Welcome to the seventh installment of PYMNTS’ eight-part series on decentralized finance (DeFi).
Over the coming days, we’ll be looking at every part of DeFi — the biggest, hottest, most rewarding and risky part of the blockchain revolution. At the end of it, you’ll know what DeFi is, how it works, and the risks and rewards of investing in it.
SEE PART 1: What is DeFi?
SEE PART 2: What Are the Top DeFi Platforms?
SEE PART 3: What Is a Smart Contract?
SEE PART 4: What is Yield Farming and Liquidity Mining?
SEE PART 5: What Is Staking?
SEE PART 6: What Are DeFi’s Top 10 Uses?
“Democracy is the worst form of government except for all those other forms that have been tried.”
—Winston Churchill
So, with that in mind, how is DeFi governed?
To answer that question, we need to frame it a little: How do you govern something that by its very nature does not, and cannot, have any central control? By voting.
Enter the DAO, or decentralized autonomous organization.
Think of DeFi governance as small-d, small-town democracy at its purest. Everyone who has a vote can step up to the front of town hall and cast a ballot — except that instead of a town secretary, it’s computer code calling the meeting to order, collecting and counting the ballots, and announcing the winner.
That is, of course, an oversimplification. For one thing, the townsfolk are scattered around the globe and don’t speak the same language.
Like everything in DeFi, DAOs are designed to make two things unnecessary: central authority and trust.
Uncontrolled
DAOs are established by central authorities, specifically the developers that built whatever protocol they created, whether that’s a decentralized exchange, marketplace, lending/borrowing platform, video game or something else. In most DeFi projects, the goal is to turn control over to a DAO once the project is up and running.
See also: PYMNTS DeFi Series: What Are DeFi’s Top 10 Uses?
All DAOs are governed by smart contracts that provide the hierarchical control. Once the rules of the platform are established and put up on the blockchain — Ethereum, in most cases — the smart contract’s code automatically executes them.
Read also: PYMNTS DeFi Series: What Is a Smart Contract?
So, in a lending/borrowing platform like Aave — the second largest DAO token, boasting a market capitalization of $2.38 billion — the smart contract oversees the lending pools in which investors lock their funds, controlling everything from the interest rate they receive to the rules of how long they must wait to cash out and withdraw funds.
The smart contract also sets the interest rates borrowers must pay, custodies their collateral and, if the value of that collateral drops too far, will sell it off, usually at a big loss, to repay the loan before the lender takes a haircut.
Built on immutable blockchains, it’s not possible for anyone to go back and change any of a DAO’s rules. But, new transaction — new rules, in this case…
Read More: www.pymnts.com