Bitcoin’s governance model? Bickering and inaction with misaligned incentives

Bitcoin – the innovative digital currency – has stirred the entire world of finance into action, from banking to payments. Tremendous research is now expended by the finance industry on how the blockchain technology underpinning Bitcoin can reduce costs, speed transactions, and eliminate errors. But increasingly, this research is focused on proprietary “permissioned” solutions, not necessarily using Bitcoin itself.

It’s hard to blame them. Bitcoin’s governance problems are well known, and have worsened over time. Its most recent civil war – centered on a seemingly simple choice of whether to increase the network’s capacity – has continued for nearly two years and only now appears to be headed towards resolution.

This and other examples of bickering and indecision are making it increasingly clear that Bitcoin’s governance is extremely broken.

Worse, Bitcoin lacks a clear mechanism for repairing its governance issues, making it likely that competitors will eventually erode its digital currency market share as they move orders of magnitude faster to meet market needs.

What’s wrong with a little anarchy?

The original vision to control changes to Bitcoin’s software was through the power of decentralized decision-making. Specifically, end users were supposed to decide which version of the software they would run, and in doing so, the majority would determine which features and functionality would be incorporated into the network. This worked quite well for the first several years of Bitcoin’s existence.

However, there was an unforeseen flaw in this approach. The mechanism used to measure end-user preferences is a process called “mining” – which is basically the process of solving of complicated math problems. Mining served the dual purposes of securing the network and measuring the approximate share of users that supported each version of the software. As long as the computing capacity to solve these problems correlated with the share of end-users choosing each version of the software, this remained an effective means of measurement and decision-making about what the network wanted.

Hey Fox, mind watching the henhouse?

Unfortunately, that correlation disappeared in 2013 with the introduction of purpose-built hardware designed specifically to mine Bitcoin. The new machines were thousands of times faster at solving these complex math problems than end-users’ desktops and laptops. As a result, end-user preferences were drowned out by those that operated the specialized mining equipment. Over time, Bitcoin mining capacity has concentrated down to a handful of large operations; those with access to the cheapest electricity and bulk equipment discounts. End-user preferences no longer matter and around half a dozen miners call all the shots.

That might not be a major concern if miners were incentivized to meet customer needs. Unfortunately, that’s not always the case. Miners care foremost about their own needs, which can lead to direct conflict with the interests of end-users. For an example, you needn’t look any further than the long running debate about whether to increase Bitcoin’s block size (which would increase the capacity of the network).

It is hard to argue that a congested network is good for users; yet miners have little incentive to increase capacity. By keeping network capacity low, users are forced to pay the miners ever-higher fees to ensure their transactions are processed quickly. At the same time, larger blocks would mean higher data processing and storage costs for miners. Therefore, miners stand to lose from a higher block size, both in terms of the fees they collect and their costs, while most users would benefit from the change. It’s not hard to see why the block size remains unchanged.

This misalignment of incentives is leaving the Bitcoin network crippled with congestion. At peak times, over 65,000 transactions may be waiting to process, leaving many users waiting hours for their transactions to confirm. In fact, at one point late last month, users were waiting an average of over six hours. This also leaves the network’s users uncertain about how much they should pay for a transaction.

Bitcoin’s flawed decision-making process isn’t the only issue leading it away from the interests of its users. The network’s development is largely funded through the Bitcoin Foundation, which depends entirely on donations. Those donations increasingly come from private companies seeking influence over the network. Besides leading to perpetual financial distress, this arrangement leaves Bitcoin developers under pressure to cater to requests from its benefactors, even if those requests conflict with users’ interests.

Other digital currencies suffer from governance issues, too, with dire consequences resulting. For example, Ethereum – number two in market share behind Bitcoin – recently experienced a conflict within its user base so severe, that it actually split the network in two. The digital currency “Ethereum Classic” was born out of the dispute.

Governance ain’t sexy, man

If effective governance matters so much, why isn’t more being done to correct it? The unfulfilling answer seems to be “it’s hard and doesn’t create hype”, but that hasn’t stopped other digital currencies from taking the time necessary to lay a more robust foundation.

While most digital currencies are little more than replicas of Bitcoin and copy its flawed governance, there are a handful of competitors that have designed alternative approaches. Several have proven that a more nimble and user-friendly decision-making process is possible. With enhanced governance in place, competitors should be able to grow and deliver new features faster than Bitcoin.

bitcoinOne approach is by explicitly centralizing all decision-making. Ripple is a venture-backed startup that manages the currency of the same name. Ripple caters to the banking industry and seeks to improve the cost and speed of international transactions between their clients. As Ripple is a centrally managed company, they can act quickly and decisively exactly like any other company to address the needs of its customers.

Another competitor, Dash, has approached the governance problem in a decentralized manner. Dash ensures decisions are made by those most affected – holders of its currency. Simply put, those that own the currency are allowed to vote similarly to company shareholders on any question facing the network such as strategic issues, the allocation of funds, or even what team of managers the network should support.

This ensures much tighter alignment between decision-making and user needs. It also results in a much more nimble decision-making process. For example, while Bitcoin has debated a block size increase for two years, Dash resolved a similar question within one day. Perversely, Dash lacks the headline-grabbing controversies common with other digital currencies… it is boringly effective.

With a robust governance foundation in place – Dash can move forward and resolve development decisions much more quickly than competitors, and deploy them with confidence to the network. It now boasts a number of features Bitcoin lacks, such as instant transactions, privacy features, and even self-funding budgets.

The budget system allows a limited amount of new currency to be created to fund anything from development to marketing – as long as the “shareholders” approve.

This directs funding toward undertakings that benefit users the most and keeps it free from the influence of would-be benefactors. The result? Dash grew nearly 500% within a year, tripled its market share, and announced integrations with countless new partners. More impressive, it now boasts a budget larger than Bitcoin’s foundation.

Hard to replace the foundation once the house is built

Bitcoin might be able to replicate the governance successes of projects like Dash, except that Bitcoin’s current governance fails to provide a clear path for such a change. Implementing a governance and funding model similar to Dash’s would require miners – which currently receive 100% of the network fees and network rewards and control all software decisions – to receive less revenue and cede all of their decision-making power. But it is the miners that would need to voluntarily cede those benefits to others, since they currently determine the software running the network.

Logic dictates this is something miners are unlikely to do except under dire threat from a competing coin. As a consequence, Bitcoin’s developers have little incentive to even attempt a major governance overhaul, instead focusing on technical features that are noncontroversial.

Bitcoin, while certainly not on the verge of failure, may fail to keep pace with its more nimble competition if its governance issues remain unaddressed. At the same time, mining (and control) continues to concentrate in the hands of a few, causing Bitcoin to stray further from its original vision over time.

Perhaps it will require a dose of healthy competition to spur Bitcoin to adopt a more sustainable and end-user friendly model. Whether it does so before competition erodes its enormous lead remains to be seen.