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Why Should Crypto Investors Be Concerned About Governance?

Bringing Governance to the Foreground: The DAO

The initial coin offering (ICO) for venture fund Decentralized Autonomous Organization (DAO) in 2016 was a success by most criteria. It was dubbed the “biggest crowdfunding initiative in human history” since it raised a record $100 million in ethers in under two days. 1

DAO was a stateless and decentralized organization with a flat organizational structure. Its operations were not bound to a single geographic location. DAO token holders could vote on investment initiatives, and their interactions with the organization were governed by smart contracts on Ethereum’s blockchain.

However, its plans were thwarted by a breach that exploited security flaws in its code and resulted in the theft of $55 million in ether. The Ethereum developer community was split about what to do with the leftover funds.

Large project backers wanted a hard fork, which would have reimbursed investors by adding a “withdraw” function to the code. Developers, on the other hand, advocated for a soft fork, which would have frozen funds and prevented the hacker from profiting from the stolen ether. Their reasoning was based on the “code is law” principle, which states that code pertaining to the original blockchain should stay unaffected by attacks. 4

The moneyed interests prevailed, and Ethereum was born as a result of a hard fork, with the original blockchain remaining as Ethereum classic. Ethereum is the second most valued cryptocurrency as of this writing, whereas Ethereum classic is rated 64th. 5 DAO token trading has been halted.

Regardless of its repercussions, the DAO debacle brought cryptocurrencies’ governance challenges into sharp focus.

The Importance of Cryptocurrency Governance

For investor recourse, equity markets have well defined stakeholder structures. These frameworks have resulted in governance mechanisms that protect shareholder interests while also preventing renegade executives from running amok with the company. Cryptocurrencies, on the other hand, have mostly escaped similar regulation. The DAO breach is just one example of cryptocurrency governance gone bad. There are a lot of scenarios like this.

“At an individual level, real monetary value is at risk, which raises investor and payment security issues,” says Philipp Hacker, a researcher who co-authored a paper on cryptocurrency corporate governance structures. Cryptocurrency investors, he claims, have rights similar to those of traditional shareholders since they are immediately affected by blockchain protocol modifications.

Changes in cryptocurrency protocol have so far been monopolized by a small group of stakeholders. When Ethereum’s protocol was split into two branches, for example, investors won the day. Bitcoin cash was created by the Bitcoin core team, which refused to update the code to allow for larger block sizes. Governance systems can aid by establishing voting processes and increasing the number of stakeholders involved in the process.

“Giving users a voice under the pretext of voting rights restricts core developers’ action space with respect to acts that harm the community but for which they are not currently appropriately accountable,” Hacker adds. But there’s a catch to that statement. Cryptocurrencies, particularly smaller ones, are currently not systemically important enough to require governance frameworks, according to Hacker.

An example of bad governance

Bitcoin investors, for example, were bystanders in the drama that culminated in a fork in the blockchain and the creation of a new cryptocurrency called Bitcoin Cash (BCH).
6 Meanwhile, Tezos, a cryptocurrency that aims to tackle governance concerns through on-chain voting processes, has run into its own governance issues after an investor sued the company’s creators. There are also technological concerns associated with the lack of governance structures. The lack of replay protection, for example, might result in duplicate transactions on both the old and new blockchains. 3

A hard fork might potentially increase the number of currencies in their investment portfolio. A lawsuit, such as the one filed against Tezos, halts protocol development and locks up investor funds until the case is resolved.

Governance systems can simplify internal change management processes in addition to protecting investors. This means they can be utilized to implement a decentralized ethos in practice.

For Cryptocurrencies, Governance Systems are Used

Bitcoin and Ethereum already have decentralized representation mechanisms in place. Improvement Proposals, proposed by developers and users to improve the functionality and performance of their respective blockchains, are at the heart of these platforms.

However, according to Hacker, these solutions may not be sufficient. “Bitcoin has certainly not established a good governance mechanism yet,” he writes, “that would balance user/community voice with some direction on behalf of core devs in times of crisis.”

As evidence, he cites the Bitcoin core team’s veto mechanism, which delayed the building of a larger block on the cryptocurrency’s blockchain for more efficient transaction processing. “This (the Improvement Proposal) frequently operates through a signaling system that provides miners a voice but not to ordinary users,” he argues. People who own cryptocurrencies, whether through complete nodes or third-party wallets, are referred to as users.

In terms of governance, Ethereum is ahead of Bitcoin. On its blockchain, the coin has already tried a number of cryptocurrency-related technologies. Voting on the DAO proposal, for example, took place through the use of a Carbon voting mechanism, in which each voting node had to make a transaction requiring the expenditure of a small amount of ether (ranging from 0.06 ether to 0.08 ether). It did, however, have a poor voting turnout. In addition, it makes transcripts of developer calls available on its website.

Other Governance Initiatives

Different types of governance structures have also been established in other cryptocurrencies. Some are a combination of off-chain governance and on-chain mechanisms, while others are entirely on-chain.

Dash’s method, for example, mixes decision-making on future development with Masternode voting on proposals made by Dash’s core development team (which are responsible for transaction consensus).

The Dash Core, which is made up of senior Dash network members, reports to Masternodes and is accountable to them. They can also get rid of it.

“In essence, the network owns us indirectly, and we owe them a fiduciary duty,” explains Ryan Taylor, CEO of Dash.

Another cryptocurrency, Decred, has a similar structure, but the entire process, including voting and proposals, is done on the blockchain. The number of votes cast by each investor or user is proportionate to the amount of coins they have invested. 9

In a privacy-focused cryptocurrency like Monero, where public keys identifying a voter are not easily disclosed, such an on-chain method would have issues. Nonetheless, according to Hacker, the march of cryptocurrencies toward developing governance mechanisms is a beneficial development. “It demonstrates that there is a market for such solutions.”

What do you think?

Written by Jordana Williams

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