When DAO Governance Goes Wrong

During extreme market downturns like we have been experiencing in the summer and fall of 2022, inefficiencies are often brought to light. We have seen over-leveraged giants like Terra, 3AC, and Celsius fall but the damage hasn’t stopped there. One of the more interesting stories among the carnage is the decision of Solend (an algorithmic, decentralized protocol for lending and borrowing on Solana) to create a DAO and forcefully take over the account of their largest whale at risk of liquidation—a plan which was eventually invalidated. Was this decision a necessary evil to save the protocol or is this a case of when DAO governance goes wrong?

What Happened

A whale on the Solana network deposited 5.7M Solana into Solend to then borrow 108M of USDC and USDT. With the market continuing to crash over the weekend, this whale’s liquidation price of $22.30 was within reach with SOL trading at a low of $25.83. If the liquidation price was reached, 20% of their borrowed funds would be liquidatable and market sold on DEXes, potentially causing Solend to acquire bad debt, a cascading drop in Solana price, or even halting the Solana network altogether due to liquidators spamming the network. Ultimately, the liquidation of this position would not only mean chaos for Solend, but the entire Solana network as well. With this in mind, the Solend team felt they had no choice but to act fast in an attempt to reduce the damage of this potential liquidation.

DAO Governance Offers a Solution

On June 19th, Solend, which previously did not have a DAO, created one in a hurry, and pushed forward their first proposal. In this proposal, they outlined what was going on with this at-risk position and the problems it introduced. The proposed solution had two main points seen below.

“Enact special margin requirements for large whales that represent over 20% of borrows. If a user's borrows amount to over 20% of all borrows for the Main Pool, a special liquidation threshold of 35% is required. This policy will go into effect upon approval of the proposal.

Grant emergency power to Solend Labs to temporarily take over the whale's account so the liquidation can be executed OTC and avoid pushing Solana to its limits. This would be done via a smart contract upgrade. Emergency powers will be revoked once the whale's account reaches a safe level.”

Essentially, the proposal is to take over the whale’s account and execute the liquidation OTC to prevent liquidity or network issues. As you will see below, the proposal passed with the vast majority of users voting yes. Although this may have been in good faith from Solend’s perspective, it absolutely hinders the trust a user might have had with the protocol. If at any moment the team can strum up a vote to take control of a user’s funds, is it really holding true to the ethos of DeFi?

This abrupt creation of a DAO and subsequent vote to take over this whale’s account has caused crypto Twitter to go into a frenzy. Like a wildfire spreading, the crypto Twitter mob was assembled and Solend was in the crosshairs. Below is just one of many tweets from prominent figures in the space bashing the governance decision by Solend Labs.

With such a huge community uproar, early Monday morning the second Solend proposal was pushed forward titled “Invalidate SLND1 and Increase Voting Time.” Citing the recent bounce off the lows buying the team more time, Solend invalidated their first proposal stating they will use this temporary reprieve to draft another plan moving forward. Although Solend never took control of the whale’s wallet, the intent was there and it is safe to say Solend’s integrity will forever be in question moving forward, irrespective of the outcome. Most projects don’t operate in this manner, but it feels like opening the floodgates, not dissimilar to the election of a dictator. Once the dictator takes over, the wild and crazy behavior begins. What project might try this next?

What Does This Tell Us About DeFi?

There are a few key takeaways from this Solend situation. The first is that on-chain governance is clearly still a huge problem within DeFi. Participation in governance is generally extremely low and it leads to just a few whales dictating the future of these protocols. Even in this example, a minority of total votes made a decision on behalf of a $100M+ whale. Additionally, this situation also sheds light on the stark differences between DeFi on Ethereum versus any other layer one network. For comparison, Ethereum is currently sitting with over $40B in DeFi and $4.6B in the largest decentralized exchange. Just one DeFi protocol on Ethereum has more liquidity than all of Solana DeFi! With the most liquidity by a longshot and longest history of success, it really begs the question of why would anyone use a layer one other than Ethereum for DeFi applications.

A full-version of this article can be found here (https://blockstar.substack.com/p/the-power-of-the-mob). 

Blockstar Advisors is a full-service web3 consulting firm focused on blockchain education. To learn more about us and what we offer visit blockstaradvisors.com or check out our Twitter @blockstar_adv.