Lord of the Flies-Fi

Lord of the Flies-Fi
Still from the film adaptation of "Lord of the Flies" (1990, Castle Rock/Columbia Pictures)
24 June 2022

DeFi protocols are in distress. Severe distress. And we’re seeing some remarkable – and remarkably quick – changes put through. A system that was supposed to operate autonomously with publicly visible immutable records is proving to be anything but.

And precisely how governance is emerging is pretty scary.

Lord of the Flies is a famous book about a group of boys who get marooned on an island in the South Pacific. They set up some kind of governance structure which is meant to ensure, among other things, that a smoke signal to attract rescuers is maintained at all times. It’s kind of downhill from there.

The titular “Lord of the Flies” is a severed pig’s head one of the boys mounts on a stick and relies on to predict the future. More violence follows, a few of the boys die and generally the system falls apart. They are rescued in the end – but that’s pure luck as they had given up on the smoke signal even though it was a core founding principle of their system.

Starting to sound familiar?

Protocol changes

Three major protocols have put through large changes – decided via off-chain processes – in recent days. The hugely important MakerDAO cut off it’s DAI link to Aave in an attempt to isolate itself from Celsius-related losses. The Bancor protocol disabled impermanent loss protection, which probably surprised Bancor stakers who were relying on that. And most egregiously Solend – a so-called DeFi protocol – considered seizing a whale’s funds with the intention of liquidating them in OTC transactions. That last one was particularly absurd as nearly all the DAO “votes” to pass the proposal came from a single wallet.

Read more: [UPDATED] Solend Reverses “Emergency Power” Proposal After Community Backlash

Say what you will about economic and political systems on this planet…but there are very few places on Earth where a single person exercises this kind of power. Selectorate theory explains how even dictators need to keep some smaller constituency happy to remain in power. And the days when the British Monarchy’s claim to rule by divine right was taken seriously ended long long ago.

Not so in DeFi it seems. Major changes are getting pushed through via pseudonymous and anonymous weighted voting. Anonymous ballots with a one-person-one-vote setup are common. But allocating a large share of voting power to a single anonymous party – that’s different.

Boys on an island

DeFi was supposed to operate with total transparency relying on public smart contracts to level the field. Of course the code was written by people. And we have examples such as Uniswap, where the code is not changeable. Parts of the system took this seriously. If Uniswap somehow blows up, nobody can edit the code to save it.

Decentralized autonomous organizations (DAOs) were supposed to offer a mechanism to inject a bit of flexibility but still retain the core ethos of DeFi. Seizing someone’s funds and liquidating them off-chain has absolutely nothing to do with that.

Promising a form of protection and then revoking it when it’s likely to be needed is also not a great look. Deciding some parts of the Maker-Aave ecosystem are more equal than others is both a different relevant famous book and a pretty bad outcome.

In the novel, the boys’ only way to start a fire is to use the one pair of glasses (which belongs to Piggy) on the island to focus sunlight. The boys want to be rescued. So they all agree to safeguard Piggy’s glasses in the service of keeping the signal fire burning. By the end of the novel the glasses are broken and the fire is out.

More familiar now?

The “pottery barn rule”

When George W Bush was considering invading Iraq, he got some prescient advice from his chief diplomat (and former Army general) Colin Powell:

“You are going to be the proud owner of 25 million people,” he told the president. “You will own all their hopes, aspirations, and problems. You’ll own it all.” Privately, Powell and Deputy Secretary of State Richard Armitage called this the pottery barn rule: You break it, you own it.

William Safire in the New York Times, 18 October 2004

The entire idea that DeFi is different is now completely out the window. It remains possible some sort of decentralized system might be constructed. But we do not have one now. Centralized exchanges were one thing; everyone understood they weren’t DeFi and were somehow required to bridge back to the fiat system.

But the headline text on Solend’s website is still “Solend is the autonomous interest rate machine for lending on Solana.” It even has a picture of a large complex machine to indicate it’s all autonomous and mechanical. I’ve taken the liberty of cutting a hole in that machine so you can see what’s inside:

Note: Solend appears to have a cartoonish court system somewhere on the inside.

If you can do this to a protocol you own it. You are in charge. And it is hard to see how whatever group is making these decisions isn’t liable for everything the protocol has done and will do. You break it, you bought it.

Sure ownership is transferable. So are voting shares in listed companies. Nobody tried to hold minor shareholders in Enron accountable for that fraud! Their losses on the equity were the minority shareholder accountability. But senior management – the people making the decisions and carrying out the fraud – was considered fair game. People went to jail.

You see it now right?

U-turn time

Following widespread complaints about the account seizure proposal Solend put out a new proposal to invalidate the first vote. That makes it painfully clear this DAO is at best a sham. There is nothing binding here. It’s not clear the votes really mean anything. The Solend team can pretty clearly do whatever they want.

Maybe community outrage is some sort of constraint. But if that’s where we are we’ve gotten nowhere. “Community outrage” is a reasonable description for the storming of the bastille that began the French Revolution.

Part of the second Solend proposal is literally “Work on a new proposal that does not involve emergency powers to take over an account.” So the team is committed to figuring something out. That is not exactly confidence inspiring.

Stressed systems reveal all

These protocols are revealing there was a lot of decentralization theater going on.

Only when the tide goes out do you discover who’s been swimming naked.

Warren Buffett

Reasonable people can disagree over how a truly decentralized permissionless protocol interacts with the traditional regulatory and legal systems. But a system under the control of a small number of parties, who put proposals up for vote and then cast the winning votes themselves? We know how that works. We have clarity there.

These folks just tipped their hands. It’s just the law of the jungle. If the majority votes to seize your funds – even if that majority is one anon – your funds are gone. We aren’t discussing a better version of democracy with a better, fairer independent judiciary – we are looking at a system more akin to Roman Dictatorship.

The Solend proposal says it will “grant emergency power to Solend Labs to temporarily take over the whale’s account.” OK. Both Sulla and Caesar employed similar language. Sulla resigned his dictatorship in the end. Caesar mocked Sulla for that decision and, famously, secured himself a lifelong dictatorship, which lasted about 6 weeks. If those references are too old, you may recognize this guy:

Emergency powers are not new. Arbitrary action is not new. Popular outrage is not new. This is now depressingly old and familiar.

Jon Reiter
Jon Reiter

Jon is a long-time derivative trader and quant that’s done both modelling and market-making work in New York, London, Tokyo and Singapore. Lately he’s applying traditional finance techniques in the blockchain space.

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