Discussion Post: Cryptoeconomics as a Limitation on Governance

Governance and Coordination
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TLDR

  • Cryptoeconomics is a combination of cryptography and economic incentives that are used to design and secure protocols such as blockchains and the applications built on top of them.
  • However, cryptoeconomics cannot account for all important factors in governance decision-making, and a reliance on it alone can lead to undesired outcomes.
  • Schneider argues that pairing cryptoeconomics with political systems can help overcome the limitations of cryptoeconomic governance.
  • Vitalik Buterin agrees with Schneider’s conclusions and argues that just as cryptography created a new space for innovation in economics and finance with blockchains, it can also create a new space for innovation in social and political systems.

At issue

Is cryptoeconomics alone sufficient to govern blockchains and blockchain applications, or is a political layer required alongside?

Citation

Schneider, N. (2021). Cryptoeconomics as a limitation on governance. Available at: OSF or Cryptoeconomics as a Limitation on Governance — Nathan Schneider

Buterin, V. (2021). On Nathan Schneider on the limits of cryptoeconomics. Available at: On Nathan Schneider on the limits of cryptoeconomics

Discussion

Cryptoeconomics has fundamental limitations. A foundational innovation in the blockchain space has been the shift from trust-based guarantees to a type of confidence machine. Rather than trusting an institution or brand, blockchains rely on a combination of cryptography and economic incentives – cryptoeconomics. Vitalik Buterin (2018) defines cryptoeconomics as “fundamentally about the use of economic incentives together with cryptography to design and secure different kinds of systems and applications”. Both PoW and PoS blockchains are secured using cryptoeconomics.

However, as the wider ecosystem and application development have progressed, challenges have emerged about how these systems can be most effectively governed. Of particular concern is how a focus on economic logic can crowd out anything that isn’t financialised. As Schneider notes: “The things not visible to the market, that is, become unthinkable and impossible. If the market cannot see a changing climate, there is no motivation to act on it.” Markets are an effective mechanism to manage the supply and demand of certain types of goods and services, however, they are not effective at managing more intangible forms of value such as trusted relationships or a sense of community. Schneider describes processes that manage non-financialised value as politics and argues that we need to design and structure political processes that can facilitate discussions about non-financial value and incorporate it into the decision-making structures of decentralized infrastructure – both protocols and applications – where appropriate.

Challenges managing non-financial forms of value are not unique to the crypto space, they present in a wide variety of contexts with a direct corollary to governance and economics in the real world. When discussing GDP as a broad descriptor of a country’s performance, Stiglitz (2018) writes: “What we measure affects what we do. If we measure the wrong thing, we will do the wrong thing. If we don’t measure something, it becomes neglected, as if the problem didn’t exist.” In the crypto space, we can apply a similar logic about what is on-chain, and what is off-chain – it is much easier to manage and account for what is on-chain. The broad implication is that being unable to adequately manage or account for value that isn’t on-chain or financialised – captured through economics or tokenomics – often results in its exclusion from consideration in decision-making structures, which can result in undesirable governance outcomes.

Schneider describes three ways these governance limitations present in the blockchain space: persistent plutocracy, discounting externalities, and suppressing participant interests. Plutocracy – defined as governance by the wealthy – is present in this space. PoW and PoS blockchains tend to provide power in proportion to a given node’s buy-in on the network through either computing power or token holdings. Applications built on these networks mostly follow the same logic using coin holder voting – 1 token equals 1 vote. Buterin (2018) provides a comprehensive account of how plutocracy can generate negative outcomes. Broadly speaking, power defaults to those with more tokens, who then make decisions based on their self-interest which is often at odds with the broader community’s desires.

The discounting of externalities is a well-recognized problem. Anything the system cannot see, cannot be accounted for. Environmental concerns, specifically climate change, is the premier example of this. PoW consensus mechanisms use significant energy – often from fossil fuel sources – which are incentivized by the cryptoeconomic security model. The externalities – climate change – are not captured in the blockchain ecosystem. Both of these factors lead to the final problem – participant interests are suppressed. Economic logic can only capture a slice, a facet, of the things people value. Concepts such as trust, fairness, legitimacy, credible neutrality, and sense of community are not captured in economic logic. An inability to structurally account for these factors can result in their exclusion from consideration in governance processes, which suppresses participants’ interests.

Schneider argues that pairing cryptoeconomics with political systems can alleviate these limitations by introducing a mechanism for people to influence protocols which is not dependant on economics/token ownership. Cryptoeconomics has significant value as a tool, but only in limited contexts – it is not a silver bullet that solves all governance problems. Incorporating the political dimension alongside cryptoeconomics could introduce more democratic tools for decision-making which can improve the function of the ecosystem. Importantly, these types of political decisions are already active in the ecosystem alongside cryptoeconomics, as Buterin (2017) notes “Miners are generally following the direction favoured by the community, which is itself gauged via social consensus aids similar to those that drive hard forks.”

The evolution of the ecosystem over the past few years has increasingly demonstrated the importance of the political dimension. When reflecting on the evolution of the Gitcoin protocol in response to the Sybil attacks in round 9 of Gitcoin grants, Kelsie Nabben (2021) writes that “Governance, even that of the decentralised variety, surfaces politics. All infrastructure is political, whether it is through human involvement or the rules that humans encode in systems. How this interplay between the social and technical entanglements of decentralised systems and their politics can be leveraged by the incentives and transparency that blockchain-based systems afford, remains to be observed.”

Nabben (2021) highlights the importance of the interplay between social and technical systems, which is echoed by Buterin (2021) in his critical analysis of Schneider’s paper. While the problems with cryptoeconomics mirror economics more broadly, the use of cryptography to create blockchains has created a new space for economic and financial innovation. Buterin (2021) argues that the same can be true for political systems – incorporating cryptography can create new spaces for social and political innovation. “Cryptography allows everyone to verify that some governance procedure was executed exactly according to the rules. It leaves a verifiable evidence trail of all actions, though zero knowledge proofs allow mechanism designers freedom in picking and choosing exactly what evidence is visible and what evidence is not.” Just as a combination of cryptography and economics has created a new era of technological and financial innovation with blockchains, perhaps a combination of cryptography and politics can unleash a new era of social and political innovation.

Overall, the interplay between economics and politics in a cryptography context raises a number of important questions. Democratic systems traditionally rely upon a 1 person equals 1 vote system, however representing identity on-chain is a persistent problem as current iterations of such systems are vulnerable to Sybil attacks. There also exists significant potential for innovation in this area, politics in the real world is constrained by existing bureaucratic and administrative systems which were designed before the widespread use of digital technology. Cryptography can bring innovations in the speed, granularity, privacy and transparency with which individual political preferences can be aggregated, allowing for more dynamic decision-making at scale.

Discussion Questions

  • Do you think a political system is required alongside cryptoeconomics for effective governance in the crypto space? Can we ever trust in code – ie ‘code is law’ – without relying on social consensus at some level?
  • If traditional finance and blockchains both require a combination of politics and economics, what are the benefits or differentiating factors that adding cryptography provides?
  • What are the underlying requirements to bring political preferences on-chain?
  • What are the most important areas for political systems to be integrated into the crypto/web3 design space?
  • Are there areas where political systems might not be necessary on-chain? Where?
  • How might an increased level of granularity of people’s opinions and preferences, enabled by decentralized ledgers, change how democracy functions?

Further Reading

Discussion of coin-based voting (Vitalik Buterin)

Discussion on plutocracy in onchain governance (Vitalik Buterin)

On the importance of legitimacy, and how it interacts with cryptoeconomics (Vitalik Buterin)

Characterising the sybil resistance problem (Kevin Owocki, Gitcoin)

Retrospective of the political and economic actions taken to retain the legitimacy of Gitcoin following a sybil attack during round 9 of the grants program (Kelsey Nabben, RMIT University).

Comparison of brand based agreements vs math based agreements (Chainlink)

Book on how a focus on economic logics can impede good governance decision-making in the real world – a corollary to the problems the crypto space faces (Stiglitz et al)
https://www.oecd.org/publications/beyond-gdp-9789264307292-en.htm

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There are two major obstacles to creation of incentive structures for non-financial measures or indices of value: the first which is non-technical is conceptualising the logic of the incentive structure, and the second which is technical is representing that logic in code.

Although Schneider’s description of processes that manage non-financial value as politics is useful in differentiating between the pure operation of market forces/instincts and regulatory intervention, I think the word ‘politics’ encompasses even the purest form of the free market. This view is based on a particular understanding of Harold Lasswell’s definition of politics as “who gets what, when and how”. If politics is about who gets what, when and how, then opinions of market participants about the value of goods and services and the price they should command are inherently political. Schneider’s distinction therefore, according to a particular perspective, refers more aptly to the dichotomy between pure market dynamics and regulation. It thus implies the relative amount of freedom and regulation in a particular market. Nevertheless, it is helpful to mention that it is common to describe political decisions and processes which have an economic impact as political economy.

Regulation on its own often calls for a centralised process, even in a democracy, except where direct democracy is practiced. This raises the possibility of centralization in a DAO unless both rule making and enforcement can be truly decentralised. In attempting to incorporate non-financial measures of value into incentive structures, whatever cannot be captured in code must be enforced, either socially by the participating entities using a consensus algorithm, or centrally by an arbiter. An ideal DAO is thus a return to the ideal of direct democracy.

In response to the first discussion question (whether a political system is required alongside cryptoeconomics for effective governance in the crypto space), I would say that blockchains as socio-technical systems already embody to some extent the politics of the social element. Separate political sub-systems with direct human involvement (in the form of a consensus mechanism or otherwise) are only needed to the extent that the technical (code) aspect of blockchains cannot account for all interests. As long as there is a “code gap”, social consensus would be needed although this is itself subject to sybil attacks.

Regarding the second discussion question (if traditional finance and blockchains both require a combination of politics and economics, what are the benefits or differentiating factors that adding cryptography provides?), I would say the differentiating factor cryptography provides is a trustless system that makes for integral enforcement of political decisions/rules.

I will attempt to answer the other discussion questions in my subsequent posts.

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The usage of the word politics was one of the bigger questions/issues I had when I was writing this post. I’m not convinced by it’s usage, but I’m also not sure there’s a better way to represent the ideas. As you point out, the definition of politics goes beyond how it used here. This was also discussed in the first thread about the paper as well, and the author originally used the term ‘crypto politics’, however that has specific meanings that were not relevant to the paper and so the broader term was used. For the purposes of this discussion, I see politics as referring to decision-making in crypto that occurs off-chain.

I agree, especially with the last part. However, I would also argue that blockchains (specifically using Eth as an example here) currently have a seperate political system that is informal, such as through the Ethereum foundation, as well as the numerous teams that work on tooling.

So far they’ve maintained legitimacy and credibility, but we’ve seen how toxic governance debates can get, such as with Bitcoin. I wonder how long the current arrangements can last, and whether a more formalised system may be required down the road. And if so, how would it be designed?

Precisely. I personally consider this to be a more exciting innovation in this space than the currency aspect. If we were to design more formalised systems, then I expect that crypto-politics would be a big part of it. There are ways to decentralise power here that have never existed before.

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The goal of a governance system is to give participants as much self-determination as possible. To simplify somewhat, I hope that anything that prevents this self-determination turns into a restriction. How deserving is a governance system of trust or confidence if it has significant constraints on its capacity to solve problems? This section’s goal is to list any governance restrictions that might or already exist due to reliance on cryptoeconomics. I go through a few apparent restrictions. These reflect well-known characteristics of cryptoeconomic systems and are also active development areas, so they might change as the field develops. However, I contend that for the time being, these restrictions imply that distributed ledgers are also relevant to earlier worries about the damaging impacts of economics on democratic governance.
The blindness of cryptoeconomics to the identity and integrity of human users—a persistent but not necessarily permanent condition—is a significant source of these restrictions. Finding participants is not always an existential issue in pre-digital political and economic governing systems. Edge-cases present challenges. Fraud can be reduced through rules that make it punishable. It’s possible that authorities don’t have straightforward procedures in place for when people’s names or gender identities change. When refugees cross borders, they could have problems identifying themselves or having their identities blatantly suppressed by unfriendly governments. But a lot of people discover that they may take the identification infrastructure that is dependent on the government for granted.
In addition, major Internet sites have started requiring government-issued identification or indirectly integrating users’ politically defined identities into their systems (such as through bank accounts or phone numbers). Also in democracies, unless majority rule is practiced, governance in itself typically includes an unified mechanism. In the absence of completely democratic principle or even implementation, this increases the likelihood of governance in a DAO. If quasi analyses of quality are to be introduced within reward systems, they should be implemented possibly directly through an adjudicator or cooperatively mostly by involved parties via a decentralized network.

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Discussion Post Question 3: What are the Underlying Requirements to Bring Political Preferences On-Chain

Crypto spaces usually embody many different sub-spaces. In order to have satisfactory on-chain governance, codes must satisfy the parametres of each sub-space. This means that the unique governance logic of each sub-space must be captured. Very importantly, the legal logic must be captured, and the logic of every other subject matter that is captured within the concerned crypto space. The application logic, of course, will also have to be designed.

As regards law, one of the challenges faced in Rules as Codes (the movement dedicated to promoting the translation of legal rules into computer code) is the translation of physical space semantics/pragmatics into the virtual environment. In order for legal rules to be effectively translated into code, code must create digital/crypto space analogues of physical space semantics/pragmatics (semantics refers to the meaning attached to particular conduct, expressions or ‘speech acts’ while pragmatics refers to the influence that different contexts have on conduct and expression).

Where digital/crypto space analogues of physical space semantics/pragmatics cannot be translated into code, then new semantics/pragmatics could be developed for the crypto space. The challenge here is that physical space semantics/pragmatics are built on legal jurisprudence deviation from which might lead to unjust results. Although jurisprudence is itself dynamic, its evolution must be justified by results. Contract law presents a very good example of this challenge. This is seen in the rules relating to offer and acceptance. Contract law rules provide that the display of goods does not amount to an offer but is merely an invitation to treat. It is the buyer that makes the offer by proposing to buy at a particular price, acceptance of which creates a contract. A series of offers (counter offers) may follow an original offer until acceptance creates a contract.

These rules are premised on the ability of the parties to have a mental exchange. In the virtual environment, there are media that permit such mental exchange. Examples are electronic mailing services, chat platforms etc. However, there are other media that only permit selecting one or more options out of a range without the possibility of making a proposal. An example of such take-it-or-leave-it media are e-commerce websites that display products and prices without the possibility of purchasers negotiating the prices.

By the usual terms and conditions on e-commerce websites, display of goods are invitations to treat and purchasers who place orders on such websites are pragmatically deemed to have made offers. Such a convention does not conform to contract law semantics/pragmatics in physical space, as purchasers do not have the opportunity to propose their own prices. If such offerings were to be made to conform with conventional jurisprudence they would be regarded as offers and the purchasers’ action of placing orders as acceptance, since all vital contractual elements apart from acceptance have been set by the seller.

Another challenge in bringing governance standards on-chain is the reality of the incompleteness of legislation/contracts. Legislation and contracts are always incomplete because it is practically impossible for draftsmen/parties to contemplate all scenarios. This necessitates human discretion and oversight. Such human oversight is already provided for in article 22 of the European Union’s General Data Protection Regulation (GDPR). The Algorithm Accountability Act has been proposed in the United States.

In a nutshell, ensuring robust on-chain governance requires, amongst others:

  • Translation of different subject matter logic and the application logic into code;
  • Capturing the physical space semantics/pragmatics in code; and
  • Putting in place structures for effective human sight, to guarantee discretion and evolution.

I will attempt to answer Discussion Question 4 (what are the most important areas for political systems to be integrated into the crypto/web3 design space?) in my next post.

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This is a very interesting and important topic as long as cryptocurrency and blockchain is concerned.
I will only attempt to give my take on this topic in the simplest way possible.
Taking the real physical world scenario for instance, economics and politics are like two sides of a coin, none actually exists independently of another and this existence ensures and creates the avenue for proper economic governance.
In essence, cryptoeconomics should also be backed and incorporated with a corresponding Cryptopolitical system which in this case will be coded as a smart contract and also run onchain to help overcome some of the challenges and limitations of Cryptoeconomic governance. These are all in line with the arguments of Schneider and Vitalik.

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Fundamentally I see public blockchains as social consensus machines, a sort of dynamic mechanism that is inherently political. While each network participant is neutral in design, they undertake actions which either legitimize or facilitate the usage of the network they participate in, implicitly consenting to the given rules of that network’s canon. The canonical chain requires validator consensus, while users also play a role in choosing to make use of a particular blockchain and accepting the exchange values of assets as given on that version of the network (e.g PoS ETH vs. PoW ETH vs. ETC).

The DAO hack’s resulting soft fork is an example of social consensus, not necessarily technically encoded rules, determining the fate of the network. Similarly, the UASF oriented debate over OFAC compliant relays, validators, and contracts have occurred entirely within the established ruleset of the blockchain. The rules and technical function of the network remain neutral while still being highly reactive to individual political decisions made by network actors.

“Code is law” is only as good as the canonical resilience of the network environment it exists on. This fundamentally parallels democratic political processes, which are often described as being legitimized by the consent of the governed. The rules of blockchains and cryptoeconomies are legitimized not only by a perception of credible neutrality or fairness, but by the aggregate social consent of network participants.

Given this, the question of governance is not one of “if” but “how” it can be formalized and facilitated in both a technically neutral and politically neutral fashion that is maximally expressive and equitable. Here, we can turn to some of the unique opportunities that exist for multilateral governance through cryptoeconomics, network actors, political systems, and classical legal frameworks.

Compliance and Consent

The existence of a potential UASF between an OFAC compliant and a purely neutral chain brings up an interesting analysis of blockchains as syndicalistic. If users can feasibly interact with either ruleset, both are legitimated in their own internal context. While I personally think there’s many downsides to a fractured landscape, and the event of divergent viable UASFs would be catastrophic to the function of markets, oracles, and DeFi applications, it remains one example of a viable application of political economy to the blockchain context.

Cryptoeconomics remain relevant in each context since the basic trustlessness and function of networks rely on economic assumptions, and fragmenting the network also fragments those economic assumptions.

Technically speaking, any political or legal framework can be applied to networks this way, simply through network actors creating soft forks compliant to a local context. I personally believe there are better and more neutral solutions, including compliance wrappers (e.g Molecule Protocol | Devpost), but we can use this context to define the first layer of blockchain governance as the product of the freedom of network actors to consent to a particular ruleset associated blockchain network.

Given freedoms of choice, users and network actors gain political expression through their choices in which networks and legal frameworks to use and legitimize.

Protocol Governance

Going deeper, we then have the protocols which operate on a given blockchain, which may make use of cryptoeconomics alongside various forms of on-chain and off-chain governance. Consisting of a combination of smart contracts and organizational structures, protocols break down further into formalized and informal rulesets. The issue of plutocracy has been addressed many times before, including in this thread, so I’ll just note that it is both highly present and problematic. However, protocol governance remains one of the areas most of interest to me for novel applications of governance.

The ability to formalize rules through smart contracts allows forms of political expression to be predetermined while also being fully open to participation.

Gitcoin is an excellent case study here, because of their use of quadratic funding (on-chain, formalized, open) alongside informal organizational structures (workstreams, committees, the DAO). Political expression in Gitcoin is participatory and highly expressive because of its ability to use both objective and subjective layers in tandem. Furthermore, they’ve recently implemented sybil-resistance mechanisms through their Passport system, something which is essential to establishing more traditional forms of democracy on-chain and may lead to new developments in on-chain governance. Their model provides some clues as to the forms cryptoeconomics, political systems, and organizational structures can use to interact and form an expressive, democratic whole.

The increasing use of Snapshot voting across protocols hints at the desire for political expressiveness to be integrated into smart contracts, and I believe this trend will only accelerate over time. Particularly, cryptoeconomic tweaks in protocols underlie the potential for cryptoeconomics to themselves be politically engaged processes. For example, Maker’s DAI Savings Rate (DSR) is a component of the protocol’s cryptoeconomic incentives which is determined by governance, allowing the formal rate to be determined in an open process using subjective criteria.

Conclusions

What is unique about blockchain governance is the potential for deep integration of stakeholder governance into a wide array of complex formalized rulesets, and for the execution of sociopolitical processes to be transparent, open, and verifiable.

If we continue to expand the tools we have, then it represents an opportunity to allow for open participation in direct democracy over the formalized rulesets which directly impact users’ lives. Blockchain governance is what allows for financial freedoms to become democratic freedoms, and for those freedoms to meaningfully represent social consensus of the governed.

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nice work @dwither
for the research question in the work “Is cryptoeconomics alone sufficient to govern blockchains and blockchain applications, or is a political layer required alongside?”

Cryptoeconomics is the study of how economic incentives can be used to design and secure decentralized systems, such as blockchains. It involves the use of cryptographic techniques, game theory, and mechanisms design to create incentives for network participants to behave in a way that is beneficial to the overall security and functionality of the system.

While cryptoeconomics can be a powerful tool for governing decentralized systems, it is not necessarily sufficient on its own. In some cases, a political layer may be required to address governance issues that cannot be resolved through cryptoeconomic mechanisms alone.

For example, blockchains and blockchain applications may need to adapt to changing regulatory environments, deal with disputes between stakeholders, or make decisions that have significant impacts on the system as a whole. In these cases, a political layer, such as a decentralized autonomous organization (DAO) or a governance council, may be required to make decisions and take actions that are in the best interests of the system and its users.

Overall, the appropriate level of governance for a particular blockchain or blockchain application will depend on its specific needs and requirements. In some cases, cryptoeconomics alone may be sufficient, while in others, a political layer may be necessary to address more complex governance issues.

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