Governance is something traditional peer-to-peer lenders don’t spend much time thinking about. And it makes sense why we don’t. After all, most of the platforms we use are private companies and have their own private decision-making processes. We decide to accept or not accept a company’s governance policies by using or not using their products. But cryptocurrencies are different. First, they are a different kind of investment than other assets as they are entirely digital. Secondly, most are public and not run by a company or some CEO or Managing Director. That means there is no decree coming from a person to change how they do business. You can see what’s going on with the cryptocurrency by looking at the on-chain data. You can also see how the cryptocurrency makes decisions on how to make changes to the protocol. In a blockchain network many people take part. For example, the Bitcoin blockchain has:
- its core developers for the open-source software
- node operators
- and users like perhaps you and me.
So how are decisions made? Who decides to add a new program on the Bitcoin network like the recently approved Taproot update? Or Ethereum’s EIP-1559 (Ethereum Improvement Proposal) that will change the fee structure AND burn some of those fees to reduce Ethereum’s supply? Who makes that decision? You may not care who makes these decisions if all you want to do is lend your money, fiat or crypto, to make money. But if you want to hold any of these cryptocurrencies as a longer-term investment, then you will understand more about your investment if you understand how they make decisions to change their protocols. Blockchains make these decisions through Governance Protocols. Governance is the process by which these networks make decisions. In a blockchain, there are on-chain or off-chain forms of governance. Off-chain governance looks like how private companies make their own decisions. So we will focus on on-chain governance. We will look at how blockchains use their chain to manage their governance and decision making. There are 2 main types of blockchain networks: Proof of Work (POW) and Proof of Stake (POS). And how they govern differs too. While all the differences between POW and POS networks are beyond the scope of this article, we will get into how they govern their blockchains.
Proof of Stake (POS) Blockchains
Most blockchains in the cryptoeconomy are POS chains. However, Bitcoin, Litecoin, and Ethereum are Proof of Work chains (ETH will be converting to POS soon). In a POS chain, individuals and businesses put up a ‘stake’ or a certain quantity of the coin. When they do, they become a staker or validator, or in the case of the cryptocurrency DASH a masternode operator. That validator is able to confirm or invalidate transactions. They are incentivized to be honest and validate real transactions as they can lose their stake if they do not act honestly. Stakers are often the largest holders of the coin on that blockchain. Let’s use DASH as an example. DASH, a coin for payments that is popular in Latin America, is currently priced at $139. To stake DASH and run a masternode, you have to put up 1000 DASH. That means for $139,000, you can run a masternode. Anytime you go below 1000 DASH, you lose your masternode status and the fees you could earn by running the masternode, although you do NOT lose the coins themselves. Validators earn fees for verifying transactions on a Proof of Stake network. On DASH, you can earn a good interest rate on your staking investment while helping to maintain the network. Current DASH masternodes are earning 5.75%, according to Staking Rewards. So it makes sense that if a network has staking and validators, that they would have a vote on how that network changes, right? This common form of governance is a validator digitally signing their vote for or against a particular proposal. By having those who are staking the token vote, those who have the most money invested in the token have the most say in changing policies the blockchain takes going forward. One typical variation of this type of governance is whether each validator has a vote or the staker vote is in proportion to their stake, meaning the vote of larger stakeholders means more.
Proof of Work Blockchains
Unlike staking and validators, in Proof of Work, computers contribute power to solve complex mathematical equations. This is the work of the miners. And when they solve them, they earn the block reward and their block is accepted into the chain. Due to the amount of power required to run these computers and the odds of solving the equation to find the block, most companies become part of a mining pool. F2Pool and Slushpool are two of the most popular. This network of servers solves equations together and splits rewards together. Miners don't stake the coin, they are staking energy to provide the work to produce the coin. Bitcoin uses something called BIP for Bitcoin Improvement Proposal to propose changes. One of the early ones, BIP9, says that miners have to show support in the blocks they mine. This means their vote is public and on-chain. Also, 90% have to support a new proposal that affects them or activates a soft fork in the network. Once 90% have approved the BIP, as just happened for the Taproot upgrade, it will lock in and become part of the Bitcoin protocol. All miners have to do to signal, which is in essence their vote under Bitcoin governance, is add a number to the block header of a block that they mine. This is how they know 90% have approved Taproot instead of 88%. When a proposal does not get approved, it is not implemented and developers start back at the beginning to try to solve the problem in a new way. It doesn’t stop there. Another important part of the community, the node operators of the Bitcoin network, then upgrade their software to include the Taproot upgrade. Now they are ready to operate their nodes with the newly approved proposals. If they choose not to upgrade, then they will be left behind by new blocks created that have Taproot. It’s like when you can only access a document as a .doc, but it won’t show as .docx or show any improvements to Word editing available in the .docx version.
So What do DeFi Projects Do?
DeFi projects, which are important for p2p lenders, are applications running on a blockchain like Ethereum or the Binance Smart Chain. They are not chains themselves, but they have matters that need to be settled and voted on too. So how do they do it? They use Governance tokens. Either the native token that they issue or a 2nd token is issued strictly for Governance purposes meaning for voting.
A Native Token Used for Governance
We’ve mentioned Compound before as an excellent DeFi app. P2P lenders can lend on Compound directly or through an agreement with MyConstant, which I reviewed a couple of months ago. Compound has their own token COMP, which they use for governance. Let’s see how they just recently used it on Compound Proposal 047. Proposal 047 is about price oracles. These are tools that connect real-world information like cryptocurrency or stock prices to blockchain smart contracts. One of the best oracles in the cryptoeconomy is a company called Chainlink. This proposal was to shift the price oracle feed from Coinbase Pro to Chainlink. But a change like this needs to be voted on. So the proposal was made and those holding the COMP token had 2 days to signal and digitally sign their vote. Here is the tweet from Compound with a description of the proposal.
And below, you can see the results of the vote on the Compound website. The vote was unanimous in favor.
Compound then tells us on the website and on Twitter that after a 2-day delay, this new proposal will be executed and a part of using the Compound DeFi app.
The importance of Peer to Peer Governance for your Crypto investments
Peer to Peer Governance is an important aspect of investing or lending cryptocurrencies. Whether it’s through miner or validator signaling on-chain or voting through governance tokens, you want to know how your cryptocurrency of choice goes about making changes, so you are not caught uninformed about your investment. Your stance on what type of governance is important will guide your investment decisions in cryptocurrencies. You can go with a Centralized Finance (CeFi) platform or a DeFi platform to lend your money, and you can hold or sell the cryptocurrencies you earn. Click on the links below to learn more about the following topics: