What Is Governance In Crypto?

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By Connor
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Crypto governance

What Is Governance In Crypto?

By definition, governance is a control mechanism that involves intervention. Governors have the ability to propose ideas and implement them on the platform, whether it's adding features, troubleshooting, or voting on someone else's ideas. Governments are present in society and also in companies, which is called the Board of Directors.

So how does governance work in crypto? It's a complex question.

Because you can integrate crypto without participating in the blockchain. There are exchanges like CoinBase, payment providers like VISA, and even locals like Starbucks accepting crypto payments. And while you can buy a lot of shares to gain voting power, the governance consists mostly of insiders and founders. Crypto or not, all centralized organizations follow this traditional, hierarchical structure. Clients and users have no governance.

But cryptocurrencies are public, decentralized blockchains. They are democratic, flat structures where anyone can participate in decisions. These are typically technical communities of developers who review the code and suggest revisions.

At the same time, the applications built in a blockchain can have their own governance. For example:

  • The Ethereum Foundation and community can discuss and "change" the blockchain rules.
  • Uniswap is a decentralized exchange (DEX) app that includes a governance feature. After voters stake enough tokens, new proposals will execute (like changing fees or deploying the dApp on other networks). It's a different community from Ethereum's.
  • Ethereum's governance decisions will affect Uniswap and all dApps built in it, But Uniswap is now compatible with many networks, so it's independent of Ethereum. Ethereum's governance can neither decide how to run Uniswap.

(You can learn more about Uniswap here)

In short:

  • Regulated crypto companies use traditional governance (the Board)
  • Public blockchains (cryptocurrencies) are governed by dev communities and implemented as forks
  • Dapps have independent governance from their blockchains. It can be token-based voting (on-chain), informal discussions (off-chain), or code-regulated (governance-free).

Types of Governance In Crypto

Just like there are many consensus mechanisms, there are different ways to govern crypto platforms. Sometimes it's better to have more than one governance type, and sometimes none. Governance can be on-chain or off-chain:

On-Chain Governance

In on-chain governance, smart contracts determine decisions based on the community's approval. Smart contracts are autonomous functions of code that implement proposals once there are enough votes. The way of voting is similar to staking, except the votes are called governance tokens.

Platforms based on on-chain governance are called Decentralized Autonomous Organizations (DAOs). Joining a DAO is available to everyone, but to have governance influence, you need governance tokens:

  • DAOs require a minimum token amount to submit proposals (e.g., 2.5M UNI in Uniswap or 50 AAVE in Aave)
  • After you submit the proposal, there's a voting period for members to approve or reject it. To be successful, it needs to cross a certain token limit within that time with a reasonably low number of votes against it.
  • After the voting period, successful proposals will apply to the protocol in the next update.

Even then, no proposal is final. Users can suggest anything, like removing previously added features if the community agrees.

Off-Chain Governance

What about off-chain governance? The most obvious benefits are:

  • There are no token minimums, so anyone can submit proposals.
  • There are no governance tokens, so there's no weighted voting.

Because it's so accessible, there are more proposals that could compromise the blockchain's security. That's why there are dozens of development experts moderating these proposals. Here's Ethereum's off-chain governance as an example: 

Ethereum off-chain governance
  • First, you submit a proposal (EIP)
  • You can then publish it as a draft, and the editors will check the formatting so it's consistent with all other EIPs. They will point out those errors, and once corrected, you can publish the EIP officially for peer review.
  • Ethereum Editors, core developers, and the most active members have two weeks to review, make questions, and request changes (AKA "last call"). If everything is resolved within that time, it switches from Last-Call to Final (Non-Core) status.
  • Then, the core developers decide whether to approve the proposal for the next fork (Final Core), reject it, delay it, or ignore it.
  • If your proposal reaches this stage, it should appear on the list of accepted EIPs on the next fork announcement.

Thus, the core dev teams have the final say on what to change. It's not enough to make proposals secure and error-free. They have to align with the Ethereum vision and efficiency goals.

Which doesn't sound very decentralized. After +5,000 EIPs published in ten years, less than 10% were approved (if not replaced).

How Exactly Does Governance Work With Blockchains?

Blockchain governance

Even decentralized governance has its limits when changing the rules. The developers of a protocol can design what can or shouldn't be changed (in case the community proposes it). But what if your improvement proposal is outside of that scope?

In 2016, a barrage of DoS attacks was threatening Ethereum. They could have played by the rules and left the network at high risk (which created Ethereum Classic). Instead, they stopped those threats with the DAO fork. A (hard) fork is an alternative blockchain that inherits the original blocks but follows new rules to continue the chain.

Blockchains are immutable and unique, a bit like collectibles. While you can "copy" the Mona Lisa or create a modified painting, people still recognize the original. When the blockchain doesn't allow a certain change, the governance creates a new chain division.

Today's Ethereum is the result of almost 20 forks (technically called Ethereum "Paris" fork). Why is the newest version the official one and not the original Ethereum (Frontier) from 2015? Because it's the most adopted by the community. 

Decentralized governance cannot impose software updates on nodes. Each of the 400,000+ peers has to manually update, and once there are enough to guarantee security (e.g., 75%+), the fork is considered the main chain.

So if someone manipulated the governance, people simply wouldn't want to update to that version. 

The Problems Of Governance in Crypto

Decentralized governance isn't any easier than traditional governance. How do you make a fair, rewarding system where people want to participate? How do you avoid concentrating power on the biggest contributors? How do you deal with those who disagree on decisions?

The first iteration was MakerDAO in 2014, so you would think that we'd have these answers by now. But like the blockchain trilemma, governance choices are subjective. At least three problems lead to its manipulation:

  • Members don't participate. The entry barrier is too high, discussions are too technical, there aren't enough incentives, maybe they don't even know that governance exists, or they're happy with the current platform, or they don't believe that they can change anything (AKA political apathy). While there are countless reasons for low participation, the consequences are the same: high centralization, and low security.
  • DAOs over-prioritize token holdings. If you get proportional governance power for every token you buy, the biggest buyers will dominate. While they may not dump the project, they can change rules in their favor and discourage smaller members from joining. Decentralization should involve probability, history length, locations, and more besides token quantity.
  • There are no standalone governance tokens. Instead, there are utility tokens for several purposes, from governance to liquidity and yield farming. And when you mix governance with trading, conflicts of interest arise. The markets control the platform.

At first, these choices may speed up development and bring more investors. But you're not building a community, only attracting traders. Eventually, governance loses participation as members switch to more competitive, welcoming platforms.

What Really Makes Governance Work

Few platforms have succeeded in decentralized governance. While there are hundreds of DAOs, most have below 100 active users and a dozen votes per proposal. The most popular have been Uniswap, Aave, ENS, Curve, and PancakeSwap.

Here's what the top 5 have in common:

  •  They're user-friendly. How easy is it to swap tokens on Uniswap? That's how easy it is to vote. You connect your wallet, click on "Vote," select an active proposal, vote for or against, select the amount, and confirm the Metamask contract (after the voting results, the tokens return to your wallet). And you don't need to know tech jargon like on Ethereum. The proposals you'll find are simple: add dApp to blockchain X, change X fee, contribute treasury funding to X, or integrate with another app.
  • There's both on and off-chain governance. There are informal discussions, but there aren't core developers regulating proposals. There are governance tokens, but new proposals have lower requirements.
  • They prevent centralization. You can only vote with the governance tokens you had up to a certain Ethereum block number (if you buy more after, it won't increase voting power). Proposals also need majority votes over 50% and participation from at least 5% of all holders.

These also happen to be competitive platforms with high utility, which isn't a coincidence. Why participate in an inactive project that's mediocre or a copy of a better one? After all, the governance incentive isn't to get free money but a better platform you already like

Is Governance In Crypto The Only Answer?

Governance will make blockchains and protocols more flexible. It encourages continuous improvement and allows us to immediately correct vulnerabilities. But even in crypto, governance is not 100% decentralized.

As we've seen, off-chain governance has centralizing elements. The network overseers have the final say on how to run the platform. On-chain might seem decentralized until you realize how governance tends to concentrate on the richest few. It takes thousands to create proposals and just a few million dollars to achieve the voting majority.

If a protocol is a final product that runs smoothly without incidents, governance can be a burden. Self-governing code really is the essence of decentralized finance. LiquidLoans is governance-free, which creates a predictable environment for stability pools, borrowing, and lending.

FAQ

Are DAOs and governance the same?  

Not exactly. Governance can be on or off-chain. Decentralized Autonomous Organizations have either on-chain governance or both.

Both platforms and blockchains can have governance systems. The difference is that DAOs are dApps used for platforms, not blockchains. There's no such thing as the "Ethereum DAO."

When it comes to ERC-20 dApps, the most successful DAOs are Uniswap, MakerDAO, and Aave. But not all platforms have DAOs, as the design can be governance-free.

What is the governance of Ethereum?

Ethereum has off-chain governance in the way of Ethereum Improvement Proposals (EIPs) and informal forum discussions. Developers can suggest new code features and send them for reviews based on an EIP template. The proposal goes through multiple statuses for weeks, from revisions to the approval of core teams.

While anyone can submit EIPs, only these teams can include them in upcoming forks. They consist of a few members from the Ethereum Foundation and Community. When accepting EIPs, they can be deferred (reserved for future consideration) or final (intended for the next upgrade). Still, the community can sometimes remove old EIPs after a closer review.

Does Bitcoin Have Governance?

Not only has Bitcoin governance, but it's similar to Ethereum's. It consists of over a hundred core developers from different organizations. Users can suggest improvements via Bitcoin Improvement Proposals (BIPs), which these teams then review.

Unlike Ethereum, Bitcoin's updates are only backward compatible (soft forks). The most important upgrades were SegWit in 2017 and Taproot in 2021.

Are governance tokens and liquidity tokens the same?

They might seem the same as they both involve locking a token amount. The more you stake, the more governance or liquidity tokens you get. While they have different utilities, they're both based on proof of ownership.

Governance tokens grant voting power, and they're proportional to what you've staked. Liquidity tokens are a receipt of the coins you provided to a liquidity pool. While you can sell these tokens for profits, you can't redeem your initial deposit without them. But you can yield-farm with liquidity tokens while earning interest from the staked amount.

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Connor

Connor is a US-based digital marketer and writer. He has a diverse military and academic background, but developed a passion over the years for blockchain and DeFi because of their potential to provide censorship resistance and financial freedom. Connor is dedicated to educating and inspiring others in the space, and is an active member and investor in the Ethereum, Hex, and PulseChain communities.

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