With more people getting involved with decentralized finance (DeFi) everyday, it becomes increasingly important to understand the basics about how DeFi works. There are many different applications of DeFi but the guiding principle is giving people direct access to financial systems without the need for a middleman or centralized institution.

DeFi projects provide tools to empower people to take control of their personal finance through decentralized applications (dApps). With the use of DeFi platforms, people have access to areas of finance they otherwise would not. However, there must still be some form of control to keep the project running smoothly post launch. Governance in DeFi handles control of a project.

What is Governance?

Governance is important because it controls the direction and future of the project. DeFi is built on smart contracts. Smart contracts are the rules that DeFi protocols play by. If an individual or entity can change the rules, then everyone on the platform is subject to whatever decisions that individual or entity makes.

Contracts have meaning because all parties involved understand and abide by the terms. Things will unfold how you expect because everything is spelled out within the contract. Everyone knows exactly what they are getting into.

Any project that continues to be controlled by a single entity is not decentralized. Decentralized finance creates security and assurance for all users by removing the inherent risk of a single entity changing the project.

To be fully decentralized, decentralized applications need to be free from control by any one party. This can be achieved by giving control to the actual users of a DeFi protocol.

Governance systems that decentralize the control of a project to the holders do so utilizing governance tokens. A governance token gives the holder a vote, proportional to their holdings, to influence the direction of a project.

Types of Decentralized Governance

Off Chain

The first decentralized governance systems were off-chain. Holders interacted through conferences and online forums which limited the ability for everyone to participate and led to more power in the hands of those with the means to attend gatherings. There were obvious drawbacks to online protocols relying on in-person meetups.

On-Chain

On-chain governance relies on the blockchain itself to resolve governance of the protocol. Users cast votes to determine changes to DeFi projects from their wallet. Votes are typically weighted based on the number of governance tokens held when the vote was initiated.

The governance process, like the rest of the DeFi project, is coded in the smart contract. Exact details of the governance model can vary from project to project. Changes can either be automatically applied or implemented by the development team based on the results of any votes.

Decentralized autonomous organizations (DAOs) operate completely based on user decisions. Users collaborate to advance the project in whichever direction they see fit. All decision making in the DAO is controlled by the community. DAOs are still an evolving space

Governance Tokens

Governance tokens are voting power. They are what gives users the ability to influence decision making in projects.

Sometimes, governance tokens can be used in ways other than strictly voting. Tokens can be bought or sold on exchanges, staked in liquidity protocols, or used in yield farming to provide further benefits to holders.

Voting is only part of the governance process. Before changes can be made, holders need to communicate with each other and have productive discussions about the needs and concerns of the project.

Constant communication and collaboration lead to knowledgeable holders with an innate understanding about the needs and challenges of a project. With a strong governance system, projects are able to leverage the holder base to build something new that benefits people.

Being forced to defend any position to the community as a whole makes the position stronger. Potential outcomes must be considered and the community can bring originally unconsidered ideas to light to improve or challenge the position.

Voting systems also encourage transparency which gives holders reassurance that all potential solutions have been considered and thought through. Greater transparency prevents fraud because there is accountability and openness about financial transactions. Things cannot be changed while the community sleeps, which comes a little easier knowing the parameters of the contract will stay the same.

Key Takeaways

It is important to consider the governance of a project because governance ultimately guides where the project will be in the future. All projects change with time but, unfortunately, sometimes can change for the worse. Those in charge may make decisions that are good for the top holders but negatively impact a majority of the userbase.

Understanding a project’s governance helps knowledgeable DeFi users anticipate where a project will be. The community should be well aware of any significant changes because it is them who are affected the most. They cannot anticipate changes as well if they do not know how changes are implemented.