, the section dedicated to DAOs on defiprime.com is still very limited, and the documentation that describes the developments and results obtained by DAOs throughout time is still very poor. However, given the development that the DeFi sector is undergoing now, it is fair to imagine that these developments will become wider and more significant in the future, not least because a lot of DeFi projects are actually linked to the success of the DAOs that manage them.
The more problems are faced and solved, the more this tool will become the norm in this sector, as there are no real alternatives capable of achieving the same results with such low-risk levels.
However, it takes time for this to happen. Just think, for example, that the most important DAO in the industry, that of Maker, was created in 2015, but only at the end of 2017 was it able to launch its smart contract on the Ethereum mainnet. Moreover, at the end of 2019, it had to be updated by uploading a second version, which is gradually replacing the first one.
Therefore, although this is an innovation that is already largely underway, it is very likely that it will have far greater developments in the future.