UNIVERSITY of NOTRE DAME
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Can Permissionless Blockchains Avoid Governance and the Law?
Article by Eric Alston, Wilson Law, Ilia Murtazashvili & Martin Weiss
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2. Christian Catalini & Joshua S. Gans, Some Simple Economics of the Blockchain, Comm. Of The ACM, July 2020, at 80; Ye Guo & Chen Liang, Blockchain Application and Outlook in the Banking Industry, 2 Fin. Innovation 24 (2016).
4. Though governance is necessary under such circumstances, government (i.e., formal political decision-making) is not inevitable. See EDWARD PETER STRINGHAM, PRIVATE GOVERNANCE: CREATING ORDER IN ECONOMIC AND SOCIAL LIFE (2015); Peter T. Leeson, Government, Clubs, and Constitutions, 80 J. ECON. BEHAV. & ORG. 301 (2011); TERRY L. ANDERSON & PETER J. HILL, THE NOT SO WILD, WILD WEST: PROPERTY RIGHTS ON THE FRONTIER (2004); ROBERT C. ELLICKSON, ORDER WITHOUT LAW: HOW NEIGHBORS SETTLE DISPUTES (1991); Oliver E. Williamson, The Economics of Governance, 95 AM. ECON. REV. 1 (2005); Alexander William Salter, Space Debris: A Law and Economics Analysis of the Orbital Commons, 19 Stan. Tech. L. Rev. 221 (2016).
6. PAUL DRAGOS ALIGICA, PETER J. BOETTKE & VLAD TARKO, PUBLIC GOVERNANCE AND THE CLASSICAL-LIBERAL PERSPECTIVE: POLITICAL ECONOMY FOUNDATIONS (2019); MARK PENNINGTON, ROBUST POLITICAL ECONOMY: CLASSIC LIBERALISM AND THE FUTURE OF PUBLIC POLICY (Peter J. Boettke, ed., 2011).
8. Whether greater centralization is “efficient” depends on comparing the expected gains from deeper integration with a centralized source of authority to the costs of imposing larger-scale government. See Peter T. Leeson, Efficient Anarchy, 130 PUB.
10. Permissioned blockchains, because they can exclude people, are closer to the traditional notion of a firm, and in our view the governance aspects, which still exist, are less interesting than with permissionless blockchains
12. Granted, participation in the Bitcoin is not costless. At the onset it requires a computer with sufficient graphics processing power and internet connection to facilitate connecting to the network, and in practice the barriers to entry for successful Bitcoin mining are quite high, due to the way in which the network preferences large concentrations of graphics processing power. We return to the governance implications of this point in the following sections.
14. PRIMAVERA DE FILIPPI & AARON WRIGHT, BLOCKCHAIN AND THE LAW: THE RULE OF CODE (2018).
16. Nakamoto, supra note 11; Vitalik Buterin, A Next-Generation Smart Contract and Decentralized Application Platform, Ethereum White Paper (2014), https://ethereum.org/en/whitepaper/#a-next-generation-smart-contract-and-decentralized-application-platform.
18. Id.; DE FILIPPI & WRIGHT, supra note 14; Marcella Atzori, Blockchain Technology and Decentralized Governance: Is the State Still Necessary? (2015); Daniil Frolov, Blockchain and Institutional Complexity: An Extended Institutional Approach, J. Inst. Econ. 1 (2020).
20. See ELINOR OSTROM, UNDERSTANDING INSTITUTIONAL DIVERSITY (2009); ELINOR OSTROM, GOVERNING THE COMMONS: THE EVOLUTION OF INSTITUTIONS FOR COLLECTIVE ACTION (1990); VINCENT OSTROM, THE POLITICAL THEORY OF A COMPOUND REPUBLIC: DESIGNING THE AMERICAN EXPERIMENT (2008); VINCENT OSTROM, THE INTELLECTUAL CRISIS IN AMERICAN PUBLIC ADMINISTRATION (2008); VINCENT OSTROM, THE MEANING OF AMERICAN FEDERALISM: CONSTITUTING A SELF-GOVERNING SOCIETY (1994). For overviews of the Ostroms’ polycentric approach to political and legal institutions, see PAUL DRAGOS ALIGICA & PETER J. BOETTKE, CHALLENGING INSTITUTIONAL ANALYSIS AND DEVELOPMENT: THE BLOOMINGTON SCHOOL (2009); Paul Dragos Aligica & Peter Boettke, The Two Social Philosophies of Ostroms’ Institutionalism, 39 Pol’y Stud. J. 29 (2011); Michael D. McGinnis & Elinor Ostrom, Reflections on Vincent Ostrom, Public Administration, and Polycentricity, 72 Pub. Admin. Rev. 15 (2011); Roberta Q. Herzberg, Governing Their Commons: Elinor and Vincent Ostrom and the Bloomington School, 163 Pub. Choice 95 (2015); Paul Dragos Aligica & Vlad Tarko, Polycentricity: From Polanyi to Ostrom, and Beyond, 25 Governance 237 (2012).
22. See William J. Luther & Sean Stein Smith, Is Bitcoin a Decentralized Payment Mechanism?, J. INST’L. ECON. (2020) (arguing that as a payment mechanism, Bitcoin is a distributed payment technology in that it relies not only on the parties to a transaction, but the network of users, to validate transactions). But see, Ben R. Craig & Joseph Kachovec, Bitcoin’s Decentralized Decision Structure, Econ. Comment. (Fed. Rsrv. Bank Of Cleveland, Cleveland, OH) July 16, 2019, at 1 (claiming that as a decision-making structure, it is decentralized in that the parties participate directly in governance.)
Permissionless (or public) blockchain networks are a new form of decentralized private governance in the digital sphere. Though legal scholars recognize the significance of law in the use of blockchain, existing research using legal and institutional perspectives leaves blockchain governance as something of a black box. We provide a more granular analysis, finding that blockchain governance operates on four distinct levels. Governance at the protocol layer involves discrete institutional design choices intended to constrain network members’ incentives in an ongoing sense. Subsidiary governance arises from the need for communities to draft protocol updates and from the fact that governance protocol design choices create discrete concentrations of political power within the network. Competitive governance forces arise because cryptocurrency networks are constrained by the possibility of exit of participants and users to other alternatives. Finally, in terms of superior governance, permissionless cryptocurrency participants and users are subject to a variety of laws and regulations due to how cryptocurrencies implicate property, contracts, tax, and securities law. Since the interaction of these governance aspects shapes the operation of any given network, legal and regulatory governance of blockchain ought to consider permissionless blockchains as confronting political and governance dilemmas much like any complex organization. Predicting the effect legal and regulatory treatment of permissionless blockchains requires an accurate understanding of the incentives of their members, all of which are greatly shaped by the governance forces we outline in detail here.
Introduction
In this paper, we provide a more granular analysis of the governance of blockchain with a focus on permissionless (or public) blockchains. Our analysis clarifies that blockchain networks are subject to governance dilemmas not unlike those of any large, complex organization and that any given network resides in a legal and regulatory framework by necessity. A more precise understanding of the networks is useful for understanding the organization of blockchain as well as offering a perspective that policymakers can use to craft laws and regulations that help blockchain fulfill its promise of improving economic performance,1 financial performance,2 and the quality of public administration.3
The reason a governance perspective on blockchain is appropriate is because any given blockchain network is a large, complex organization. Rule-based governance is ubiquitous in groups above a certain size because an organization’s members tend to reach decisions through a collective decision-making process.4 Governance at scale often entails considerably centralized decision-making, perhaps nowhere more so than in the canonical case of the private firm.5 Public governance is also inevitably centralized to a certain extent, though institutions such as democracy and federalism considerably decentralize public authority compared to other forms of government,6 thereby addressing to some extent the knowledge or information problem confronting the government.7 Regardless of the level of centralization of an organization’s authority, the reality is of a world whose interactions are continually increasing in scale and complexity.8 Governance outcomes in practice are typically characterized by numerous overlapping layers of jurisdictional authority as a result of the inevitable increases in the magnitude and complexity of social processes.9
Enter permissionless blockchains and their protocol-based decentralized governance.10 Permissionless blockchains are what Nakamoto11 envisioned when creating Bitcoin: publicly accessible ledgers available to anyone to join and participate in governance.12 Bitcoin is the best known permissionless blockchain. It is a virtual currency where the processes of issuance and transfer are public and transparent. Simultaneously to maintaining the underlying ledger, miners create bitcoins, which are then used in transactions reflected on the distributed ledger. Unlike all fiat currencies in the modern era, the government has, at best, a limited role in its ongoing processes, which are governed primarily by network participants and users.13 This is because the novelty of these cryptocurrencies’ organizational structure meant existing law and regulation were, in many instances, ill-equipped to deal with them.14 Indeed, Bitcoin and Ethereum, two of the largest cryptocurrencies, could not be regulated by the SEC as securities because there is no third-party residual claimant to either of those networks’ activities. Because of the structure of permissionless blockchain protocols, all payments from network actions flow to individual miners without any residual benefits (profits) flowing to the network as a whole.15 It presents a novel form of private governance that facilitates impersonal online exchange because the blockchain network’s performance and changes in the rules occur via a decentralized process that is transparent and open to anyone with the right software, internet access, and electricity access.
Despite the claim to be decentralized and self-governing,16 we argue that permissionless cryptocurrency blockchains cannot avoid the forces of governance, both within and external to the blockchain networks. The requirement of governance within blockchain arises because the code and rules predictably need to be changed periodically in ways that cannot be anticipated ex-ante.17 One user might see a system behavior as a bug, but another might see it as a feature because they have different objectives or desire different outcomes. How do protocol changes take place? Who adjudicates disputes related to network processes and rule changes? These conflicts are not too different from a political process with all its pitfalls. Blockchains have also been characterized as promising a complete contract because users must agree on all rules ex-ante. But rules inherently need to be changed from time to time. Thus, our analysis hinges on the analogy that using a blockchain system is not unlike being a citizen of a country in the sense that each subjects a given individual to a specific polycentric balance of overlapping governance authorities. These layers of institutions resultant from overlapping governance units define distinct, and at times competing, interest groups subsidiary to each blockchain network, and create pressure for change within the blockchain. The distinct roles associated with shaping governance outcomes on a given cryptocurrency network create specific incentives surrounding the outcomes of network processes. While existing research emphasizes blockchain as a novel system of governance,18 less attention had been paid to the granular details of how permissionless blockchains are governed. In addition, while a sizable literature considers the legal aspects of blockchain governance (or external governance),19 we argue that the legal and regulatory aspects cannot be understood without consideration of the numerous polycentric governance forces to which permissionless blockchains are subject.
Drawing on the tradition of polycentric governance specifically,20 along with the new institutional economics more generally,21 we argue that there are four distinct, yet interrelated, levels of governance of permissionless blockchains. Governance at the protocol level is necessary because codes and rules need to be changed periodically in ways that cannot be anticipated ex ante, as well as requiring procedures to adjudicate disputes arising during these changes. As a system of governance themselves, permissionless blockchains provide a means of decentralized execution and validation of network processes that are defined by the resultant effects on network participants and users’ incentives.22 While the core protocol governance is the consensus mechanism, other direct governance outcomes include the possibility for forking and better user interfaces to broaden blockchain access.23 The need for governance at the subsidiary level arises from the need for communities to draft protocol updates and from the possibility that specific protocol design choices create concentrations of political power within the network. Dilemmas of competitive governance arise because cryptocurrency networks are constrained by the possibility of exit of participants and users to other alternatives. Finally, in terms of superior governance, permissionless cryptocurrency participants and users are subject to a variety of laws and regulations due to how cryptocurrencies implicate property, contracts, tax, and securities law. In our analysis here, we detail these predominant forms of cryptocurrency blockchain governance and discuss their implications for the ongoing development of these novel organizational forms, with emphasis on how an understanding of these governance aspects informs legal and regulatory responses to increasing deployment of permissionless blockchains.
Section I of the paper sets the stage by arguing that blockchain, often viewed in terms of complete contracts, is, like all governance systems, incomplete, and that as a result, its organization is dynamic, costly, and polycentric. Section II delves into the core aspects of permissionless blockchains and the contention that governance by code is replacing more traditional governance. Sections III-VI consider each of the four aspects of governance: protocol, subsidiary, competitive, and superior. The Conclusion discusses the implications for regulation and law: while we provide no specific recommendations for how blockchain ought to be governed, our analysis clarifies that regulation and legal reforms ought to take as a starting point that blockchain networks are adaptive, evolving enterprises that are subject to internal and external governance dilemmas, much like any large, complex organization.
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1. See, e.g., MELANIE SWAN, BLOCKCHAIN: BLUEPRINT FOR A NEW ECONOMY (Tim McGovern, ed., 2015).
3. DARCY W.E . ALLEN, CHRIS BERG & AARON M. LANE, CRYPTODEMOCRACY: HOW BLOCKCHAIN CAN RADICALLY EXPAND DEMOCRATIC CHOICE (2019).
5. Armen A. Alchian & Harold Demsetz, Production, Information Costs, and Economic Organization, 62 Am. Econ. Rev. 777, 793-94 (1972).
7. Decentralization has costs, such as increasing decision-making costs, at least mechanically. See JAMES M. BUCHANAN & GORDON TULLOCK, THE CALCULUS OF CONSENT (1962). At the same time, it has benefits, including reducing oppression and corruption and unleashing a host of economic, technological, and institutional innovation. See DOUGLASS C. NORTH, JOHN JOSEPH WALLIS & BARRY R. WEINGAST, VIOLENCE AND SOCIAL ORDERS: A CONCEPTUAL FRAMEWORK FOR INTERPRETING RECORDED HUMAN HISTORY (2009); Daron Acemoglu et al., Democracy Does Cause Growth, 127 J. Pol. Econ. 47, 54 n.4 (2019).
9. Elinor Ostrom, Beyond Markets and States: Polycentric Governance of Complex Economic Systems, 100 Am. Econ. REv. 641, 642 (2010).
11. Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System (2008), https://bitcoin.org/bitcoin.pdf (last visited Jan. 22, 2021).
13. Rainer Böhme et al., Bitcoin: Economics, Technology, and Governance, 29 J. Econ. Persp. 213 (2015).
15. Gerald P. Dwyer, The Economics of Bitcoin and Similar Private Digital Currencies, 17 J. Fin. Stability 81, 83 (2015).
17. Sinclair Davidson, Primavera De Filippi & Jason Potts, Blockchains and the Economic Institutions of Capitalism, 14 J. Inst. Econ. 639, 651 (2018).
19. DE FILIPPI & WRIGHT, supra note 14; Kevin Werbach, Trust, but Verify: Why the Blockchain Needs the Law, 33 Berkeley Technol. L.J. 487 (2018); Kevin Werbach & Nicolas Cornell, Contracts Ex Machina, 67 Duke L.J. 313 (2017).
21. LIYA PALAGASHVILI, ENNIO PIANO & DAVID SKARBEK, THE DECLINE AND RISE OF INSTITUTIONS: A MODERN SURVEY OF THE AUSTRIAN CONTRIBUTION TO THE ECONOMIC ANALYSIS OF INSTITUTIONS (2017); ERIC ALSTON ET AL., INSTITUTIONAL AND ORGANIZATIONAL ANALYSIS: CONCEPTS AND APPLICATIONS (2018); Simon Deakin et al., Legal Institutionalism: Capitalism and the Constitutive Role of Law, 45 J. Compar. Econ. 188 (2017).
23. Jeffery Atik & George Gerro, Hard Forks on the Bitcoin Blockchain: Reversible Exit, Continuing Voice, 1 Stan. J. Blockchain L. Pol’y 24 (2018).
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