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, 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 decentralised 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 specialised 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 per cent 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 specialised equipment producers and mining pool operators. We show that in this ecosystem, a single firm dominates the market for specialised 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 decentralised blockchain differs from a traditional financial intermediary as a provider of trust.

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Notes:

This blog post appeared originally on the Oxford Business Law blog under the title Corporate Interests and the Governance of Blockchains.

This piece is NOT under a Creative Commons licence. © Oxford Business Law blog. Reposted with the blog’s permission.

The post is based on the authors’ Corporate Capture of Blockchain Governance, European Corporate Governance Institute (ECGI) – Finance Working Paper No. 593/2019

This piece gives the views of its authors, not the position of LSE Business Review or the London School of Economics.

Featured image by skeeze, under a Pixabay licence

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Daniel Ferreira is professor of finance at LSE, a research fellow at the Centre for Economic Policy Research (CEPR), and a fellow at the European Corporate Governance Institute (ECGI). He has a PhD in economics from the University of Chicago. His research interests are in theoretical and empirical corporate finance and governance, and organisational economics.

Jin Li is a professor of management and strategy, with joint appointment in economics at Hong Kong University. He has taught at Kellogg School of Management and LSE, where he was a tenured associate professor of managerial economics and strategy. During his tenure at LSE, Professor Li won the management department’s teaching prize. His main research area lies at the intersection of organisational economics, personnel economics, and labour economics.

Radoslawa Nikolowa is a senior lecturer at the School of Economics and Finance of Queen Mary University of London and a research associate in the Financial Markets Group (LSE). Her main research interests are organisational economics and corporate finance.Before joining Queen Mary, Radoslawa was a postdoctoral fellow at the LSE’s managerial economics and strategy group.