Governance: Why Crypto Investors Should Care

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.

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