All blockchains have rules that govern their operations. As blockchains evolve they may need to change their rules. Blockchain governance refers to the system in place through which decisions regarding the evolution of the blockchain are made. The question of blockchain governance is at the heart of a burgeoning debate in the blockchain community, where different governance systems are being tested by small scale blockchains.
In a recent working paper, Corporate Capture of Blockchain Governance, we argue that as in corporate governance, a key challenge for blockchain governance is to avoid capture by interest groups. The focus of our paper is on permissionless (public) blockchains, which are governed by some form of direct voting by stakeholders. More specifically, we focus on the proof-of-work system ─ the system currently adopted by the largest blockchains (eg, Bitcoin and Ethereum) ─ and its vulnerability to capture by interest groups.
The proof-of-work system is not only a mechanism for validating transactions but also a mechanism of decentralized governance. According to Bitcoin’s founder Satoshi Nakamoto (2008), ‘[proof-of-work] solves the problem of determining representation in majority decision making. (...) Proof-of-work is essentially one-CPU-one-vote.’ In the proof-of-work system, players called miners enter into a competition where a single winner is allowed to add a block (a set of transactions) to the chain. To win, a miner must solve a mathematical puzzle that requires significant computational power. The probability of a miner being the first to find a solution is proportional to the amount of computer power they allocate to the process of mining a block. If a proposed change of rules leads to a disagreement among stakeholders and if there are competing versions of the same blockchain, each version with its own set of rules, miners collectively ‘vote’ for their preferred set of rules by allocating their computing power to one of the chains.
Our paper shows that the proof-of-work system is not immune to capture by interest groups. Our main finding is that proof-of-work may lead to a situation where the governance of the Blockchain is captured by a large corporate stakeholder.
Our model fits the description of the Bitcoin mining ecosystem, where the dominant specialized equipment producer is also the largest player in the pool services market. There has been a number of instances when Bitmain Technologies ─ the leading cryptomining ASIC chip designer, which has 75% of the market ─ has used its control over the ecosystem to leave its mark on the governance of Bitcoin. One example is the hard fork of the Bitcoin blockchain that created Bitcoin Cash on August 1, 2017, as the result of unresolved disagreements among members of the Bitcoin community concerning changes to the size of blocks. A few large players in the Bitcoin ecosystem, including the Bitmain-affiliated pool ViaBTC, sponsored the creation of the new currency, which shared the same history as Bitcoin but had a larger block size. In November 15, 2018, Bitcoin Cash itself split into two competing blockchains. Bitmain rallied behind Bitcoin Cash ABC against Bitcoin Cash SV, in what became known as the ‘hash wars’. Prices of both currencies fell steeply right after the split, as did the prices of Bitcoin and other cryptocurrencies.
Consistent with what we observe empirically in blockchains such as Bitcoin, in our model the proof-of-work system creates a mining ecosystem with specialized equipment producers and mining pool operators. We show that in this ecosystem, a single firm dominates the market for specialized mining equipment. The dominant equipment producer thus has incentives to foster competition in the mining pool services market, because lower prices for pool services make mining more attractive and thus increase the demand for mining equipment. In our model, the equipment producer then becomes a large player in the mining pool services market. Since the managers of the mining pools decide which blocks to mine, by controlling a large share of the mining pool market the equipment producer has a disproportionate influence on the governance of the blockchain. That is, the governance of the blockchain is captured by a large corporate stakeholder.
When a single large firm captures the governance of a blockchain, blockchain stakeholders have to trust one company to look after their interests. In that case, it is not clear how a decentralized blockchain differs from a traditional financial intermediary as a provider of trust.
Daniel Ferreira is a Professor of Finance at the London School of Economics
Jin Li is a Professor of Management and Strategy at Hong Kong University
Radoslawa Nikolowa is a Senior Lecturer at the School of Economics and Finance of Queen Mary University of London