Some high level thoughts on cryptocurrency governance

This essay is an overview of some high level concepts in cryptocurrency governance, followed by some specific examples.

Governance: Control and Power

Governance is the process by which the members of a community or organization make decisions.  More than any other topic, the question of “who runs Bitcoin?” is the one that takes newcomers to cryptocurrency the longest to grasp.

Power in cryptocurrency is often indirect.  The executives of Coca-Cola have great control over the product they release, but ultimately serve the demands of customers or the company will go out of business.  Similarly, cryptocurrency miners with specialized hardware (ASICs) have strong incentives to support the long-term demands of cryptoasset buyers since their mining is only profitable if they mine an asset that someone else wants to buy.  When thinking about power in cryptocurrency, it’s useful to note both who has elements of direct control, and also who sets incentives that strongly influence those with direct control.  Those setting the incentives may have more power in most scenarios.  In the case of Bitcoin, miners collectively have control over which transactions to include in blocks, but the community of current and potential BTC buyers may have more power, since miners must cater to their desires to be profitable.

Developers are sometimes more ideologically motivated, but still want to develop a protocol that will be used.  Usage is supported by service providers like exchanges, hardware wallet manufacturers, and custodians.  Developers also want a secure protocol, which requires the support of miners or validators.  Developers often have powerful influence over changes to the protocol, but must serve the other stakeholders or their changes are unlikely to be adopted, or unlikely to result in a valuable cryptocurrency.

Most stakeholders benefit if the value of the crypto asset and size of the network is maximized, which requires support from other stakeholders. This produces a “Keynesian beauty contest”, in which stakeholders bet on what other stakeholders will support.  This results in lots of public debate in which parties attempt to convince other stakeholders that their own position has the strongest support.

Who are the stakeholders?  Anyone who contributes to a cryptocurrency’s value and benefits from that value.  This includes holders and buyers, developers, exchanges and other liquidity providers, some types of service providers, and those securing the network (miners, stakers, etc).  Stakeholder are aligned in wanting to maximize the value of the asset, but may differ on important specifics.  For example, miners generally want to maximize revenue from transaction fees, while service providers and users may want to minimize transaction fees.

Tradeoffs

All governance introduces incentives for ‘corruption’ and rent seeking behavior.  The more complex the governance model and the more it supports swift decision making and implementation, the greater the potential attack surface.  We can minimize the effects of bad governance and minimize the uncertainty that stems from unknown future governance decisions by choosing to have as little governance as possible, resulting in a relatively static protocol.

Alternatively, the lack of governance at the base layer may slow down valuable innovation.  Developer resources may not be well organized, and may not be directed to the needs of the broader community.  Additionally, even when there is strong consensus supporting a change, a lack of governance processes may make implementation of the agreed upon changes difficult.

Perhaps crypto assets should adopt the mindset of federalism and have minimal governance at the global protocol level, and more active governance for “local” protocols that can exist as layers on top of, or connected to, the global protocol, or for more specialized ‘local’ use cases?   There may be a lot of interesting ways to combine different governance models for various use cases, similar to how a US citizen is subject to US national governance, and can then choose which state and municipality governance they prefer.

A few types of governance

As a rough mental model, I think about governance as divided into the following categories, but many examples are some blend of the below:

  1. On-chain governance: decision making that is built into the protocol itself.
  2. Formal off-chain governance: decision making that occurs outside the protocol in a pre-specified way. Authority may be vested by law, by direct control (like the ability to directly edit a live smart contract), or by strong social consensus.
  3. Informal off-chain governance: decision making that occurs by weak community consensus.

Bitcoin:

Bitcoin’s governance is primarily informal off-chain.  Changes to the Bitcoin network follow a process supported by a weak form of community consensus.  Specific proposals usually begin life as conversations among developers on technical Bitcoin mailing lists or other mediums.  A developer will then produce a specific BIP (Bitcoin Improvement Proposal), a standardized format for proposing changes.  This will be subject to public peer review, and may then be integrated into a future release of the Core client.  Individual node operators and miners may choose to install the new client or not.

Bitcoin’s governance may best be described as “governance by exit.”  Changes to the consensus rules produce a chain fork.  There is a strong community norm that the protocol should not be changed without near unanimous support.  Governance in Bitcoin often means “exiting” the existing network and creating a new community as we saw with the birth of  “Bitcoin Cash” (BCH).

Bitcoin has made use of on-chain signaling mechanisms for miner activated and user activated soft forks (e.g. BIP 148).  Miners or users may update their Bitcoin clients to take action automatically if a critical threshold of mined Bitcoin blocks contain a signal for a change, or at a pre-specified time.

To learn more: https://bitcoin.org/

Ethereum:

Ethereum’s governance is formal and informal off-chain.  Ethereum has a proposal process, EIP, similar to Bitcoin’s BIP process.  A key distinction is the strong leadership of founder Vitalik Buterin and the coordinating and financing role of the Ethereum foundation.  Vitalik and the Ethereum Foundation have no direct control, but have strong community support.

Ethereum has community norms supporting relatively frequent major protocol changes, and many in the community support the idea of at least a temporary “benevolent dictatorship” to coordinate development for faster innovation.

In July of 2016, Ethereum underwent a contentious hard fork in response to the DAO hack, that led to the creation of “Ethereum Classic.”  This changed the makeup of the Ethereum community as crypto investors supportive of the fork stayed, and some of those opposed left the community.  It is easier to “move” from one cryptocurrency to another than from one political regime to another.

This ease of movement may lead to a self-reinforcing governing dynamic in which a community becomes more similar over time via self-selection.  In the case of Ethereum, self-selection after the fork may have strengthened norms of immutability in the ethereum classic community and weakened that norm in ethereum.  This is not intended as a criticism of either community.

To learn more: https://www.ethereum.org/

EOS

EOS governance is primarily on-chain and formal off-chain.

EOS utilizes on-chain voting by token holders voting for block producers (1 token, 1 vote.)  EOS also has a formal constitution governing behavior by block producers and empowering them to make off-chain governing decisions, like coordinating to freeze accounts that have engaged in criminal activity.

EOS is a new protocol (launched June, 2018) and one of the many governance experiments in cryptocurrency.  Ideally, token holders will vote for block producers who are “good actors” for the ecosystem, which could include building general tools like wallets and block explorers.  We’ve already seen evidence of cartels forming amongst block producers, and of “vote buying”, but also of block producers responding to incentives and investing to strengthen the ecosystem and increase token value.

As with any political system that involves voting, one challenge is complexity and voter knowledge.  It is difficult for EOS token holders to intelligently monitor, analyze, and then vote for a slate of block producers who are likely to be “good actors.”  This is something that fascinates me personally in both politics and cryptocurrency.  How can stakeholders make informed decision under antagonistic conditions?  In a conflict between stakeholders (or in an attack by external actors), we can expect disinformation campaigns and confusion in both cryptocurrency and politics.  This applies to all cryptocurrency governance models, but is exacerbated when stakeholders have to make frequent decisions about a wide range of topics with a diverse set of choices.

To learn more: https://eos.io/

Storecoin

Storecoin is an early stage project that aims to primarily make use of on-chain and formal off-chain governance.  It is loosely modeled after the US representative democracy with an emphasis on the checks and balances reflected in the various branches of government.  Storecoin aims to implement a “one entity one vote model”, in contrast to plutocratic proof of stake systems that are “one token one vote.”

Like the US government, Storecoin aims to balance responsiveness with steadfastness; change should be possible, but difficult in this community’s view.  Additionally, different types of responsibilities (e.g. validation, network security) are managed by specialists, but subject to review by other governance ‘branches’, aiming to balance the benefits of specialization while limiting the potential for abuse of power.

To learn more: https://storeco.in/

 

Conclusion

I view all cryptocurrency governance models as experiments.  We’re just now leaving the first decade of live crypto networks and still have much to learn from trial and error.  We may also find that some forms of governance perform better in different contexts.  Perhaps on-chain governance makes sense for some use cases and off-chain governance is preferable for others?

My intuition for cryptocurrency is the same as for politics.  The more diverse the stakeholders, the simpler we want the governance.  In politics, this suggests something like the federalism model we see globally today with minimal global governance, stronger national governance, and stronger still local governance.  The smaller and more homogenous the set of stakeholders, the more likely a strong governance model is to produce more good and less harm.

Imagine if we had a global democracy and voters in Asia could assert their will over voters in the rest of the world combined?  We’d likely want to minimize how much control the majority could assert over the minority.  In contrast, a stronger form of governance in a small town might be fine, since the residents are more likely to be closely aligned in their values and similar in their resources.

I look forward to learning from these real-time experiments.

Disclosures: BlockTower is a cryptocurrency investment firm that may take long or short positions in crypto assets, and our positioning may change suddenly.  At the time of publication, we have long positions in each of the assets discussed.  Nothing in this essay is intended as investment advice.

About Ari Paul

Ari Paul is co-founder and CIO of BlockTower Capital. He was previously a portfolio manager for the University of Chicago's $8 billion endowment, and a derivatives market maker and proprietary trader for Susquehanna International Group (SIG). Ari earned a BA in political science from the University of Pennsylvania, and an MBA from the University of Chicago with concentrations in economics, entrepreneurship, strategic management, and econometrics & statistics. Ari is a CFA charterholder.
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1 Response to Some high level thoughts on cryptocurrency governance

  1. Pingback: Towards a free market for P2P governance - The Block

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