Decentralized Finance, Governance Tokens, and the Rise of Oligarchies
To what extent do DeFi platforms deliver on their promises of decentralized governance?
How much are DeFi platforms actually delivering on their promises of decentralized governance? That and more in this guest post.
From decentralized apps to autonomous organizations
Most of us are still reliant on banks to make payments, move money, or—in a broader sense—manage our finances. The traditional finance world includes centralized intermediaries like banks, plus fintech firms and exchanges. Regulators keep a close eye on these middlemen.
The world of Decentralized Finance (DeFi), by contrast, is built on unregulated crypto networks. DeFi platforms are run by decentralized autonomous organizations (DAOs). Online communities with pseudonymous members replace formal governance. The technical backbone powering these DeFi projects—think Ethereum—is decentralized and thus harder to regulate.
DeFi services range from peer-to-peer lending to stock-like trading venues and derivatives swaps. DeFi exploded in growth from 2020 to 2021: Bloomberg now publishes the “Galaxy DeFi Index,” comprising projects like Uniswap, Aave, Maker, Compound, SushiSwap, Synthetix, Yearn Finance, 0x, and UMA, which shortly after its launch (Aug 9, 2021) managed about $31 billion in assets. Even traditional financial players don’t see DeFi as a threat; they’re hoping to learn about efficiency gains, capital deployment, and innovation.
The governance of DeFi platforms is pseudonymous and (in legal terms) unaffiliated with any corporate entity. Voting rights on the future of a platform are embedded in tradable tokens—often called governance or vote-tokens. In a token’s definition, you’ll see how many votes it carries and what powers those votes grant.
Token holders can decide the project’s future through different voting processes. DeFi projects are thus governed by token holders. Since governance tokens can, in principle, be acquired by anyone, DeFi platforms promise “democratization.” But does that hold up in practice?
Governance tokens work only to a limited extent
On September 5, 2020, a developer using the alias "Chef Nomi" poached more than $13 million in governance tokens from a fund they managed. The treasury didn’t belong to a company or public entity, but to SushiSwap, a DAO governed by governance-token holders. Facing public backlash and token-holder protests, he apologized and six days later moved the tokens back to the SushiSwap treasury.
However, with that alias, Chef Nomi would have been hard for regulators or law enforcement to pin down. Neither other developers nor token holders could reverse the transaction, force Chef Nomi to return the funds, or even restrict access to the treasury. The question of who actually controls DeFi platforms—the token holders or the developers—remains controversial.
DeFi proponents critique the “fat cats” in traditional finance. They themselves are creating a new breed of financial magnates often called “whales.” These whales are the developers, advisors, and early investors in a DeFi project who accumulate governance tokens before the broader public can via crypto exchanges. A recent study from the University of Luxembourg spotlights a gap between hype and reality: researchers trace governance-token distribution on the public Ethereum blockchain to analyze the opaque and sometimes questionable governance of DeFi projects.
To measure the concentration of DeFi voting power, the study uses common inequality metrics like the Gini coefficient and direct voting scenarios. The authors argue that DeFi governance leans more toward centralization than decentralization. DeFi appears closer to an oligarchy (or more precisely a timocracy, where rights are tied to wealth): votes are sometimes decided by as few as four token holders (whales). The French historian and philosopher Alexis de Tocqueville warned in the 19th century: “When a nation tampers with aristocracy, centralization follows.” History seems to be repeating itself.
Looking ahead
On July 27, 2021, the U.S. Senate Banking Committee held a hearing on cryptoassets and DeFi projects. Because DeFi relies on public blockchains that cross multiple jurisdictions, regulators worry that DeFi platforms may evade oversight. Actors around DeFi projects aren’t subject to know-your-customer (KYC) rules, and anti-money-laundering (AML) or counter-terrorist-financing (CFT) measures aren’t being applied.
DAOs typically lack a statutory seat and employees who can be identified or held liable for fraud. In this context, Senator Elizabeth Warren called the unregulated exchange of crypto assets “the Wild West of our financial system.” In Europe, fears about DeFi’s lack of oversight have helped motivate the recent EU Parliament proposal to ban “unhosted wallets,” i.e., individuals storing their own tokens and other cryptoassets.
Meanwhile, the hi-fi industry has begun to mature and is now exploring approaches to mitigate these risks with new technical solutions. Selected projects (like Aave Arc) have acknowledged institutional and regulatory interest and are building solutions to protect investors and meet regulatory requirements. If others want to follow, policymakers must strike a balance: a legal framework is needed that enables innovation without undermining regulatory goals. Otherwise, Europe’s digital sector could face renewed economic headwinds, with growth being stifled and later imported by other economic powers.
