Governance: Why Crypto Investors Should Care

Bringing Governance Into Focus: DAO

By most measures, the 2016 initial coin offering (ICO) for venture fund Decentralized Autonomous Organization (DAO) was a success. Billed as the “largest crowdfunding project in human history,” it raised a record $100 million worth of ethers in less than two days.

DAO was stateless and decentralized, meaning that its operations were not tied to a specific geographic area, and it had a flat organizational structure. DAO token holders could vote on projects for investment and the relationship between them and the overall organization was governed by smart contracts on Ethereum’s blockchain. 

But a hack, which exploited security vulnerabilities in its code and resulted in the theft of $55 million worth of ether, foiled its ambitions. The question of what to do with the remaining funds cleaved the Ethereum developer community.

Large investors in the project demanded a hard fork, which would have refunded investors by creating a "withdraw" function in the code. But developers argued for a soft fork, which would have frozen funds and prevented the hacker from cashing in on the stolen ether. Underlying their argument was the "code is law" rule, wherein code pertaining to the original blockchain should remain immutable regardless of hacks.

The money guys won, and a hard fork created Ethereum while the original blockchain continued as Ethereum classic. As of this writing, Ethereum is the second-most-valuable cryptocurrency while Ethereum classic is ranked 64th. Trading in DAO tokens was discontinued.

Regardless of its consequences, the DAO fiasco brought governance issues within cryptocurrencies into sharp focus.

Why Cryptocurrency Governance Matters

Equity markets have clearly defined stakeholder structures for investor recourse. These structures have resulted in governance systems that protect investor interests and prevent rogue executives from running amok with the company. But cryptocurrencies have largely been shielded from similar oversight. The DAO hack is just one example of governance gone wrong within cryptocurrencies. Similar situations abound. 

“At an individual level, real monetary value is at stake, which in turn gives rise to investor and payment protection concerns,” says Philipp Hacker, a researcher who has authored a paper on corporate governance systems in cryptocurrencies. According to him, cryptocurrency investors have rights similar to those for company shareholders because they are directly affected by protocol changes in a blockchain. 

Thus far, changes in cryptocurrency protocol have been hijacked by a select group of stakeholders. For example, investors won the day when Ethereum’s protocol was bifurcated into two branches. The Bitcoin core team, which resisted changes to code to enable longer block sizes, was responsible for the creation of Bitcoin cash. By establishing voting systems and multiplying the number of stakeholders involved in the process, governance systems can help.

“Giving users a voice in the guise of voting rights constrains the action space of core developers with respect to actions that affect the community but for which they are not sufficiently accountable at the moment,” says Hacker. But that statement comes with a caveat. Cryptocurrencies, especially the smaller ones, are not systemically important enough currently to warrant governance systems, Hacker adds.

Example of Governance Gone Wrong

For example, Bitcoin investors were bystanders in the drama that culminated in a fork to its blockchain and resulted in the formation of a new cryptocurrency—Bitcoin Cash (BCH). Meanwhile, Tezos, a cryptocurrency designed to solve governance issues through on-chain voting systems, became embroiled in a governance problem of its own after an investor filed a lawsuit against its founders. There are technical issues with the absence of governance systems as well. For example, the absence of replay protection could duplicate transactions across an old and new blockchain.

A hard fork may have the effect of multiplying the number of coins in their investment portfolio. Similarly, a lawsuit, such as the one at Tezos, stops development work on a protocol and locks up investor funds until resolution.

Governance Systems Used for Cryptocurrencies 

Bitcoin and Ethereum already have systems in place to implement decentralized representation. The core of these systems is Improvement Proposals, suggested by developers and users to enhance the functionality and performance of their respective blockchains. 

But Hacker suggests that these proposals alone might not be enough. “Bitcoin clearly has not implemented an effective governance framework yet that would balance user/community voice with some steering on behalf of core developers in times of crisis,” he says.

As proof of his assertion, he refers to the veto mechanism from the Bitcoin core team that prevented the development of a larger block on the crypto’s blockchain for efficient processing of transactions. “Often this (the Improvement Proposal) works via a signaling mechanism that gives voice to miners, but not to ordinary users,” he says. Users, in this instance, are people who own cryptocurrencies, whether through running full nodes or third-party wallets.

Ethereum is ahead of Bitcoin in the governance game. The cryptocurrency has already tested several cryptocurrency-related innovations on its blockchain. For example, voting on the DAO proposal occurred through the implementation of a Carbon voting mechanism, in which each voting node had to make a transaction involving spending a minimal amount of ether (ranging from 0.06 ether to 0.08 ether). However, it recorded low voter participation. In addition to this, it also publishes transcripts of developer calls on its website.

Other Governance Programs

Other cryptocurrencies have also implemented different forms of governance systems. Some are a hybrid of off-chain governance and on-chain systems while others are purely on-chain systems.

For example, Dash’s system combines decision-making about future development through voting on proposals presented by Dash’s core development team by Masternodes (which are responsible for transaction consensus). Dash Core, which consists of senior members from the Dash network, is answerable to Masternodes and is answerable to them. It can also be removed by them.

“In essence, we are owned indirectly by the network and have a fiduciary duty back to them,” says Ryan Taylor, CEO of Dash. Decred, another crypto, implements a somewhat similar structure, but the entire process, voting, and proposals are implemented on the blockchain. The number of votes per stakeholder or user is proportional to their stake of coins.

Such an on-chain system may face problems in a privacy-focused cryptocurrency, such as Monero, where public keys identifying a voter are not easily divulged. Still, the movement of cryptocurrencies toward establishing governance systems is a positive development, says Hacker. “It shows that there is a demand for them (such systems).”