What is Governance For?

Photo by Jace Grandinetti on Unsplash

There has been a lot of talk in the blockchain community about what governance systems should look like, but little has been said about their need and what they are supposed to do.

Without explicitly identifying what these systems should accomplish, their design is a bit like shooting darts while blindfolded. As it turns out, economics has quite a bit to say about the subject of governance and it can provide a framework for more deliberate governance design.


What is governance for?

We need governance systems because it is impossible to spell out in advance what should be done in every possible scenario — as I have written before: contracts are incomplete.

| Governance systems enable organizations to adapt over time through established decision-making processes.

If we could specify every possible decision in advance, then we would not need governance. Due to the fact that circumstances change as time goes by and more information becomes available, we need decision systems in place in order to adapt. Governance is the set of rules guiding those systems.


How has governance been implemented historically?

In privately held companies with a majority owner, on-going decisions are made by that owner. Ownership gives that individual decision rights. The owner can choose to take into account other people’s opinions, but they cannot be forced to do so. If one individual has a majority ownership, her decision rights are the system of governance.

In most other organizations, including not-for-profits and cooperatives, a governance structure is set up to facilitate decision-making. This structure typically grants owners, or other stakeholders in the case of not-for-profit organizations, a vote over a board of directors (or a seat on the board if ownership is concentrated enough), who in turn choose a single individual, usually a CEO, to make those on-going decisions. While variations on this structure exist, large organizations universally incorporate some type of representation in at least some decisions.


Why have decisions typically been made by a single individual as opposed to a group?

Previously, I explained that in a context where a group shares a common goal, such as maximizing equity value, voting can be used to deal with uncertainty about which choices will lead to good outcomes. However, in order for this to be successful, it must be the case that the decision-making group has all the relevant information. In the case of large organizations, it is extremely costly to provide all relevant stakeholders with complete information.

Alternatively, compared to a board member or investor, a person who is involved in the day to day operations of the company would be in a much better position to obtain and utilize relevant information. In addition to this, as the types of decisions made by a CEO often rely on industry and other areas of expertise, someone with the relevant know-how is likely better suited to interpret available information than a crowd lacking similar skills.

Beyond information, incentive alignment is another reason to focus decision rights on one person. A single individual can be both motivated and held accountable more effectively than a group. Even if we were to suppose that a CEO could be replaced by a group of individuals, that group would be subject to a free-riding problem: a situation in which individual team members each decrease their own performance because no one individual can be held accountable for outcomes produced by the team. By providing incentives to the CEO based on performance variables that matter to the relevant stakeholders, steps can be taken to ensure that the objectives of the chosen CEO are aligned with the goals of those stakeholders and consequences for bad outcomes can be given to the person responsible for them.


What does this mean for blockchain?

Governance is not a new issue.

| The understanding that the point of governance is to provide mechanisms by which future decisions can be made should guide the design of those governance systems.

If we know that the reason for governance is decision-making, then the next natural question is, ‘What kinds of decisions?’ Only after this question has been asked and answered can a system which successfully enables those decisions be designed.

Knowing what types of structures have been used in other contexts, such as those listed above, can inform design choices for blockchain organizations. That being said, it is important to identify unique challenges and opportunities posed by blockchain technology in an effort to adapt governance design accordingly. For some platforms or decisions it is possible that the ideal governance structure will look very similar to those we have seen in the past, but will incorporate the voices of different stakeholders. For others we may come up with innovative new structures. Either way, to be successful they must be designed with purpose.

Some questions to guide governance design:

  • What kind of decision needs to be made?
  • What information is required to make these decisions?
  • What expertise is required to make these decisions?
  • Whose preferences should be taken into account for these decisions?
  • What individuals or groups should be directly involved in the decision-making process?
  • How can these individuals be selected?
  • What mistakes could be made in this selection process?
  • How can we minimize the probability of these mistakes?
  • How can we ensure decisions are implemented?
  • How can we determine whether a rule has been broken?
  • What are the consequences when rules are broken?