BoE | Oct 19, 2022

Carolyn Wilkins talks about ways in which the crypto ecosystem can help reimagine governance. However, the models we see today may not be as decentralised as they might appear. To build trust, she encourages the crypto industry to build best practices in governance, codes of conduct, and set high expectations for transparency.

• Examples when TradFi governance failed:  The history books are full of instances when faulty governance in traditional finance led to both failure of a particular financial institution, and financial instability. Just look back to the global financial crisis (GFC) when generalised weakness in risk management frameworks led to limited understanding and control of balance sheets.
  • Remember Bear Stearns, where the concentration of mortgage securities had been increasing for several years and was beyond their internal risk limits?
  • Lehman Brothers, of course, is another example.

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• Crypto governance:
  • The first is the possibility of organisational structures based on a greater degree of decentralised decision making than in traditional finance. Given this, some crypto proponents aim to challenge traditional economic institutions of capitalism – firms, markets, and potentially governments which allows financial services to occur at scale, with less recourse to an intermediary than in traditional finance.
  • The second opportunity is that the governance itself can spur growth by framing decision making as a game or an activity in which participants have something at (or to) stake.
  • The successful completion of Ethereum’s project – called “the Merge” – is a recent example of what can be achieved under the right circumstances. This accomplishment hopefully foreshadows further success as Ethereum works on upgrades to lower transactions times and costs, and will inspire other platforms to learn from this experience.Governance of this project looks quite familiar in a couple of ways:
    1. It was fairly centralised. The project was coordinated by the Ethereum foundation that oversaw a core development team, rather than a fully decentralised community. Given the complexity of the project, this centralisation was a necessary mechanism to accelerate the project. Vitalik Buterin – one of Ethereum’s key founders was understandably quite influential, although he did not have unilateral decision-making power.
    2. There were parallel runs and extensive testing. Almost two years ago, Ethereum developers created a new network called the “Beacon Chain” that uses the PoS validation mechanism. It ran in parallel to the PoW-based Ethereum network. They also conducted trial runs over a number of years, prudently delaying the project on a number of occasions given outstanding issues and the amount of money at risk. Their checklist of “readiness” milestones ahead of the Merge, shows efforts to be transparent about the project.

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• Limits to decentralised governance in practice:
  • In practice, the governance of critical decisions is not completely decentralised even in a permissionless blockchain such as Bitcoin. In fact, the consensus mechanism and other governance protocols can lead to undesirable concentrations of power.  For instance, a few individuals who have accumulated significant voting rights can dominate.  A recent study shows that, among the top 10 proof of stake platforms by market capitalisation, the top ten validators held between 23% and 88% of the stakes, while the top 50 held between 47% and 100% of the stakes
    • the idea of quadratic voting to mitigate the issue of concentration in decision-making. Under this mechanism, 1 vote would cost 1 token, 2 votes would cost 4 tokens, 3 votes would cost 9 tokens and so on. Even though owning more tokens would still mean enhanced voting rights, the ability of large token holders to dominate would be reduced.
  • There are also issues regarding transparency. This raises questions about who is accountable for decisions and outcomes. There is a rich debate in the United States regarding whether the core protocol developers should be held accountable as fiduciaries. And the CFTC’s recent enforcement action against token holders of Ooki DAO is a live case study of the extent to which governance token holders can be held liable.
  • The hard lesson here is that, when tokens are transferable, special care is needed to ensure that their supply, distribution and price accurately represents the community members who are invested in the project.
  • On-chain voting can take too long:  The on-chain voting process on the blockchain platform Tezos is currently divided into five governance cycles (each lasting roughly two weeks): a proposal period, a testing-vote period, a testing period, a promotion-vote period, and an adoption period. In platforms like this, any event that requires urgent action is unlikely to be resolved promptly through the usual governance process.
    • Polkadot, an open source blockchain platform and cryptocurrency, allows for emergency referenda to be initiated by an assigned technical committee.
    • MakerDAO can implement an emergency shutdown functionality whereby a smart contact can suspend its normal operation and return the invested assets to their owners.

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• Financial risk and stability:  Institutional investors in DeFi are focused on reputational risk, not just financial risk, and will expect to see better governance and outcomes on this front.  “You can fool some people sometimes, but you can’t fool all the people all the time.”
• Narrowing window for crypto to improve governance:  The window for the crypto industry to improve its approach to governance is narrowing: regulated firms in traditional finance are increasingly applying the underlying blockchain technology to traditional capital markets. They will be in a better position to capture this market if the crypto industry does not get its house in order, if only because they have more familiar and battle-tested governance.
• A good place to start for DeFi is with industry-led mechanisms that develop codes of conduct and best practices. For instance, institutional investors may ultimately want to see high standards around disclosures in financial statements, sources and uses of funds, conflicts of interest and related parties, regardless of whether the activity is subject to regulatory requirements or not. These expectations could include regular audits of the code, and disclosure of how rights to change the code are determined and who holds the “commit keys.”
• Governments and regulators still have work to do to build supporting legal and regulatory infrastructure. Finance is global but regulation is local, so coordination across borders is essential.

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