Maintaining decentralization: Are custody services a threat to DeFi protocols?

Decentralization is portion of the cryptocurrency industry’s core, with assorted protocols trying implicit clip to execute the level of decentralization that Bitcoin (BTC) managed to get arsenic it grew organically from a achromatic insubstantial published to a mailing database to a caller plus class.

Decentralized concern (DeFi) protocols person brought the thought of decentralization to a caller level with the usage of governance tokens, which springiness holders the close to ballot connected oregon taxable proposals regarding issues that govern the improvement and operations of a project. Governance tokens often correspond investors’ ownership successful decentralized autonomous organizations (DAOs), which run utilizing astute contracts.

Governance tokens and DAOs are autochthonal to layer-1 blockchains that enactment astute contracts. Often these tokens are bought for concern purposes and kept connected centralized trading platforms, which inadvertently gives centralized platforms an outsized powerfulness implicit the protocols they govern.

Last month, cryptocurrency speech Binance accidentally became the second-largest voting entity by voting powerfulness successful the DAO down the largest decentralized exchange, Uniswap. According to Binance’s CEO Changpeng Zhao, an interior Uniswap (UNI) transportation automatically delegated tokens.

Binance aboriginal clarified it doesn’t ballot with user’s tokens, but the incidental highlighted a occupation affecting however decentralized protocols support decentralization with custodial services being arsenic fashionable arsenic they are.

Can custodians endanger DeFi protocols’ decentralization?

Through its accidental token delegation, Binance could suggest governance votes arsenic it had 1.3% of the full proviso of UNI, acold exceeding the 0.25% threshold. The exchange, however, couldn’t walk votes connected its ain owed to a 4% quorum requirement.

Its power — if the speech chose to usage it — would person nevertheless been significant.

Sasha Ivanov, laminitis of blockchain level Waves, said that perchance centralized power from custody work providers is simply a “serious contented with decentralized governance,” adding that the “promise of decentralization” is “totally unrealized with a azygous token governance model.”

To Ivanov, there’s “nothing to halt centralized custody services from exercising their close arsenic token holders,” which means that if Binance wishes, it could “make proposals, ballot for them and alteration the absorption of the level and community.” Ivanov’s solution is simply a governance exemplary “based connected much than conscionable token ownership.”

Speaking to Cointelegraph, Hamzah Khan, caput of DeFi astatine Ethereum scaling solution Polygon, said that it’s important to support successful caput that governance tokens person power implicit each protocol, with each protocol being antithetic successful however power is exercised.

Khan added that UNI tokenholders, for example, cannot marque changes to the protocol’s codification oregon power users’ assets but tin marque different changes, specified arsenic deciding fees connected an idiosyncratic liquidity excavation basis, for example.

Daniel Oon, caput of DeFi astatine blockchain web Algorand, told Cointelegraph that users usually show what centralized platforms are doing with their governance tokens and question them implicit a deficiency of religion successful supporting applications, including wallets and mediocre tokenomic designs.

Per Oon, determination are assorted DeFi governance platforms that “ask their users to work aggregate proposals, enactment successful mandatory voting, bash X,Y,Z, and involvement their tokens” to person output arsenic a reward. He added:

“In look of each of these administrative tasks, the idiosyncratic decides to manus it implicit to third-party centralized platforms to grip the voting process truthful that they tin get immoderate output ex-fees charged.”

As centralized platforms are known to stock generated income with users, the simplified usage of governance rewards people attracts users to these platforms. This leaves DeFi protocols with the situation of remaining genuinely decentralized.

Decentralization arsenic a goal

To Ivanov, the situation of remaining decentralized isn’t presently achievable with single-token governance systems, arsenic protocols utilizing these tin lone stay decentralized if their token is besides decentralized.

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Ivanov said that the manufacture is successful a signifier wherever “decentralization is precise overmuch inactive a extremity and not a reality,” arsenic crypto users indispensable “interact with centralized entities to on-ramp and off-ramp into the decentralized economy.” A alteration volition happen, helium said, erstwhile “we person real-world outgo systems done decentralized services.”

Khan took a antithetic view, saying that DeFi protocol teams request to stay conscious of what specifically tin beryllium changed done governance votes, adding:

“As agelong arsenic the protocol is open-source, permissionless, enables self-custody and has nary governance power implicit idiosyncratic funds oregon worldly protocol upgrades that would impact idiosyncratic funds, it remains decentralized.”

Khan added that veTokenomics models utilized by protocols similar Curve and QiDao “seem to beryllium an absorbing solution to combat decentralized exchanges and different custody agents” from gaining excessively overmuch power implicit a protocol’s governance. veTokenomics models let tokens to beryllium locked oregon frozen for a circumstantial play of clip successful speech for non-transferable veTokens that tin beryllium utilized successful governance.

Put simply, veTokenomics forces centralized entities not to enactment successful governance, arsenic locking tokens would trim the liquidity they request to process idiosyncratic withdrawals. Moreover, the play successful which tokens are locked besides influences voting power. Khan added:

“veTokenomics does look to support against centralized custodian governance attacks, whereby token holders are capable to ‘lock’ their token successful the protocol to enactment successful governance. For example, if a idiosyncratic locks up a token for 4 years, they person 4x the voting power.”

Unlocking tokens earlier than expected, helium said, typically results successful a 50% penalty, portion voting powerfulness boosts decay on with lock-in periods.

Oon noted that centralized entities “have been observed to prosecute much profitable paths specified arsenic lending retired those tokens to different organizations” that supply a output equivalent oregon higher to that of a DeFi protocol’s voting sessions, which leads to a little magnitude of committed votes.

As those holding their tokens connected centralized platforms bash not enactment successful governance, the voting powerfulness of those who bash is boosted. When centralized entities bash ballot directly, helium added, wide observations “have shown that the centralized entity volition usually ballot successful favour of higher emissions and the like, which increases fees generated.”

Such a determination could person unpredictable consequences. Michael Nonaka, a spouse astatine multinational instrumentality steadfast Covington and Burling, told Cointelegraph that a DeFi protocol tin beryllium decentralized adjacent if the voting powerfulness is concentrated successful a tiny fig of token holders, adding:

“Problems originate if a ample token holder is capable to wield capable power to change the trajectory of the DeFi protocol to bespeak the holder's objectives, alternatively than the objectives identified by the protocol to spur involvement successful the token and protocol. “

Nonaka noted that successful specified a scenario, different holders whitethorn merchantability their tokens implicit the content that they nary longer correspond the worth of the protocol’s laminitis oregon tokenholders.

As it stands, immoderate enactment centralized entities instrumentality could easy impact decentralized governance. Most centralized entities seemingly bash not enactment successful on-chain governance but simply safeguard users’ tokens connected their platforms.

Influencing decentralized governance

If centralized entities bash effort to power a protocol’s governance — either for their ain summation oregon due to the fact that they judge it’s the close happening to bash — determination are respective options disposable to tokenholders.

Khan believes that 1 enactment is to nary longer enactment successful that protocol. He said:

“One of the superior principles of Web3 and DeFi is the close to exit and the close to fork — users are not required to proceed utilizing a circumstantial DeFi protocol if they don’t hold with its governance.”

Khan elaborated that if centralized actors leverage their custodied voting powerfulness for malicious intent, users tin “simply retreat their funds and developers tin fork the codification to make a governance operation that is much aligned with the values of the users, developers, investors, and different stakeholders.”

Anton Bukov, co-founder of decentralized speech (DEX) aggregator 1inch Network, seemingly agreed with Khan, stating:

“DeFi users should recognize that depositing their integer assets to custodian platforms besides gives voting powerfulness to these platforms. I privation to judge that if those platforms would instrumentality immoderate unexpected actions with deposits, this would pb to reducing deposits and idiosyncratic base.”

Speaking to Cointelegraph, David Weisberger, CEO of astute bid routing bundle supplier CoinRoutes, said the actions of regulators astir the satellite could besides heavy power decentralized governance. If “regulators request visibility into the controlling owners of protocols,” attraction connected custody work providers could “help the protocol adapt.”

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OKCoin main operating serviceman Jason Lau told Cointelegraph that, implicit time, superior flows summation arsenic much fiscal institutions get progressive successful DeFi. He predicted that services volition apt accommodate to the abstraction alternatively than power it to change:

“Custody services shouldn’t beryllium seen arsenic the superior situation to DeFI. DeFi proponents volition apt grapple with idiosyncratic spot failures, arsenic seen with the Tether scandal, and apt authorities regularisation that volition alteration however DeFi operates. Instead, we person seen custody services accommodate to see DeFI principles successful their services.”

The emergence of decentralized custody solutions besides means organization investors tin self-custody their funds portion allowing protocols to stay decentralized, Lau added. Nevertheless, utilizing regulated custodians tin “enhance the credibility of a Defi protocol,” helium said, and could some amended information portion ensuring transparency.

There’s inactive a batch near to beryllium figured out, arsenic decentralized protocols are, conscionable similar cryptocurrencies, the cutting borderline of fiscal technology. Engaging successful decentralized governance, for now, tin beryllium seen arsenic a brave endeavor arsenic tokenholders research the unknown.