Paradigm Founder: The Best Protocol, Minimal Governance

Written by: Fred Ehrsam and Dan Robinson, the former is a co-founder of the well-known crypto investment fund Paradigm, and the latter is a Paradigm analyst
Compiled by: Perry Wang

The best government is the one that governs least.

------Anonymous

Why? Because minimizing governance allows stakeholders to rely on a protocol. This creates a positive feedback loop of adoption that can achieve scalability that is difficult to realize through other means.

The best examples are successful traditional internet protocols, such as HTTP and SMTP. Look at the immense power these protocols have today. It is minimized governance that has made them the standards everyone relies on, with levels of adoption far exceeding those achieved by any corporation.

While governance remains important, this article explains minimized governance and speculates on its implications.

What is "Minimized Governance"?

Minimized governance means reducing power and dependence on governance as much as possible.

Minimized governance is important because it underpins the main value proposition of a protocol: trustworthy neutrality. Minimizing governance often enhances the trustworthy neutrality of the protocol.

In current practice, minimized governance most directly applies to on-chain governance minimization. If a protocol wants to achieve maximum adoption and avoid governance over its protocol functions, it should do so by minimizing on-chain governance.

What is Trustworthy Neutrality?

Trustworthy neutrality means reliability, which means stakeholders (such as users or developers) can use or build on the protocol, confident that the protocol will not change in ways that betray their interests. The protocol maintains trustworthy neutrality by avoiding becoming a "puppet" of any specific group.

Why is Trustworthy Neutrality Extremely Important?

Trustworthy neutrality is the main value proposition in today's crypto space. It opens the door to new forms of open and predictable currency, creating a platform where anyone can publicly create and access new applications.

The lack of trustworthy neutrality in existing platforms further highlights its importance. Central banks, as currency platforms, lack trustworthy neutrality because some stakeholders can decide to print money at will. Facebook and Twitter, as application platforms, are not trustworthy neutral parties because some stakeholders can make changes that stifle entire developer ecosystems.

Trustworthy neutrality creates a secure environment for the value locked within the platform, preventing value from being stolen, shut down, or restricted. This value can be both tangible (e.g., funds) and abstract (e.g., development time, users).

If trustworthy neutrality completely fails, it becomes a scam ready to run away at any moment. Some stakeholders of the platform can partially or wholly abscond, taking away the value owned or created by other stakeholders. For example, suppose the operator of a centralized crypto exchange absconds with user funds. An abstract example could be: suppose Twitter shuts down its third-party developer interface, making Twitter's own interaction interface the only option.

What Minimized Governance Is Not?

Minimized governance is not the idea that governance can or should completely disappear. In fact, this is impossible! Without governance ("essential governance," which will be explained later), some protocol functions are difficult or impossible to execute. At the very least, governance always exists through social coordination ("informal") and the ability to hard fork.

Minimized Governance Creates More Neutral Protocols

Creating a perfect governance system is like designing a perpetual motion machine. Well-known game-theoretic results indicate that all governance systems are inherently unstable and cannot simultaneously satisfy all ideal attributes. Formalizing governance systems often amplifies these inherent problems by reducing the ability of informal governance to resolve edge cases.

Thus, the more formal a governance system is, the more likely it is to become a puppet of certain interest groups over a sufficiently long time frame. This is primarily because formalizing a governance system requires formalizing stakeholders (who has a voice and how much voice they should have). Formalizing stakeholders is difficult to implement at a single point in time and nearly impossible over time.

Token Holder Misalignment

The formalization of on-chain governance stakeholders is often confirmed through simple token ownership, while governance itself is realized through token holder voting. Unfortunately, for many reasons, token holdings do not accurately reflect the value of stakeholders in the protocol, including:

• Not all stakeholders are necessarily token holders, especially users and developers.
• Token ownership may not accurately reflect stakeholders' importance to the protocol, current or future. When the next application reaches the scale of Facebook or Google, it may be stifled in its infancy by those who hold more tokens.
• Stakeholders will change over time. This is especially evident when considering future stakeholders that do not yet exist. Consider the interests of giant applications that have yet to be created.

As a result, voting by token holders on the long-term use of the protocol creates a series of misalignment issues, including:

• External pressure. For example, Facebook faces external pressure to block external developers from accessing the world's most detailed social graph. Whether this is right or wrong, it has indeed stifled many applications and countless, yet-to-be-created future applications.
• Value capture. Token holders may seek to capture value at the expense of others. For example, Twitter monopolized its protocol's interaction interface at the expense of third-party developers.
• Time horizon mismatch. Unlike the protocol, the time horizons of token holders can vary significantly. This may drive them to seek short-term value at the expense of the protocol's long-term usability. For instance, token holders of Maker, focused on short-term appreciation prospects, may raise stability fees to create value in the short term, regardless of long-term impacts. Ironically, Facebook is a great example, as its founder Mark Zuckerberg's decision to refuse to show ads (to capture value) while its network effects were still growing was a sensational event in the internet world.
• External economic interests. Token holders may also be whales of another token, considering this interest when voting rather than the interest of bringing changes to the protocol. Liquidity mining projects in DeFi are particularly susceptible to this form of misalignment.

Profiting from these misaligned behaviors is well-documented and difficult to avoid. Prominent issues include pay-to-play bribery or voting with borrowed tokens, which has become easier due to the invention of flash loans and has already occurred in practice!

Other Side Effects

Even if participants do not explicitly turn the system into a puppet, governance can still produce unintended side effects. For example, formal governance systems may encourage action rather than inaction, even when inaction is the better solution. Governance can also consume significant time and energy.

Speed of Evolution

A common argument in defense of on-chain governance is that it allows protocols to evolve faster. However, there is almost no empirical evidence to suggest that on-chain governance accelerates protocol evolution.

However, on-chain governance is still in a very immature nascent state, so it may be too early to make overly strict judgments about it.

Past practices have actually shown the opposite: protocols without on-chain governance can achieve rapid evolution. For example, early Ethereum and Uniswap were protocols that evolved rapidly purely through hard forks. This agility can be attributed to their tight-knit communities, low systemic importance, and high trust in core development teams.

What has happened in the evolution of blockchain protocols since then? With the combined effects of network effects, pointer stickiness (protocols embedded in the code of other protocols/applications), and risk aversion, evolution may slow down. However, if the change is significant enough, users and applications can voluntarily choose to join. This often means hard forks of first-layer protocols (public chains) and voluntary migrations of second-layer protocols or applications, as seen in the transitions from protocol v1 to v2 in Uniswap, Maker, Compound, and Augur.

Ultimately, if a protocol is absolutely inferior to a new alternative, it will eventually be surpassed and die. This is how evolution works in nature. In the sense of genetic code, individual organisms do not evolve. Evolution occurs when copies are brought about by mutations. This approach has also worked in open-source (like Linux) ecosystems.

Since trustworthy neutrality is the main value proposition of a protocol, advancing toward minimized governance over time, even if it means a slower evolution rate at the individual protocol level, will still lead to maximum adoption rates.

Minimized Governance Can Achieve Faster Evolution for the Entire Ecosystem

Most importantly, reliable individual protocols support faster evolution for the entire ecosystem because developers can confidently use these building blocks. Imagine how quickly internet application development would be if every company's code were open-source, neutral, and available for anyone to use.

When is Governance Valuable?

Governance is needed when the core mechanisms of a protocol require human input parameters. When the response of the protocol to specific operations cannot be known in advance or derived from on-chain data, and thus cannot be encoded into the protocol, human input is required. We refer to these mechanisms as "essential governance".

Areas where governance is essential include:

• Protocol consensus itself (e.g., the first-layer consensus mechanism of Bitcoin or Ethereum). Consensus determines which of two histories is valid. This governance is strictly limited: Bitcoin miners can double spend and roll back history, but they cannot issue an infinite amount of Bitcoin.

• Oracles. Oracles require some form of human mechanism to determine whether their data is valid.

Areas that may require governance include:

• Wealth management. Governance may be needed in the foreseeable future: deciding how to allocate funds is a challenging problem to automate.

• Complex parameter settings: For example, Maker currently requires governance to approve new types of collateral and set corresponding collateral requirements. New collateral (some of which may not even exist today!) presents applicability issues, and its risk profile is difficult to assess in advance, making these functions inherently challenging to implement through coding.

Over time, certain governance can be eliminated. For instance, Maker could build a mechanism to programmatically set interest rates without governance to set the rates.

Governance is often a complex trade-off. For example, the Maker system chooses to allow many different types of collateral to improve capital efficiency. Of course, this also has a downside: the ability to handle new types of collateral requires governance, along with all the systemic risks, community energy, and complexity associated with that governance. A governance-minimized alternative to Maker could be built by using only one type of collateral; assessing whether this system is "better" is quite challenging.

Finally, in some cases, governance may be a feature. For example, people can change the rules of the game (governance), which may become a core mechanism for attracting users to certain games or social applications.

Minimized Governance Is Not a Panacea

While protocols with minimized governance are more reliable, they can still have adverse effects on certain stakeholder groups.

For example, the majority of participants in a minimized governance protocol can still choose to hard fork to benefit themselves at the expense of others. However, the cost is high: openly violating trustworthy neutrality can lead to potential future stakeholders losing trust, and the exit of stakeholders often reduces network effects and the use of the protocol. Of course, forks can also be a feature: two different stakeholder groups can utilize forks to each get the protocol they want.

Most importantly, removing governance in some areas does not mean governance can or will be eliminated everywhere. It may even lead to governance becoming more important in areas where it is less concentrated.

Crypto governance remains important, and the time for innovation is ripe

Well-functioning governance is still crucial, especially in areas of essential governance (such as first-layer consensus and oracles). If the essence of blockchain is to provide a ledger of truth that is widely accepted, then its integrity is paramount.

Innovation in on-chain governance systems remains an important area. Improvements may be made beyond the current naive "one token, one vote" standard (e.g., quadratic voting, decision markets, futarchy), and creating these is very important.

Seeing these experiments run, I remain excited and believe: we will see more innovations in governance systems brought by blockchain in the coming decades than in the "real world."

Value Capture

The degree of governance required for value capture is an experiment unfolding in real-time. Pointer stickiness, gas costs, user startup states (e.g., real-time bidding in decentralized exchanges, where users need to restart in new protocols), and other network effects can create defensiveness and enable minimized governance protocols to capture value.

Value Capture = Usage x Conversion Rate. The core argument of this article is that using protocols with minimized governance will achieve higher value capture (the left side of the equation). The conversion rate (the right side of the equation) remains a question without a definitive answer.

Compared to traditional enterprises, the number of uses of minimized governance protocols may be higher, but the conversion rate is lower. This is a relationship to be discovered economically.

Additionally, many people are eager to hear about "value capture" but consider it "evil"! Value capture can serve several important purposes. First, it incentivizes the creation of protocols. Second, if governance is needed, capturing governance value is necessary to incentivize contributions to governance and security (making the cost of a 51% attack on governance higher). Finally, it can help fund further development.

Ultimately, only "essential governance" is defensible. Anything non-essential may be outcompeted over time.

Conclusion

Protocols with minimized governance will see the broadest usage. This is a core attribute that opens a positive feedback loop between trust and adoption. It will also empower all creators with strong, fundamental tools, creating more opportunities and faster progress for the entire crypto ecosystem.

As crypto technology grows to become one of the most important technologies of the coming decades, minimized governance can bring greater opportunities and faster progress to society as a whole.

Thanks to Brian Armstrong, Vitalik Buterin, Gus Coldebella, Jacob Horne, Matt Huang, Georgios Konstantopoulos, Steve Lee, Charlie Noyes, James Prestwich, Dan Romero, and David Vorick; conversations with them greatly contributed to this article.

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