On-Chain Governance: Definition, Types, Vs. Off-Chain

What Is On-Chain Governance?

On-chain governance is a system for managing and implementing changes to cryptocurrency blockchains. In this type of governance, rules for instituting changes are encoded into the blockchain protocol. Developers propose changes through code updates and each node votes on whether to accept or reject the proposed change.

Key Takeaways

  • On-chain governance is a system for managing and implementing changes to cryptocurrency blockchains.
  • On-chain governance includes rules for instituting changes that are encoded into the blockchain protocol.
  • Developers propose changes through code updates and each node or participant votes on whether to accept or reject the proposed change.

Understanding On-Chain Governance

A blockchain network is a system that contains a distributed ledger similar to a shared database. Transactions are recorded on the blockchain and shared with all of the participants. Whenever a new transaction is conducted, a new block needs to be added to the blockchain. However, there are consensus protocols, which need to be followed for the transaction to be considered valid. Miners, who are also called nodes, verify the data to make sure it's accurate and that the parameters regarding the transaction have been satisfied. 

Once miners have completed their verification process, the results are submitted to the network. After review by other nodes or participants and consensus has been achieved, a new block is added to the network. Miners usually receive some type of compensation for their efforts, which is called a Proof of Work (PoW) system or process.

Participants in On-Chain Governance

Unlike informal governance systems, which use a combination of offline coordination and online code modifications to effect changes, on-chain governance systems work only online. Changes to a blockchain are proposed through code updates. Improvement proposals to make changes to the blockchain must be submitted by developers. A core group, consisting mostly of developers, is responsible for coordinating and achieving consensus between stakeholders. Typically, on-chain governance involves the following stakeholders:

  • Miners—who operate the nodes, which validate the transactions
  • Developers—who are responsible for core blockchain algorithms
  • Users or participants—who use and invest in various cryptocurrencies

Stakeholders in the process are provided economic incentives to participate. For example, each node can earn a cut of overall transaction fees for voting, while developers are rewarded through alternate funding mechanisms.

The participants or nodes can vote to accept or decline the proposed change. However, not all nodes have equal voting power. Nodes with greater holdings of coins have more votes as compared to nodes that have a relatively lesser number of holdings. If the change is accepted, it is included in the blockchain and baselined. In some instances of on-chain governance implementation, the updated code may be rolled back to its version before a baseline, if the proposed change is unsuccessful.

Types of On-Chain Governance

Implementation of on-chain governance differs between various blockchains. For example, Tezos uses a form of self-amending ledger. Proposed changes are implemented to the coin's blockchain and rolled out onto a test version of the chain. If the planned changes are successful, they are finalized into a production version of the blockchain. If not, they are rolled back.

DFinity, a startup that is using blockchain to build what it claims will be the world's biggest virtual computer, unveiled a plan to adopt a hardcoded constitution on its network. The constitution triggers passive and active actions. An example of the former might be an increase in reward size for blocks while the latter might involve quarantining certain parts of the network for updates or rollbacks.

Current governance systems in Bitcoin and Ethereum are informal. They were designed with a decentralized ethos, first promulgated by Satoshi Nakamoto in his original paper.

Concerns About On-Chain Governance

Critics of the system claim that this form of informal governance is, in fact, centralized among miners and developers. They point to two prominent forks in the cryptocurrency ecosystem as proof.

Ethereum Fork

The first is a split of the original Ethereum blockchain into Ethereum Classic (ETC) and Ethereum (ETH) in 2016 as a result of a hack into the system in which $50 million worth of funds were stolen. A hard fork was performed to secure the network and to return the stolen funds to their original owners. A hard fork is a major change to a blockchain protocol that might make previous blocks or transactions valid or invalid. A hard fork requires the developers and nodes to agree to the upgrade or change to the protocols. Sometimes a hard fork is not agreed upon by all participants, which can create concern, debate, and criticism.

The Ethereum fork was widely debated by the community as was whether to support Ethereum Classic or Ethereum following the fork. Critics argued that this was a contravention of the widely-held "Code is Law" principle, in which the governing parameters for software are laid down in the original code. Others have argued that the fork demonstrates that malicious attacks on the system can be dealt with effectively restoring the funds of those involved.

Bitcoin Fork

In 2017, Bitcoin also went through a hard fork, which resulted in two separate blockchains; the original Bitcoin and Bitcoin Cash. At the time, the Bitcoin community was trying to determine how to improve the network's scalability or the ability to process more transactions at the same time. As new transactions are added to a network, only so many can be processed simultaneously. For example, Bitcoin could only process one megabyte of transactions at a time, which led to delays in transactions being completed.

During the fork, a proposal to increase the average block size in bitcoin's blockchain was rejected by the cryptocurrency's core development team. They rejected the change, despite the fact that high transaction fees made bitcoin's use as a medium for daily transactions unsustainable. The only constituency that benefited from high transaction fees were miners. In the end, a renegade group of developers and miners moved away to create their own cryptocurrency with variable block sizes. The hard fork between Bitcoin and Bitcoin cash was done, in part, to increase the processing limit from one to eight megabytes.

Future of On-Chain Governance

On-chain governance emerged as an alternative to informal systems of governance. It claims to solve the problems of the centralization of bitcoin by incorporating all nodes within a blockchain network into the decision-making process.

Blockchain technology offers an inclusive approach to technology in which all participants can share the benefits. As the blockchain community and their networks look to improve their scalability allowing them to process more transactions and compete with traditional electronic payment systems, such as Visa, updates to the technology are likely to continue.

These changes will continue to be implemented in an effort to improve blockchain technology and the shared benefits of the community. On-chain governance will likely center around enhancing transparency and trust in the process of a distributed ledger as these changes and improvements are implemented.

However, the blockchain community will need to ensure that on-chain governance is not largely controlled by a small group of developers and miners who can Implement changes as they see fit. With developmental changes to the blockchain networks, there is the risk of future disagreements and hard forks, which could divide the blockchain community.

Advantages of On-Chain Governance

According to its proponents, the advantages of on-chain governance are as follows: 

It Is a Decentralized Form of Governance

Changes to a blockchain are not routed through a core development community, which evaluates its merits and demerits. Instead, each node is allowed to vote on the proposed change and can read about or discuss its benefits and drawbacks. It is decentralized because it relies on the community for collective decision-making.

It Offers Quicker Turnaround Times for Changes

Informal governance systems require time and effort between stakeholders in order to achieve consensus. On-chain governance achieves consensus regarding proposed changes in relatively less time among stakeholders. For example, the bitcoin cash fork and Ethereum classic fork took months to build up and implement.

What's more, off-chain maneuvering can result in messy situations where certain nodes can agree to disagree and not run the proposed changes. Algorithmic voting mechanisms are relatively faster because test results for their implementation can be seen via a code update. Running the code change on a test net, as in the case of Tezos, also enables stakeholders to see the effects of that change in practice. 

The Possibility of a Hard Fork Is Reduced Significantly

Because each proposed change requires consensus from all nodes, this means that the possibility of a hard fork is reduced significantly. Through the use of rewards, on-chain governance proposes economic incentives for nodes to participate in the voting process.

The informal governance process does not provide economic incentives to end-users, who utilize cryptocurrencies for daily transactions or invest in them for long periods. Instead, economic incentives rest with miners and developers. Once voting is concluded, all node operators are required to follow the decision. 

Disadvantages of On-Chain Governance 

Based on initial experiments conducted with on-chain protocols, the disadvantages of this type of governance are as follows:

It Has a Low-Voter Turnout

As with real-world elections, low voter turnout may become a problem for on-chain governance. The DAO Carbonvote, which at one time had recorded participation rates of 4.5%, is proof of this problem. Low-voter turnout is also undemocratic because it could result in a single node with significant holdings manipulating the overall future direction of the protocol.

Users With Greater Stakes Can Manipulate Votes 

Nodes with more coins get more votes. Again, this means that users with more stakes can take control of the voting process and steer future development in their desired direction. More importantly, it skews the dynamic away from miners and developers towards users and investors, who may be simply interested in maximizing future profits as opposed to developing the protocol towards innovative use cases.

Critiques of On-Chain vs. Off-Chain Governance

The question of blockchain governance is not unique or unprecedented. Legal philosophy and theory have grappled with this issue for hundreds of years, and the issues there have direct relevance to the question of on-chain versus off-chain governance.

Central to the debate between governance that includes human decision making (off-chain) and rule-based decision making that can be conducted entirely through automated processes (on-chain), is the question of "whether existing rules and decision-making processes governing a blockchain-based system should be changed from the inside or the outside by the reference community, and whether the system should provide for a mechanism to change the governance structure itself. This practical question leads to the more theoretical and normative question of whether an existing set of code-based rules could and should overtake the exercise of human judgment in decision-making, and what are the ethical and political considerations this would entail."

On-chain governance is based on a version of positivist legal order that enables peaceful and legitimate resolutions of disputes in a pluralist society, without recourse to external sources (moral or political) to justify its legitimacy. In the case of crypto governance, this means the competing interests of stakeholders don't have to come down to an arbitrating authority (like "what would Satoshi do?") or a fight over moral priorities, like "it's unfair that miners get to make decisions on fees when coin holders are left out in the cold."

The critique asks if this is possible, or if, as conservative legal theorist (and one-time German Nazi party member) Carl Schmidt argued, such positivist orders are vulnerable to capture by private interests. According to Schmitt, positivist regimes break down during situations where exceptions arise outside the norms of governance that are written into the rulesin this case, the code that runs the blockchain.

In such a situation, the rule system itself starts to embody unsustainable contradictions. For example, if one set of users of the blockchain insist that blocks must be modified to increase the liquidity and supply of its tokens, which could produce inflation, and another set insists that the financial pain of less-liquid currency is necessary to defend against the evils of inflation.

In these situations, Schmitt argues one person or one group will step in to make a decision that breaks the unresolvable tie—someone above the rules. This is, of course, anathema to the radically decentralized ethos of blockchain philosophy.

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