Blockchain Governance

As blockchains scale up and their network increases in size and value, the issue of governance becomes more and more prominent. Borrowing ideas from the theory and practice of corporate governance, we explore which characteristics of blockchains promote good governance and which need improvement.

One of the most important and often overlooked issues in the design of blockchain protocols is their governance structure. From the theory and practice of corporate governance, we know that the aim of good governance is to set rules that enable the organization or network to achieve its stated goals, assure compliance and manage the relevant risks, using a decision-making process that is transparent and balances the interests of all stakeholders. Are these aims taken into consideration when a blockchain protocol is designed? How are they achieved? These questions are important, because there is a large academic literature examining the impact of specific characteristics of good governance on the operating efficiency and success of an organization. For example, Bhagat and Bolton (2008) find that stock ownership of board members and CEO-Chair separation are significantly positively correlated with both current and future operating performance, whereas board independence is negatively correlated.

Nakamoto (2008) did not mention a specific governance structure for the Bitcoin protocol, as the emphasis was on creating a decentralised digital payment system, which can withstand attacks aiming to corrupt transactions or take control of the network. Bitcoin’s current governance structure is informal, where there are no clearly specified roles, such as those of a CEO and the board of directors. As with Ethereum, changes are first suggested by developers and then discussed by the wider community of stakeholders (developers, miners and users),  using the Bitcoin Improvement Proposals (BIP) platform for Bitcoin and the EIP for Ethereum.1 However, the final decisions are taken by a small core group of stakeholders, using consensus. This process is not transparent and is done offline. An alternative structure is formal governance, where rules are encoded in the protocol and often involve online voting by stakeholders. Two interesting examples are Decred and Tezos.

Governance Failures

Whether formal or informal, the issue of governance becomes more important as the network scales and its value increases, thus amplifying opposing interests and making it harder to reach consensus. To provide some context, consider two examples where governance failed and the network split. In 2016, a software bug allowed the theft of $50 million worth of ether. The theft could be reversed through a fork, however no consensus was reached, leading to two separate blockchains, Ethereum, where the theft was reversed, and Ethereum Classic, where it was not. In 2017, there was a proposal to increase the block size of Bitcoin, to allow a greater number of transactions per block and decrease the miners’ fees. This proposal was rejected by the core developer team, leading a substantial number of developers and miners breaking away to create Bitcoin Cash.

We now elaborate on the following four characteristics of good governance: transparency, security, decentralization and accountability.

Transparency

Transparency refers to making some aspects of the decision-making process and the transactions of a network observable and verifiable by outsiders and stakeholders, so that there are checks and balances. In the case of public blockchains, transactions are recorded on the distributed ledger and can be accessed by anyone, leading to much greater transparency relative to the transactions of private firms, such as banks. The degree of transparency of the decision-making process varies across protocols. For Bitcoin and Ethereum, all proposed changes are publicly observable and discussed, through the BIP and EIP platforms. However, decisions are taken by a small core team of stakeholders using an informal procedure, which can lead to less transparency. If the rules of reaching a decision and abiding by it are not clear and accepted by all, disputes may not be resolved and the network may split, as it happened with Ethereum Classic and Bitcoin Cash.

Security

Although transactions can be transparent, they should also be secure from unauthorized access and, more importantly, be tamper-resistant. In the case of Bitcoin, although transactions are public, the identity of the transacting individuals is not. Moreover, Bitcoin has never been compromised and there is no incident of a successful attack, either to change a transaction or to take control of the network.2 Other blockchains, however, have been attacked successfully, for example Ethereum in 2016, as we mentioned above. As we explain in more detail in “An Introduction to the Distributed Ledger Technology”3, a recorded transaction becomes more secure as the number of blocks mined on top of it increase, together with the nodes that maintain and update the ledger.

Decentralization

One way in which security is achieved is through decentralization.4 If the ledger is stored, maintained and updated by a large number of independent nodes, it is very difficult for an attacker to destroy or corrupt all copies simultaneously. However, decentralization also has an impact on governance. A centralised governance structure can reach decisions quicker, while being more efficient and adaptable to sudden changes. However, it may also ignore the interests of some stakeholders, leading to decreased fairness and stakeholder engagement. A decentralised governance structure is slower in reaching consensus, but can be more inclusive and thus more effective in the long run. An interesting example is EOS, which is governed by 21 independent block producers, who are voted by token holders. Although this seems like a more transparent structure than that of Bitcoin, it has been reported that the largest block producers have colluded, making the network much more centralised.5

Accountability

Do stakeholders know who is responsible for each of the network’s failures and successes? Can they attribute blame (and achievement) where it is due? If yes, then there is accountability in the network. If people are accountable, then they feel that they have ownership of the tasks that they execute, giving them an incentive to perform well, as they are going to be rewarded. Therefore, there is a direct connection between accountability and performance. How accountable are public blockchains? On the one hand, because of their decentralised structure they lack accountability, especially when there are no formal executive roles in an informal governance structure and decisions are made through consensus, so that there is collective responsibility. On the other hand, because code changes are proposed using an online platform (such as the BIP and EIP) where everything is recorded, proposers take ownership of the changes that are implemented and can be rewarded accordingly. Furthermore, good or bad decision-making should be reflected in the cryptocurrencies price, incentivizing or punishing token holders through market forces, for good or bad decisions.

Conclusion

Blockchain governance is an often overlooked issue, however it becomes more and more important, especially when the underlying network increases in size and value. Most blockchain protocols are not governed in a very structured way, at least when compared to private firms and organizations. Do they fulfil most of the requirements for good governance? The answer is mixed. On the one hand, they perform very well in terms of security and transparency of their transactions. On the other hand, their decision-making process is usually not very transparent, and there is a lack of accountability. Finally, by design they are very decentralised, which has both benefits and costs.

Bibliography

Bhagat, S. and Bolton, B., 2008. Corporate governance and firm performance. Journal of Corporate Finance, 14(3), pp.257-273.

Nakamoto, S., 2008. Bitcoin: A peer-to-peer electronic cash system. Unpublished white paper.

Footnotes

1 More information about the Bitcoin Improvement Proposals  is at https://en.bitcoinwiki.org/wiki/Bitcoin_Improvement_Proposals and for EIP is at https://eips.ethereum.org/.

2 See the Attacks on the Blockchain, where we analyse some of the attacks that are possible in a blockchain, such as the 51% attack and selfish mining.

3 The report can be found here.

4 See An Introduction to the Distributed Ledger Technology for an explanation of the connection between the two and their relation to the scalability trilemma.

5 The news report can be found here.

Disclaimer

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