Are custodians a threat to DeFi protocols?

Decentralization is part of the core of the cryptocurrency industry, with various protocols trying over time to achieve the level of decentralization that Bitcoin (BTC) managed to obtain as it grew organically from a white paper published in a mailing list to a new asset class.

Decentralized finance (DeFi) protocols have taken the idea of ​​decentralization to a new level with the use of governance tokens, which give holders the right to vote or submit proposals regarding issues that govern development and project operations. Governance tokens often represent investor ownership in Decentralized Autonomous Organizations (DAOs)that operate using smart contracts.

Governance tokens and DAOs are native to layer 1 blockchains that support smart contracts. Often these tokens are purchased for investment purposes and held on centralized trading platforms, inadvertently giving centralized platforms outsized power over the protocols they govern.

Last month, cryptocurrency exchange Binance accidentally became the second largest voting entity in voting at the DAO behind the largest decentralized exchange, Uniswap. According to Binance CEO Changpeng Zhao, an internal Uniswap (United) to transfer automatically delegated tokens.

Binance later clarified that it does not vote with user tokens, but the incident highlighted an issue affecting how decentralized protocols maintain decentralization, with custodial services being as popular as they are. are.

Can custodians threaten the decentralization of DeFi protocols?

Thanks to its accidental token delegation, Binance was able to offer governance votes because it held 1.3% of UNI’s total supply, far exceeding the 0.25% threshold. The exchange, however, was unable to vote on its own due to a 4% quorum requirement.

Its influence — had the stock market chosen to use it — would nonetheless have been significant.

Sasha Ivanov, founder of blockchain platform Waves, said the potentially centralized control of custodial providers is a “serious problem with decentralized governance”, adding that the “promise of decentralization” is “totally unrealized with a single-token governance model”.

For Ivanov, “nothing prevents centralized custodians from exercising their right as token holder”, which means that if Binance wishes, he could “make proposals, vote for them and change the direction of the platform and the community”. Ivanov’s solution is a governance model “based on more than just token ownership.”

Speaking to Cointelegraph, Hamzah Khan, Head of DeFi at Polygon, Ethereum’s scaling solution, said it’s important to keep in mind that governance tokens control every protocol, every protocol being different in the way control is exercised.

Khan added that UNI token holders, for example, cannot make changes to protocol code or control user assets, but can make other changes, such as determining fees based on a individual liquidity pool, for example.

Daniel Oon, head of DeFi at blockchain network Algorand, told Cointelegraph that users typically monitor what centralized platforms are doing with their governance tokens and seek them out for lack of trust in supporting apps, including wallets. and poor tokenomic designs.

According to Oon, there are various DeFi governance platforms that “require their users to read multiple proposals, participate in mandatory voting, do X, Y, Z, and stake their tokens” to receive a yield as a reward. He added:

“Faced with all these administrative tasks, the user decides to entrust the task to third-party centralized platforms to manage the voting process so that he can obtain a certain return without the fees charged.”

As centralized platforms are known to share generated revenue with users, the simplified use of governance rewards naturally attracts users to these platforms. This leaves DeFi protocols with the challenge of remaining truly decentralized.

Decentralization as a goal

For Ivanov, the challenge of staying decentralized is currently not achievable with single-token governance systems, because the protocols that use them can only stay decentralized if their token is also decentralized.

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Ivanov said the industry is in a phase where “decentralization is still a goal and not a reality” as crypto users must “interact with centralized entities to enter and exit the decentralized economy.” A change will occur, he said, when “we have real payment systems through decentralized services”.

Khan took a different view, saying DeFi protocol teams need to stay aware of what specifically can be changed by governance votes, adding:

“As long as the protocol is open-source, permissionless, allows for self-custody, and has no governance control over user funds or protocol hardware upgrades that would affect user funds, it remains decentralized. .”

Khan added that the veTokenomics models used by protocols like Curve and QiDao “seem to be an attractive solution to prevent decentralized exchanges and other custodial agents” from taking too much control over a protocol’s governance. veTokenomics models allow tokens to be locked or frozen for a specific period of time in exchange for non-transferable veTokens that can be used in governance.

Simply put, veTokenomics forces centralized entities not to participate in governance because token locking would reduce the liquidity they need to process user withdrawals. Moreover, the period during which the tokens are locked also influences the voting power. Khan added:

“VeTokenomics appears to protect against centralized custodian governance attacks, whereby token holders can “lock” their token into the protocol to participate in governance. For example, if a user locks a token for 4 years, they receive 4x the voting power.

Unlocking tokens earlier than expected, he said, typically results in a 50% penalty, while voting power increases decay as well as lockout periods.

Oon noted that centralized entities have been observed to “follow more profitable paths such as lending these tokens to other organizations” which provide an equivalent or better return than a DeFi protocol’s voting sessions. , leading to fewer cast votes.

Since those who hold their tokens in centralized platforms do not participate in governance, the voting power of those who do is enhanced. When centralized entities vote directly, he added, general observations “have shown that the centralized entity will generally vote in favor of higher emissions and the like, which increases the fees generated”.

Such a decision could have unforeseeable consequences. Michael Nonaka, a partner at multinational law firm Covington and Burling, told Cointelegraph that a DeFi protocol can be decentralized even if voting power is concentrated in a small number of token holders, adding:

“Problems arise if a large token holder is able to wield enough influence to alter the trajectory of the DeFi protocol to reflect the holder’s goals, rather than the goals identified by the protocol to drive interest in the token. and protocol. “

Nonaka noted that in such a scenario, other holders might sell their tokens thinking that they no longer represent the value of the founder or the token holders.

As things stand, any action taken by centralized entities could easily affect decentralized governance. Most centralized entities apparently do not participate in on-chain governance, but simply protect user tokens on their platforms.

Influencing decentralized governance

If centralized entities attempt to influence the governance of a protocol – either for their own gain or because they believe it is the right thing to do – there are several options available to token holders.

Khan thinks one option is to no longer participate in this protocol. He said:

“One of the fundamental principles of Web3 and DeFi is the right to exit and the right to fork – users are not required to continue using a specific DeFi protocol if they disagree with its governance.”

Khan explained that if centralized actors misuse their voting power for malicious purposes, users can “simply withdraw their funds and developers can forge the code to create a governance structure more aligned with the values ​​of users, developers, investors.” and others “. stakeholders.”

Anton Bukov, co-founder of decentralized exchange (DEX) aggregator 1inch Network, seems to agree with Khan, saying:

“DeFi users should understand that depositing their digital assets on custodian platforms also gives voting power to those platforms. I want to believe that if these platforms take unexpected actions with repositories, it will lead to lower repositories and user base.

Speaking to Cointelegraph, David Weisberger, CEO of smart order routing software provider CoinRoutes, said the actions of regulators around the world could also heavily influence decentralized governance. If “regulators demand visibility into the controlling owners of protocols,” focusing on custodial providers could “help the protocol adapt.”

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Jason Lau, COO of OKCoin, told Cointelegraph that over time, capital flows are increasing as more financial institutions get involved in DeFi. He predicted that services will likely adapt to the space rather than influence it to change:

“Custodial services should not be seen as the main challenge for DeFI. DeFi proponents will likely grapple with user trust failures, as seen with the Tether scandal, and likely government regulation that will change how DeFi works. Instead, we’ve seen custodians adapt to include DeFI principles in their services.

The emergence of decentralized custody solutions also means that institutional investors can self-custody while allowing protocols to remain decentralized, Lau added. Still, using regulated custodians can “boost the credibility of a Defi protocol,” he said, and could both improve security while ensuring transparency.

Much remains to be discovered, as decentralized protocols are, just like cryptocurrencies, at the forefront of financial technology. Committing to decentralized governance, for now, can be seen as a brave undertaking as token holders explore the unknown.

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