Vol. 2: Governance Within the Cryptocurrency Industry
It’s impossible to spend much time in the cryptocurrency space without hearing about the importance of decentralization.
Blockchains are decentralized ledgers where a distributed network of nodes work together to verify and extend the chain without the need for centralized oversight. This decentralization is key to their utility, because it makes them trustless (a slightly counterintuitive technical term meaning users aren’t required to trust some particular third-party). Projects built on top of blockchains generally try to maintain this decentralization, and one way to assess the value of a crypto project is how seriously they take decentralization and how they leverage it to provide value to users.
Decentralization brings stability and security, but it introduces major issues of coordination. If no person or organization is in charge, how can decisions get made?
Until recently, governance — the methods through which decisions are made and enacted — in the industry has mostly been cumbersome and loosely defined. But the past year has seen an uptick in focus on governance, particularly within decentralized finance (DeFi). This has led to a flurry of innovation and a significant number of new products and services which would be impossible under a centralized model. Indeed, many of the projects in the CkSum portfolio have governance at the forefront of their value proposition.
In this edition of the CkSum Insight series, we’ll take a look at some of the different ways cryptocurrency projects approach governance, explain why this could be a strong indicator of long-term performance and growth, and consider the potential impact these new forms of governance will have on the world at large.
Like any software, blockchain protocols are honed in the wild, undergoing constant iteration and evolution. In a centralized model, software governance is straightforward. If Microsoft wants to update Windows, for example, they have the sole authority to push updates to all devices running their operating system. Users might hold out for a while before updating, and customer feedback will certainly influence development, but ultimately the company has control.
Blockchains have no equivalent mechanism. There is no central authority to push changes, and if node runners don’t want to adopt a change, it simply won’t be implemented.
So how are blockchains governed? Let’s look at the two biggest in the industry: Bitcoin and Ethereum.
Bitcoin (BTC) is the first and still most influential cryptocurrency. Its launch in 2009 was heralded by the release of the Bitcoin whitepaper, attributed to Satoshi Nakomoto, a pseudonym.
Although Nakomoto has no further direct influence on Bitcoin — no-one knows who they are or even if they’re still alive — they still loom large over Bitcoin governance. Proposed changes which don’t match the ethos of Nakomoto’s paper are generally quickly rejected. In this way, the white paper functions like a constitution or even a manifesto.
Since Bitcoin is leaderless, changing the protocol is a very slow, extremely deliberative process. Anyone can theoretically make a Bitcoin Improvement Proposal (BIP), but a BIP must be accepted by a very high threshold of node runners worldwide to be implemented. Since node runners are independent, this is a huge task, With few formal procedures for doing this, changes are rare. To date, fewer than 50 BIPs have been implemented, out of many hundreds of proposals.
This lack of governance might seem concerning, but to many Bitcoin’s resistance to change is a feature, not a bug. The Bitcoin protocol underpins global financial instructure securing billions of dollars of value, and this proven stability is what makes it so reliable.
The industry’s second biggest blockchain, Ethereum (ETH), is a different beast entirely. Ethereum is faster and more dynamic that Bitcoin, and its support for smart contracts has allowed for a huge ecosystem of other cryptocurrencies to be built on top.
Ethereum is currently in the middle of a sweeping transition from being a proof-of-work blockchain like Bitcoin to a less energy-intensive proof-of-stake blockchain. This change, dubbed Eth2, has been years in the making and has been delayed many times, partly because of a lack of formalized governance.
Unlike Bitcoin, Ethereum’s creator and leader is very active and well known. Vitalik Buterin is one of the most influential figures in cryptocurrency, and people look to him for leadership.
Ethereum governance is slightly more structured than Bitcoin, and this is reflected in the number of changes which have been made over the years: more than a thousand improvements, grouped into around a dozen named upgrades. But the process is still largely informal, and Buterin and the core development team have by far the most influence.
The outsized control held by Buterin may seem contrary to the ethos of decentralization, but it does bring advantages. Buterin has shown himself to be thoughtful and cautious, and his leadership has facilitated changes which would otherwise be impossible. It’s very difficult to see how Bitcoin could make a transition as major as the Eth2 shift, for example.
This added dynamism is important to Ethereum’s role as a platform for services, rather than just stored value. While Bitcoin still stores the most value of the two chains, Ethereum has long-since eclipsed its rival in terms of number of transactions and value of transaction fees generated.
The term “Flippening” refers to the hypothetical moment of Ethereum (ETH) overtaking Bitcoin (BTC) as the biggest cryptocurrency. At 100% they both have the same market capitalization.
Higher Layer Governance
Blockchains are low-level infrastructure, and it makes sense for them to be hard to change. Any mistake could jeopardize the ledger and risk billions of dollars in stored value. But the crypto industry is much more than just blockchains. Thousands of projects are built on the blockchain base layer, particularly Ethereum, each providing different services for users. These projects are often closer to standard companies, and usually require far more dynamic and flexible governance.
Governance By Foundation
One common model is to split executive control between a for-profit company and a non-profit foundation, with the foundation retaining control of the majority of the token supply and acting as a balance to the executive and development teams. In theory this allows for dynamic decision making while maintaining a level of decentralization.
However, there have been several high-profile examples of this model going wrong, either due to a feud between the foundation and the for-profit entity, or an insufficient divide between the two, dissolving the checks and balances. Tezos provides a notable example of the former: after raising over $200m in an initial coin offering (ICO) in July 2017, a feud quickly broke out between the project founders and the Swiss-based Tezos Foundation over regulatory anomalies. The legal case was settled in 2020, and Tezos is now hitting significant milestones, including hosting the space’s biggest NFT marketplaces. But for several years the bitter governance dispute overshadowed development and led to severe delays and a significant drop in token price.
Foundation-based governance can work well, but when investing in projects using this model, it’s crucial to do strong due diligence. Is the project using this model because it’s become traditional in the industry to simplify compliance issues, or is it a genuine desire to provide strong governance?
DeFi and Governance Tokens
One of the most interesting recent developments is the proliferation of governance tokens, particularly within decentralized finance (DeFi). Governance tokens seek to formalize the allocation of governance power and proceduralized the governance process, allocating governance power to tokenholders, who often feel underrepresented in the decision making process.
In general the process for on-chain governance is as follows: someone makes a proposal, token holders allocate their tokens to support or reject the proposal, and the side with the highest weighting wins. Unlike civic governance, where systems are usually one person, one vote, tokenized governance is usually one token, one vote. This means the more tokens you hold, the more voting power you have.
While this might seem strange, in many ways it's not new. Governance tokens share many similarities with share-based voting familiar from traditional corporate governance. The key difference is that the entire process can be automated. Instead of a vote being merely an indicator of intent, with the possibility that the decision will be overturned, delayed, or otherwise thwarted, a decision made on chain can be automatically implemented.
Compound (COMP) is an algorithmic lending platform with decentralized governance. COMP holders can vote on technical parameters governing new lending pools, such as the interest rate and collateralization factor.
Participation is simple and everything from voting to implementation is automatic.
Compound has created a powerful way to harness the wisdom of the crowd to finetune a financial service in response to market movements. This innovation has paid off, with almost $10b in crypto assets currently locked within the compound protocol. It also recently survived its first major test: some were sceptical that Compound’s wisdom of the crowd approach would be sufficiently risk-averse at setting collateralization rates. The fear was that the token holders would be over optimistic about the bull run, and when token prices faltered the lack of collateral in the protocol would cause the lending pools to collapse. But Compound successfully weathered the recent market dip, showing the huge promise of this decentralized approach to setting lending parameters and to governance in general.
And Compound is just one of dozens of DeFi projects with a decentralized governance model, giving token holders direct control over how the services run and evolve. In addition to lending, governance tokens are being used to govern decentralized token exchanges, stablecoins, token sales, investment platforms and more.
It’s hard to underestimate the potential disruptive power of this approach to traditional finance — an industry which has typically relied on centralized gatekeepers to limit access and control.
Source: Compound: Governance Overview
These DeFi projects show the power of giving token holders full control over a narrow set of on-chain decisions, but perhaps the most interesting use of governance tokens is in service of broad governance, where the range of possible decisions is not predefined. DAOs (decentralized autonomous organizations) are an attempt to build a fully decentralized legal entity which is able to use on-chain governance to enact decisions both on- and off-chain.
The potential here is hard to overstate: building a legal entity where anyone in the world can participate instantly and anonymously simply by buying tokens would provide an unprecedented level of freedom and access to a world which has previously been off limits to most.
Development of DAOs has been hampered by legal concerns about liability and regulatory oversight, but progress is starting to be made. The US state of Wyoming recently passed legislation recognizing DAOs as legal entities, and more jurisdictions are looking to follow suit.
Governance tokens are a logical step for the industry. Decentralized governance is a problem of coordination, and blockchains are a tool explicitly designed to reach consensus amongst peers. Using the blockchain itself as a basis for governance makes perfect sense.
We predict that we’ll soon see this governance approach spread to other areas of the crypto space and even back into the traditional world.
Governance and the CkSum Portfolio
This is all very interesting, but what does it mean for investors? Which governance projects are theoretical curiosities, and which are likely to provide real value and growth? For some projects flexibility and token holder input will be an asset, for others, particularly blockchains themselves, this can prove a liability.
When deciding to invest in any project, governance is one of the key factors we consider. How is the project run? How quickly can it adapt? How easy is it for the project to grow both on- and off-chain? How much control do token holders have over the project’s direction, and how transparent is the implementation of this governance?
CkSum is committed to diversifying risk by ensuring our portfolio is spread over a broad range of the most promising projects and technologies. These governance technologies are in their infancy, and it can be hard to predict which will succeed and which will falter. What’s certain is that developments in cryptocurrency governance over the coming months and years are going to have a huge influence on the industry, and maybe how we think about traditional corporate governance as well.
Richard Sparrow - CIO/ Director
In addition to being the Chief Investment Oﬃcer for CkSum Capital, Ltd, Richard is a Vice President of Attribution at CipherTrace, Richard has spent the past 4 years building on Bitcoin and blockchain helping law enforcement, regulators, and the ﬁnancial industry understand how crypto is transforming industries. For the prior 20 years, Richard worked in the Silicon Valley providing mobile and ﬁntech infrastructure solutions for Amdocs, Deutsche Bank and Lending Tree, among others
Paul Wehner - Director
Since graduating from MIT with a Bachelors in Finance, Paul has been a serial entrepreneur specializing in ﬁnancial technology. He is the Co-Founder and Chief Product Oﬃcer of SFB Technologies, a venture-backed company selected to lead the development of the world’s ﬁrst decentralized legal tender, the SOV, for the Republic of the Marshall Islands. He also won the $100K First Place Prize at 2018 EOS Global Hackathon in Hong Kong for a decentralized identiﬁcation solution. Previously, Paul led Product Management for the eCommerce vertical of Endeca Technologies which was purchased by Oracle for $1.1 billion, and led development eﬀorts at MyLife, growing it from 0 to 250,000 monthly active users and an eventual acquisition by Meredith.
CkSum invests in a well-researched, diversified portfolio of cryptocurrencies and decentralized finance (DeFi) projects. CkSum follows a multi-stage investment process which includes identifying key, long-term industry trends, picking the best currencies, protocols and companies within those trends, and leveraging our holdings to generate increased returns through low-risk, high-yield staking and lending opportunities. We strive to provide an easy, safe, and reliable entry point into this revolutionary industry.
This material does not constitute an offer or solicitation to purchase an interest in CkSum Select Fund I, LLC or any related vehicle; such an offer will only be made via a confidential offering memorandum. An investment in the fund is speculative and subject to a risk of loss, including a risk of principal. There is no secondary market for interests in the fund and none is expected to develop. No assurance can be given that the fund will achieve its objective or that an investor will receive a return of all or part of its investment. This material contains certain forward-looking statements and projections regarding the future performance and asset allocation of the fund. These projections are included for illustrative purposes only and are inherently speculative, as they relate to future events, and may not be realized as described. These forward-looking statements will not be updated in the future. Returns for each investor and investment series will differ based on the timing of capital contributions. Please note, information above is subject to change; this is for general, illustrative purposes only.