Alex Fatuliaj
August 16, 2023
Tokenomics Tuesday

What is governance?


In Web3, there is a mantra of things owned by their communities. Of course this is nearly always a façade, as very rarely is ownership truly shared. Nonetheless, despite not giving direct ownership, protocols can still offer their communities executive sovereignty via governance.

Governance refers to the mechanism by which stakeholders can make decisions and implement changes to the protocol or rules governing a particular blockchain network or project, and it's generally done by users staking / owning the native cryptocurrency / token and casting their vote / answer to a specified question.

There is on-chain and off-chain governance:

  • On-chain: the rules for instituting changes are encoded into the blockchain protocol. In this system, smart contracts lay the foundational rules to execute collective decisions, vote, and even publicly audit the code itself.
  • Off-chain: finalises decisions away from the blockchain (i.e. just on the platform website, or some forum).

How does governance actually work?


From the olden days of Ancient Athens, where people came together in the Athenian Ecclesia to participate in political decision-making, to the golden days of today, where politics is enter something political here, it's important to understand traditional systems of governance if we want to offer governance to our communities.

And to truly understand our modern traditional systems, we need to cover three fundamental topics: the separation of powers, democracies, and electoral systems.

Separation of Powers


Most countries have some sort of separation of powers, a notion whereby different functions and responsibilities are separated between different branches of government.

There are generally three branches:

1. Executive: responsible for implementing and enforcing laws. It is typically headed by the President, Prime Minister, or a similar executive leader, and includes government agencies like the police.

2. Legislature: responsible for making and passing laws. It is usually composed of a bicameral or unicameral parliament, congress, or similar legislative bodies.

3. Judiciary: interprets and applies the laws. It consists of courts and judges who ensure that laws are applied fairly and that disputes are resolved according to the legal framework.

This separation of power creates inherent checks and balances within politics. For instance, the executive branch assumes great control in times of stress, but the extent of that control is determined by the legislature, and in instances of either branch (or individual within) breaching 'protocol', the judiciary steps in to judge.

Ideally, all three branches should be separate from each other and impartial. However, there are often times of overlap, such as judges in the judiciary branch being selected by the President in the US if a gap appears (due to death for instance). Nonetheless, this system generally works as it's supposed to.

Democracies

Who is within the executive and legislative branch is determined by the political system. Democracy is one of those systems (others are dictatorships, monarchy, anarchy, etc.), and is merely a system of governance where the people (should) have their voices heard and adhered to as the legislative, generally via the act of voting.

There are two main types of democracies.

Direct

Citizens can directly vote on things, like in ancient Athens. Someone proposes a law, the citizens vote, law gets passed. The modern example is Switzerland, where citizens can propose a law via "initiatives" which get put through to 'popular vote' - where the citizens vote 'yay' or 'nay'. If 'yay', then the law is passed.

However, when there are millions of people, it's hard to do this for every political decision. Even Switzerland utilises the next type of democracy for most of its governmental dealings (as in, the citizens have the ability to directly legislate, but more often they leave that to the representatives).

Representative

Citizens here vote for representatives / delegates instead of on the laws directly, who then vote on the behalf of the citizens. Most countries utilise this type of democracy due to its efficiency and logistical prowess over direct democracies given population sizes.

Image source: A16Zcrypto


Electoral Systems

How the representatives / delegates get elected is down to the electoral system in place. There are a few different methods used, but there are two main ones.

First Past the Post


1. Political parties choose one person (candidate) each to represent them on the ballot for a given constituency.

2. Citizens vote for their preferred candidate, and the most votes in a constituency wins that seat in parliament as the MP (member of parliament).

3. The party with the most seats becomes the government (i.e. the leading party), and generally elects a leader for the Executive branch.

Party List Proportional Representation


Closed List:
citizens vote for a political party to represent their region of the country (larger than a constituency). Seats in parliament are proportionately filled to the votes received across the country.

Open List: citizens vote for a candidate, instead of just the party. Because the regions are bigger and represent more seats, parties (generally) select multiple candidates. Seats are allocated in the same way as in a Closed List system.

What is Web3 Governance?


There are vast debates on the positives and negatives of different governing systems and electoral procedures; we're not here to debate any of those.

However, we'd like to point out a key fact about Web3: it can facilitate a direct democracy without the logistical issues, meaning we are now in an era where technology can facilitate the most fundamental type of governance.

This means two things:

  1. Firstly, we need to dive much further into politics and understand the thousands of years of trial and error in order to implement governance for our projects properly.

  2. Secondly, if a particular project showcases a great system of governance utilising crypto technology, that could be the case study used as a gateway for entire countries to experiment with adopting blockchain voting, creating a fairer and more transparent system for all.

When should governance be implemented?


When faced with a decision that has Option A or B as the possible routes, it is sometimes better to find the middle ground, and other times to choose A or B. This is known as concave or convex decisions, respectively.

In a concave situation, neither option A or B are the best solution, but rather a blend of both. For example, what sector should government spending be allocated to.

In a convex situation, either A or B are the best solution. For example, you can reach your destination by driving via a toll motorway or free residential roads, but doing both is the worst of both worlds.

This distinction matters because groups of people tend to have decision advantage in their response accuracy, but at the cost of speed [Hsieh, et. al. 2020]. In essence, if decisions needs to be made quickly based on specialised information, it is better to have authoritative leadership; otherwise, it's beneficial to implement group decision-making, which in this case will be done via governance.

Source: DAOs are not corporations - Vitalik Buterin

That being said, governance is still something that is important to be implemented to facilitate decentralisation and sovereignty, which means that regardless of whether the decisions are concave or convex, governance is worth considering from the fundamental perspective of giving users ownership of their ecosystem.

Alas, that is only the view when governance is responsible for everything.

In reality, if the project only has partial governance, then they need to think about what they’re letting people govern from the fundamental perspective, and from the concave v convex perspective.

Examples of Web3 related governance proposals

  1. Protocol maintenance and upgrades
  2. Allocating resources
  3. Resolving disputes within the network

1. Protocol upgrades and maintenance: how are upgrades, regular maintenance, and adjustment operations on parts of the protocol that are not long- term stable (e.g. lists of safe assets, price oracle sources, multi-party computation keyholders), agreed upon?

2. Allocating resources: how should the protocol allocate its finite resources to the infinite wants and needs of its base of users and investors, whilst maximising everyone's alignment with end goals?

3. Resolving disputes within the network: what is the best way to resolve protocol-level disagreements that encourages a fair trial?

The answer to all of these questions is governance.

What problems can arise with governance?


a.
inadequate implementation - utilising governance for convex decisions faces the problem of time delay and facilitates problematic information asymmetry, whereby founders may have a much better understanding of the intricacies of the protocol compared to users yet let users decide protocol-level actions.


b.
inequality - governance requires staking / owning the protocol's coins: more coins equals more voting power. Furthermore, there is a risk of outright attacks through various forms of (often obfuscated) vote buying.


c.
misaligned incentives - governance empowers coin holders' interest at the expense of the remaining community.

Solutions to consider


Solution 1: Limited governance

Limiting governance to fixed parameter choices. Uniswap does this by only allowing governance to affect token distribution and fee rate in its exchange.

Solution 2: On-chain vs off-chain governance

Use on-chain governance only for applications, not base layers: DAOs and other apps on top of Eth are sometimes governed through on-chain governance, while Eth protocol itself is governed through off-chain governance.

Solution 3: Add buffers

Buffers like the requirement for a supermajority or a time delay where a governance decision made at time T only takes effect at e.g. T + 90 days, act as safety nets.

Solution 4: Non-coin governance

Proof of Personhood and Proof of Participation are two examples of systems that protocols can implement that will minimise capital discrimination.

Solution 5: Skin in the game

By making users pay to vote, rather than simply stake or own the token, enacting governance becomes a much more costly exercise with no refunds, thereby making whale activity more expensive.

Conclusion


If used correctly, governance is a powerful way to create a sense of sovereignty, delegate executive power to communities, and promote democracy in decentralised entities.

However, one needs to think carefully about its implementation because poor execution could lead to detrimental effects to the protocol and/or the alienation of its community.


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