State of Crypto Governance: Part II - Specifics of governance infrastructure in Blockchain

We've covered general governance basics and how it works in decentralized blockchain settings in the first part. Now, in the second part, we’ll dive deeper into the specifics of blockchain governance and explore its unique mechanisms and challenges.

Specifics of Governance in Blockchain Infrastructure

The software underlying blockchain protocols can be seen as a type of digital commons that typically lack sufficient individual incentive for users to fund improvements unilaterally. This leads to collective action problems similar to the tragedy of the commons in blockchain communities, where it's challenging to finance public infrastructure.

Various innovative methods have been explored to address these funding issues, such as token sales and token engineering techniques (like bonding curves and work tokens). Additionally, several mechanisms have been proposed to manage fund allocation effectively.

A key issue in the governance of blockchain infrastructure is determining how to implement changes in the protocol rules, which in turn affects the governance system itself. To understand why this issue arises, let’s delve into the specifics of Blockchain governance infrastructure one by one.

Typical Stake Holders in Blockchain Governance

In blockchain ecosystems, there are several key stakeholder groups, each playing a crucial role:

1. Miners: In proof-of-work blockchains, miners help secure the network by providing computational power. The more they invest in security, the safer the transactions. They participate through a mining process defined by the blockchain’s protocol.
2. Validators: In proof-of-stake and similar blockchains like proof-of-authority, validators secure the network. They validate transactions and stake native tokens as a security guarantee. Validators may be categorized into different types based on the protocol’s design.
3. Users: Blockchain users vary from beginners storing minimal value on exchanges to power users who run businesses on the blockchain, such as merchants or financial service providers. In decentralized governance systems, users may have formal control over the protocol through mechanisms like token-based voting.
4. Full-Nodes: These are power users who independently validate blockchain transactions without relying on third parties. They play a significant role in the network by choosing which blocks to accept and propagate, influencing the blockchain's direction through collective decision-making.
5. Core Developers: These developers shape the blockchain’s infrastructure and future by working on protocol specifications and software implementations. They can be part of the founding team or contribute voluntarily, motivated by factors ranging from personal interest to financial incentives.
6. Exchanges: Exchanges impact blockchain value and security by listing tokens. They play a critical role during forks, as the way they label different blockchain versions can influence public perception and market dynamics.
7. Foundations/Companies: Often, foundations manage funds raised from the community and decide on fund allocation, while holding trademarks and defining official versions of a blockchain. For-profit companies involved in blockchains also hold significant sway, particularly if they possess substantial token holdings for operational funding or profit generation.

These groups interact within the blockchain’s governance framework, influencing everything from daily operations to strategic decisions about the network’s future.

Navigating Forks: Soft and Hard

In the blockchain world, protocol changes are commonly implemented through forks.

There are two types of forks: soft forks and hard forks.

Soft forks are updates that tighten or add new rules but are backward compatible. This means that transactions valid under the new rules were also valid under the old rules. Soft forks allow multiple versions of the software to coexist on the same blockchain. For example, changes like reducing rewards or decreasing the maximum block size are soft forks. A soft fork requires the majority of the network's hashing power (in Proof-of-Work systems) to enforce the new rules for the change to be widely adopted, ensuring all nodes continue to agree on a single chain.

On the other hand, hard forks loosen or remove existing rules, making previously invalid transactions and blocks valid. This type of fork requires all nodes to upgrade their software to stay compatible with the new version of the blockchain. If not all nodes update their software, this can lead to a permanent split in the blockchain, creating two separate chains, each followed by part of the community. An example is an increase in block rewards or block size. Hard forks can be controversial because they challenge which version of the blockchain is recognized as the original.

Exchanges play a significant role in determining how versions are labeled post-fork. For instance, the Ethereum Foundation controls the Ethereum trademark and can decide what constitutes the "original" Ethereum, as opposed to Ethereum Classic after a fork.

The consensus layer, which includes rules on block validity like data formatting and transaction signatures, is the hardest to change because it can lead to a split if not all participants agree on the new rules.

User-activated soft-forks (UASF) represent a method where users (non-mining nodes) decide to adopt new rules without miner consensus. Miners, motivated by profits, are expected to follow these new rules. However, they can choose to initiate their own changes through a "miner-activated soft fork."

Overall, the dynamics of blockchain forks involve a delicate balance of miner and user interests, software compatibility, and the strategic decisions of major players like exchanges and foundations.

Types of Blockchain Governance

On-Chain Governance

On-chain governance refers to managing blockchain protocol changes directly on the blockchain. In this system, token holders vote on proposed changes; if a proposal garners sufficient support, it is automatically executed. This process usually involves transactions or smart contracts, enhancing transparency and building trust in decision-making. Token holders, based on their holdings, have the power to influence these decisions.

The primary advantage of on-chain governance is its efficiency and transparency, enabling swift decision-making. However, it can also centralize power in the hands of token-rich users, potentially leading to dominance in decision-making. Additionally, the permanent nature of changes on the blockchain means any poor decisions can have lasting negative impacts.

Examples of blockchains using on-chain governance include Tezos with its self-amending ledger, Polkadot, and Cosmos, where token holders directly influence updates. Decred features a hybrid approach, combining proof-of-stake and proof-of-work, allowing stakeholders to engage directly in governance.

Off-Chain Governance

Off-chain governance happens outside the blockchain via forums, developer meetings, and other collaborative tools. Decisions from these discussions require manual code updates by developers. This method is seen in Bitcoin’s governance, which relies on consensus from a decentralized community including contributors, miners, and users.

The decision-making process in off-chain governance involves community discussions, followed by coding, peer review, testing, and eventual deployment to the live network. This method can be slower and more cumbersome than on-chain governance and may face issues of centralization, as influential community members or developers might wield significant control over decisions.

Ethereum and Litecoin also utilize off-chain governance, with Ethereum employing Ethereum Improvement Proposals (EIPs), developer gatherings, and community forums to guide decisions, mirroring Litecoin's approach of relying on developer and community consensus.

Other Building Blocks of Blockchain Governance

• Proposal Systems - Many blockchain networks use formalized systems like Bitcoin Improvement Proposals (BIPs) to suggest off-chain protocol changes. Discussions about these proposals occur across various platforms, including forums, social media, and conferences.
• Resource and Fund Allocation - A key aspect of governance in crypto networks involves the allocation of resources. Typically, a foundation or legal entity is set up to manage funds raised to support the network's objectives. These entities can be non-profit foundations or for-profit companies. For-profit companies may provide services to the network, hold tokens to increase their value, or offer additional services. Decision-making within these organizations depends on their legal structure and leadership, which can range from centralized to decentralized. Often, these entities run grant programs aimed at funding initiatives to enhance the protocol and address research, development, and implementation challenges.
• Token Holder Voting (1 token = 1 vote) - This method is common in decentralized on-chain governance systems due to its simplicity. Each token grants the holder one vote, resembling a shareholder-value system in corporations. However, this can lead to plutocracy, where the wealthiest have the most influence, potentially skewing governance towards their interests.
• 1 Person = 1 Vote Reflecting traditional democratic systems, this approach requires a reliable identification system to ensure each vote comes from a unique individual. 
• Liquid Democracy - Liquid democracy allows voters to delegate their votes to experts or representatives, especially in topics they care about less, combining elements of direct and representative democracy. This system is particularly adaptable to blockchain technology, allowing for programmable, domain-specific voting.
• Quadratic Voting - In quadratic voting, participants are given a budget to allocate to various issues based on their personal importance. The cost of votes increases quadratically the more votes are cast for an issue, helping to balance majority and minority interests. This system also requires a reliable identity system to function properly.
• Reputation-Based Voting - Votes are weighted based on a voter’s reputation, which is built over time through contributions to the network. This method can incentivize positive contributions but may also lead to power concentration among those with high reputation scores. Systems like Oscoin and SourceCred are exploring ways to quantify contributions in open-source communities and link them to governance power.

Each of these voting systems has its strengths and challenges, often requiring trade-offs between decentralization, identity management, and resistance to manipulation.

Conclusion

Blockchain governance is all about finding the right balance between decentralization and effective decision-making. There are different ways to manage this, like voting systems on the blockchain (on-chain governance) or through community discussions (off-chain governance). Each method has its own pros and cons.

On-chain governance is quick and transparent but can concentrate power among those with many tokens. Off-chain governance allows for more detailed discussions but can centralize power among influential members.

Other methods include systems like quadratic voting, which helps balance the power between majority and minority interests, and reputation-based voting, where votes are weighted based on a person's contributions to the network.

As blockchain technology evolves, so will its governance models. The success of these models will be crucial in determining the future of blockchain networks.

Stay tuned for the third part of our series, where we’ll explore how governance works in specific Layer 1 blockchain and the challenges they face.