30 April 2019

ECGI: Corporate capture of blockchain governance

The paper written by Daniel Ferreira, Jin Li, Radoslawa Nikolowa shows that the proof-of-work system is not immune to capture by interest groups. Their 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.

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.

As in corporate governance, a key challenge for blockchain governance is to avoid capture by interest groups. The focus of their paper is on permissionless (public) blockchains, which are governed by some form of direct voting by stakeholders. More specifically, authors focus on the proof-of-work system -- the system currently adopted by the largest blockchains (e.g 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.

Consistent with what authors observe empirically in blockchains such as Bitcoin, in their model the proof-of-work system creates a mining ecosystem with specialized equipment producers and mining pool operators. Authors 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 their 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.

Full paper

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