Governance, blockchain and value creation
Decentralized governance is one of the hottest topics in crypto today. Within the crypto community, there is a strong sense that good governance is a key value driver for many protocols. At the same time, the topic is still poorly understood, and many protocols struggle with the messy nature of decentralized governance decisions.
Q is taking this challenge head-on: Many of the design choices are driven by the desire to create a transparent and enforceable ruleset that governs key decisions within the protocol. Whereas for many crypto projects, governance tends to be an afterthought, Q puts governance at the center of the protocol.
In this blog post, we explore the background and rationale for this choice and explain why we believe that Q’s focus on decentralized governance will create significant value and be a major driver of the project’s success.
Governance and value creation
Good governance leads to outperformance
In the traditional corporate world, the relationship between governance and performance is clear: Companies with good corporate governance perform better than those with poor governance. This has been shown in many studies: In a classic paper from 2001¹, researchers from Harvard, Stanford and Yale University showed that stocks of companies with best-in-class governance outperformed stocks of companies with worst-in-class governance by 8.5% p.a. (!) on average. In the words of the authors, companies with strong governance exhibited “…higher firm value, higher profits, higher sales growth…”.
The general finding that companies with strong governance exhibit better performance is supported by many studies across different geographies and varying time frames. For example, a 2012 study² found a “causal relationship between an overall governance index and higher share prices” for Korean companies; a 2013 study³ focusing on the Indian market found that “governance ratings have positive and significant impact on corporate financial performance” and a 2012 study⁴ of the Italian market found that “Corporate Governance positively impacts on firm performance”.
Governance at the nation state level
The realization that governance is a major driver of value is by now universal. As the OECD states in their 2019 Corporate Governance Factbook⁵, “the quality of a country’s corporate governance framework is of decisive importance for the dynamics and the competitiveness of a country’s business sector”. This insight has greatly impacted economic and business policy in many countries. In Germany, for example, the “German Corporate Governance Code”⁶, which was integrated into German Corporate law in 2002, mandates companies to disclose whether they comply with governance guidelines that are defined by experts on the topic. All countries with well-developed legal and regulatory frameworks have adopted policies which are aimed at promoting good governance. Across the board, the primary driver behind such regulatory efforts are not primarily ethical considerations, but the very practical desire to improve the performance of the private sector and hence the wealth of the respective country’s citizens.
But the effect of good governance is not limited to corporations. Similarly, the performance and economic development of countries as a whole is driven by the quality of their governance. In their seminal 2012 book “Why Nations Fail”⁷, Daron Acemoglu from MIT and James A. Robinson from the University of Chicago show that “it is man-made political and economic institutions that underlie economic success (or the lack of it)” of nations — in other words, their systems of governance.
Governance of public goods
Furthermore — and this is of great importance to crypto projects — the question of governance is highly relevant for common goods and open-source projects. As Nobel-Prize-winning economist Elinor Ostrom has shown⁸, the design principles applied to the governance of common goods (such as natural resources) determine the utility which a community can derive from the respective common good.
Today, the insight that governance drives the value of almost all human undertakings has impacted many more areas. For example, software development frameworks (e.g. agile frameworks such as Scrum and Kanban) are to a large part a formalization of the governance of the software development process, defining roles, responsibilities and more generally how different stakeholders interact.
Given the importance of governance to the performance of economic systems, what is the role of governance in blockchain projects?
Blockchain and governance
Governance as a social contract
The first generation of cryptocurrencies — in particular Bitcoin — was developed without a formalized governance system. The system can best be described as being based on a social contract, where people working on and interacting with Bitcoin generally share some common ideas⁹ about how things should evolve, but there is no formalized way of changing and advancing the protocol. Of course, there are tools and methods that are used, for example the Bitcoin Improvement Proposal (“BIP”) process, but those tools and methods have emerged through an informal social process and are not binding for stakeholders in the project.
Arguably, such implicit governance by social contract works well enough for relatively simple¹⁰ applications such as unbacked cryptocurrencies like Bitcoin. Differences in opinion between stakeholders — which frequently occur — are either solved through informal social processes, or — as a last resort — lead to forks of the blockchain, where differing factions split and each faction runs their own version of the blockchain, implementing whichever ruleset they decide upon. An example of this is the blocksize debate in Bitcoin, which famously led to Bitcoin Cash forking from Bitcoin.
However, with the advent of smart contract platforms such as Ethereum, it has become clear that this implicit form of governance is not sufficient, especially if and when more complex, long-term and high-value use cases and business models are to be implemented on a public blockchain. In such cases, solving contentious issues through forking is no longer an option. One simple reason is that once external assets are linked to a blockchain (for example via a security or asset-backed token), participants require clarity as to which blockchain represents “the truth” and identifies the respective asset. Another is that in a world where blockchain-based applications are increasingly composable and cointegrated, systems of smart contracts reference each other, again necessitating a single source of truth that is constant over time. Arguably, Ethereum today is already practically “unforkable”; however, there is no formal governance mechanism ensuring that forks can be ruled out. People, companies and organizations wanting to deploy applications on Ethereum need to blindly trust the community that solutions to existing and emerging problems will be found through social interaction.
Towards formalized governance frameworks
The necessity for a more formalized blockchain governance has been highlighted by many observers. Outlier Ventures, a venture capital firm specializing in decentralized technologies, has proclaimed that there is “no such thing as decentralized governance”¹¹, effectively exposing the fallacy that “the market” is able solve all issues most effectively. Recently, the World Economic Forum has introduced an initiative to raise governance standards of digital currencies and blockchain projects¹². Whether or not such initiatives will have a lasting impact remains to be seen, but at least they highlight the fact that current governance systems need to improve further.
There have been a number of crypto projects that actively address the topic of governance in some shape or form. Early examples include EOS and decred, both of which have introduced a formalized constitution, or Tezos and Cosmos, both of which have formalized protocol upgrade mechanisms baked into the protocol. However, the governance mechanisms chosen remain relatively soft, with no ability to effectively enforce the self-imposed rules within the respective system. With any governance framework being only as good as its stakeholders’ ability to enforce it, the improvement over an implicit social governance framework may not be as significant as it might appear at first sight.
On the other end of the spectrum, private blockchains do provide certainty and enforceability for its parties, but do so at the expense of being open, permissionless and immutable — which are the main reasons why people want to transact on blockchains in the first place.
The significance of good governance becomes even clearer when moving on to the application layer. With increasing sophistication and complexity of applications — particularly in the decentralized finance space — formalized governance becomes inevitable. But as Vitalik Buterin recently pointed out, “Decentralized governance in some contexts is both necessary and dangerous”¹³, opening up a number of new attack vectors that can threaten the viability of projects and put users’ funds at risk. Without addressing the hard problems of application layer governance, the full potential of decentralized financial applications will not be unlocked.
Enter Q
Q takes blockchain governance one step further. Based on its constitution, which all participants implicitly or explicitly agree to, the system architecture enables effective enforcement of the agreed-upon rules both at the blockchain and at the application layer. Therefore, participants can be confident that governance rules are more than a “feel-good-feature” but are an integral part of the system which they can rely on. Given what we know about the positive impact of good governance on value creation, we are confident that Q’s governance framework will be highly beneficial both for Q’s stakeholders and the broader crypto ecosystem.
[1] Corporate Governance and Equity Prices, Paul A. Gompers, Joy L. Ishii, Andrew Metrick, 2001, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=278920
[2] Does Corporate Governance Predict Firms’ Market Values? Evidence from Korea, Bernard S. Black, Hasung Jang, and Woochan Kim, 2012, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=311275
[3] Impact of Corporate Governance on Corporate Financial Performance, Priyanka Aggarwal, 2013, IOSR Journal of Business and Management (IOSR-JBM)e-ISSN: 2278–487X, p-ISSN: 2319–7668
[4] Corporate Governance and Financial Performance of Italian Listed Firms, Matteo Rossi, Marco Nerino, Arturo Capasso, 2015, in Corporate Ownership & Control / Volume 12, Issue 2, Winter 2015
[5] OECD Corporate Governance Factbook,” OECD, 2019, www.oecd.org/daf/ca/Corporate-Governance-Factbook.pdf
[6] https://www.dcgk.de/en/code.html
[7] Why Nations Fail, Daron Acemoglu, James A. Robinson, 2012, ISBN 978–0307719218
[8] Governing the Commons: The Evolution of Institutions for Collective Action, Elinor Ostrom, 1990, Cambridge University Press, ISBN 978–0–521–40599–7.
[9] it should be noted that those ideas evolve over time, as has for example been shown by researchers Hasufly and Nic Carter, https://medium.com/@nic__carter/visions-of-bitcoin-4b7b7cbcd24c
[10] simple in the sense of the functionality provided — of course the path to solving the double spend problem, which was achieved by Bitcoin, was anything but simple
[11] https://outlierventures.io/research/the-crypto-trias-politica/
