A Brief History of Governance in Cryptocurrency Land

I recently had dinner with someone who holds sizable cryptocurrency positions. He reiterated what I hear often from people bullish on public blockchains: private projects like R3 are great insofar as they will win the banks over to using a cryptocurrency as their form of value transfer.

Though I’m sympathetic to cryptocurrencies as a social and economic experiment, I believe this transition will never happen. Most cryptocurrencies are optimized to achieve a high-integrity ledger while evading censorship. The design choices that allow for cryptocurrencies to thrive in hostile environments also pose a tax on the throughput and efficiency of these systems.

Many of the design choices that render cryptocurrencies unsuitable for financial services can be altered through forks, whereby the cryptocurrency’s protocol uses new conditions for validating transactions in the network. While these events can make cryptocurrencies more attractive to financial institutions* (likely while alienating their existing user base), the methods available to implement forks point to a larger issue with cryptocurrencies: a lack of robust governance structure.

Two Case Studies
The world has already seen two major crises arise from a lack of governance mechanisms in the two most popular cyptocurrencies: Bitcoin and Ethereum.

Over the last eighteen months, the Bitcoin community has undergone a debate over how the Bitcoin protocol should scale to support more transactions. Without getting into the technical details, several proposals were made to achieve this – some of which were mutually exclusive to one another. Ultimately, the debate over how to amend the protocol led to intense disagreement among the Bitcoin developer community. The path forward had no means to transfer from debate to enforcement in a dynamic fashion.  

More recently, some aspiring former Ethereum developers created a smart contract-based, kickstarter-esque, investment project called “The DAO.” Unlike traditional investment management shops, The DAO was to be governed exclusively by a few thousand lines of code and the votes of its token holders to pick investments. Though it was known to have several critical deficiencies prior to launch, the brazen developers behind the project pushed it to market. When one of the many issues with The DAO was exploited to the tune of ~$50 million going to one clever hacker, Ethereum holders were incensed and called for some form of time-out.

In the heat of The DAO exploit, a hard fork to “undo” the DAO was proposed. At first, the Ethereum Foundation said that they miners would decide if a soft fork to freeze the hacker’s account would take place. Then, the Ethereum Foundation incented miners to soft fork. Soon after, a proper hard fork emerged. For concise summaries, see my colleague Tim Swanson’s posts on the topic – and related ppt for consultants. Long (and unfinished) story short: though the Ethereum Foundation, miners, etc. pursued a course of action, it remains unclear what threshold of dispute over ETH/ETC at the hands of buggy code will cause them to hit “reset” again. 

Closing Thoughts
In short, cryptocurrencies allow stakeholders to benefit from the integrity borne of the incentives for miners… until they don’t. This is a poor value proposition for banks, which are already subject to the will of many external parties. In order to survive, cryptocurrencies will have to learn how to incorporate governance.

* – Though probably not ever because the world still does their accounting in terms of dollars, pounds and the like.

The Weekend Read: June 5

1. Mike Hearn’s Post

Mike’s post counters a point from Fred Ersham’s post last week as a launching point to discuss developer issues across Bitcoin, Ethereum, and private ledgers such as Corda alike.

If we as an industry misunderstand the pain points in developing decentralised financial applications then we won’t be able to fix them.

2. WSJ “What is a Bank?” Series

The series looks at the rise of the megabank, and also has several pieces by different thought-leaders including Chris Larsen of Ripple on the role of, and future of, banks.

3. Cryptocurrency Update

DAO cracks the top five cryptocurrencies.  WSJ writes an article on 5/30 on the recent Bitcoin price surge, and buying pressure from China…the price ripped up another 10% from that price. The ETH-BTC friends-or-foes debate.

The CFTC establishes jurisdiction over Bitfinex.

4. R3 News

Coindesk speaks with Tim Swanson about the Ethereum platform review by Vitalik Buterin.  Hong Kong insurance giant AIA joins the consortium.  A profile on R3’s relationship with Ping An.  Lastly, watch Lee Braine’s presentation on smart contract templates.

The Weekend Read: May 22

1. This Week in DAO

I had not planned to share another batch of DAO related articles this week, but the topic has generated lots of interesting takes and opinions, and honestly the rest of the week’s news is kinda meh. So let’s DAO it up.

Funding is now above $150m and counting. Nathaniel Popper has a nice piece profiling the creators, as well as telling the story of one early supporter, a “French socialist with an appetite for risk” (of course!). Two other articles in the skeptic camp gained attention this week. Daniel Larimer, founder of BitShares, shared his unique perspective as someone who has lived thru the second and third order problems of massively decentralized governance:

Fancy technology can obscure our assessment of what is really going on. The DAO solves a single problem: the corrupt trustee or administrator. It replaces voluntary compliance with a corporation’s charter under threat of lawsuit, with automated compliance with software defined rules. This subtle change may be enough to bypass regulatory hurdles facing traditional trustee’s and administrators, but it doesn’t solve most of the problems the regulations were attempting to address.

What The DAO doesn’t solve is all of the other problems inherent with any joint venture. These are people problems, economic problems, and political problems. In some sense, The DAO creates many new problems caused by its ridged rules and expensive machine-enforced process for change.

Eris Industries’ Preston Byrne gives his legal perspective on The DAO, walking thru an (almost) marmot-free example. In summary:

I sympathise with THEDAO’s intentions, in that I believe that the financial markets are currently rigged against the “little guy” and that there is no reason why the kinds of investment opportunities (and returns) available to the super-wealthy should not be available to small investors whose traditional means of accumulating wealth (savings) are all but useless given current, zero interest-rate monetary policy. 

I also believe that blockchain tech will one day play a role in facilitating more democratic access to the capital markets. However, the current body of laws governing this sphere of conduct exists to ensure that people to whom investments are marketed can be absolutely certain about what they’re getting in exchange for their money.

In this respect THEDAO clearly falls very short of the mark.

Peter Vessenes gives a sobering take on Ethereum smart contract code, the ‘stuff’ that DAO folks will be funding. His audit reveals some shocking stats:

Dan Mayer cites research showing industry average bugs per 1000 lines of code at 15-50 and Microsoft released code at 0.5 per 1000, and 0(!) defects in 500,000 lines of code for NASA, with a very expensive and time consuming process.

My review of Ethereum Smart Contracts available for inspection at shows a likely error rate of something like 100 per 1000, maybe higher.

FInally, the incomparable Matt Levine focuses in on The DAO with his usual gimlet eye in this longish article:

Smart contracts are cool! Companies are weird bundles of contractual relationships that have become stereotyped and calcified over time, and re-imagining those relationships for a new and more technology-enabled age is a good project. But companies aren’t just networks of contracts; they aren’t pure agreements negotiated freely between willing participants and no one else. They are also structures that are embedded in society, with rights and responsibilities that are regulated by background rules as well as by contracts. The blockchain-y reinvention of everything in the financial world — money, contracts, companies — is fascinating and impressive and, viewed from a certain angle, adorable. But sometimes it could stand to learn from what has gone before. After all, the elements of finance — money, contracts, companies — have already been invented. Perhaps their historical development might hold some lessons for their re-inventors.

2. This Week in Bitcoin Gossip

The Mt. Gox implosion is a gift that keeps on giving…to internets reporters at least. The Daily Beast gives an ‘insiders’ account of all the shenanigans and (mostly) incompetence that went on behind the scenes. And boy was there incompetence. The article also gives more credence to the “Willy Bot” theory. It proves the old trading adage: never trade your way out of an out trade.

The Weekend Read: May 15

1. “The DAO” Jonesing

[High five self for NY Post style headline pun]. The DAO public crowdsale that isn’s an equity raise continues to gobble up investors and Ether (already over 13% of the float!). CoinDesk did a great job this week of summarizing both the goals of The DAO and the inscrutable semi-organizational structure behind it. I also asked The Swanny to give me two paragraphs on the topic, which in his world means a whole blog post, which you can read in full here.

Overall this is a fascinating experiment, as a few have put it, but one that is being done WITH MONEY, particularly OPM. Is this a result of folks not knowing or more likely not caring about the time value of money, since real rates are so low? What would be an investor’s time horizon to realize returns, as the VC rule of thumb is ~7 year time frame? When you consider that Angellist put roughly $70m to work in public syndicates in 2015, The DAO would need quite a few years to put its money to work, and that would only start the clock on the investment…

Isn’t this like “Ether squared” from a risk perspective? Since you need to believe that Ether will be stable to higher AND that DAO tokens will be stable to higher AND that using a global censorship resistant computer to allocate investment capital will outpace the returns of other investments (opportunity costs). It most definitely could work and give great returns to those who have invested, but with a VERY unclear risk profile. There will be lots of good and bad (and definitely worthwhile) lessons that come out of this experiment, I am just happy that I don’t have to fund it.

2. A Warm Regulatory Embrace

CFTC Commissioner Giancarlo preceded our panel at Markit’s annual customer conference to give another pro-innovation speech Blockchain: A Regulatory Use Case

This speech reiterated the commissioner’s belief that “we need DLT to succeed” and highlights five steps for a “do no harm” approach. It also has a nice shout out to Corda. The speech also discussed “Regulatory Sandboxes” such as the UK FCA. Speaking of the FCA, they announced a “Fintech Bridge” with the Monetary Authority of Singapore (MAS) earlier this week.

3. Even More Links

Vitalik Buterin’s recent post on settlement finality is a volley in a gentleman’s debate with our Tim Swanson. The Swanny’s article argued that public blockchains by design cannot definitively guarantee settlement finality. Vitalik breaks the argument down into three sections: 1. issues from probablistic finality (such as forks) 2. the interestingly named “law maximalist” position and 3. the economic argument (if value traded >> price of tokens, then attack). Dense stuff but very readable, as is usually the case with Vitlalik’s writing.

CoinDesk’s always interesting State of Blockchain: Q1

The SWIFT Institute (not to be confused with SWIFT itself) released a whitepaper entitled The Impact and Potential of Blockchain on the Securities Transaction Lifecycle. The authors interviewed 75 organizations in post-trade and tech, taking a similar cautious tone and “cold water” approach to other recent papers via market intermediaries.

Nice quick interview with Massimo Morini on his recent paper and the challenges/opportunities facing banks.

IB times profile of David Rutter.

Gideon Greenspan discusses four blockchain use cases: lightweight financial systems, provenance tracking, inter-organizational recordkeeping, multiparty aggregation.

And finally, Fran Strajnar has an interesting post on protocols and standards, a topic that we discuss quite a bit at R3 HQ:

We believe it is too early to tell exactly how things will pan out, but can reflect back to the Internet days and take away the following insights:

Standards/Protocols are inevitable and required.

Networks ALWAYS end up demanding inter-operability.

It took 15 years to shake out the ideas and protocols that solidify the Internet we use today. It will take at least 5-7 years for Distributed Ledger Technology to be implemented commercially on a global scale by enterprise – i.e., using some form of blockchain to replace the SWIFT network, or back-end infrastructure for inter-bank or even inter-branch settlements.

We expect to see proposals rise and fall and flip-flop as solutions and standards evolve, so don’t count on anything proposed today becoming the de facto operating standard. Whatever happens, we know one thing for sure: Millions will be spent, burned, made, and the world will only remember the victors.