Bitcoin poses a revolutionary challenge to conventional models of financial governance, says a University of Luxembourg researcher.
Financial market infrastructures—or ‘FMIs’, for short—are the most heavily regulated part of the traditional financial system.
FMIs include national payment systems, central securities depositories, securities settlement systems and central clearing counterparties.
“Safe and efficient FMIs contribute to maintaining and promoting financial stability and economic growth,” say the Bank for International Settlements (BIS) and the International Organization of Securities Commissions (IOSCO), which jointly published a 182-page report in 2012 outlining the principles governing these global infrastructures.
The reason for the heavy regulation of FMIs is that they concentrate risk, say the BIS and IOSCO.
“If not properly managed, FMIs can be sources of financial shocks, such as liquidity dislocations and credit losses, or a major channel through which these shocks are transmitted across domestic and international financial markets,” the regulators write in the report.
The conventional approach to the governance of financial infrastructures, embodied by the BIS/IOSCO principles, is to set top-down requirements for the oversight and governance of FMIs, the management of credit and liquidity risks, settlement procedures and default management.
Central clearing counterparties (CCPs), for example, have elaborate risk management procedures and back-up mechanisms, designed to ensure that the potential failure of a market participant does not put the CCP itself at risk.
According to Nabilou, the rules governing conventional FMIs don’t apply to bitcoin
But is it possible to have a market infrastructure that doesn’t play by these rules?
Yes, says Hossein Nabilou, a post-doctoral researcher at the University of Luxembourg and author of a new research paper entitled ‘Bitcoin governance as a decentralized financial market infrastructure’.
According to Nabilou, the rules governing conventional FMIs don’t apply to bitcoin because its central principle is to be immune to censorship.
“The application of the stringent governance standards (as applied to conventional organizations and FMIs) to bitcoin is misguided, not only because the application of the centralised governance models to decentralized models can be counterproductive, but also because for a censorship-resistant network to remain so, it needs to be regulation-resistant too,” Nabilou writes in the paper.
“The ultimate objective of bitcoin is to have an uncensorable payment, value storage and value transfer infrastructure. The governance of bitcoin should aim to preserve and enhance that value proposition,” he told New Money Review.
But the absence of a centralised governance body for bitcoin poses significant theoretical challenges, says Nabilou.
“The ‘code-as-law’ narrative is far from accurate”
In the paper, he highlights four past governance crises in the bitcoin network—the so-called integer overflow episode of 2010, an erroneous software upgrade in 2013, the 2017 ‘hard fork’ over bitcoin’s block size limit and the 2018 discovery of an inflation bug.
Although the bitcoin network has survived these crises, they have raised serious questions about how errors and conflicts are resolved amongst network participants, Nabilou says.
“Human intervention in bitcoin’s open or permissionless blockchain has proved that [its] governance is not immune to human discretion, and that the ‘code-as-law’ narrative, put forward by the early proponents of such innovations, is far from accurate,” Nabilou writes.
“These developments have put forward a serious governance question about who controls the changes to the bitcoin network and specifically to the protocol. The current literature on bitcoin governance is far from thorough in providing answers to such questions,” he says.
Nabilou argues that traditional models of organisational governance fall short when it comes to decentralised cryptocurrency networks.
For example, theories of the governance of companies rely on the assumption that a company’s shareholders are less well-informed than its managers. As a result, shareholders (the ultimate owners, or ‘principals’ of a corporation) select board members to monitor the managers (the agents).
However, in bitcoin, says Nabilou, there does not seem to be any meaningful separation between ownership and control, and hence there is no agency relationship.
According to Nabilou, the transparency of the bitcoin blockchain minimises the information asymmetry between various bitcoin stakeholders. As a result, he says, the possibilities for opportunistic behaviour by insiders are practically closed—the opposite to the principal/agent problems in a conventional limited liability corporation.
And while some critics of bitcoin governance have argued that fiduciary standards could be applied to core software developers—those who implement changes in bitcoin’s open-source code—Nabilou disagrees.
“Some of the market failures in the governance of the internet have been designed out with various innovations in bitcoin”
“The problem with fiduciary duties in bitcoin governance is that developers can only propose changes to the protocol, whereas the implementation of Bitcoin Improvement Proposals (BIP) requires a consensus to be reached by other participants, especially bitcoin users,” Nabilou says.
“It is not clear how such fiduciary duties are to be designed if the developers do not have the authority or power to implement and impose that implementation on other network participants. In this sense, the developers are said to be one of the least powerful of major bitcoin stakeholders,” he argues.
And while the challenges involved in bitcoin governance do resemble those affecting the internet as a whole, says Nabilou, the cryptocurrency has introduced some important improvements over the existing, private-sector-led, multi-stakeholder governance model for the internet, which is increasingly being challenged by national governments.
“Some of the market failures in the governance of the internet have been designed out with various innovations in bitcoin,” Nabilou says.
“Embedding the digitally scarce native asset [the bitcoin token] is one such innovation that motivates the stakeholders, including miners, users and developers to play an active role in securing the bitcoin network and contributing to the maintenance of the network,” he says.
“In addition, embedding the proof-of-work algorithm in the bitcoin network shields it against various attacks and spamming activities and indirectly encourages cooperative behaviour on the part of the participants in the ecosystem.”
Proof-of-work is the incentive scheme designed by Satoshi Nakamoto, bitcoin’s inventor, to keep computers around the world involved in processing the network’s transactions.
“The users of bitcoin are in charge”
In fact it’s the main design aim of bitcoin—providing a censorship-resistant store of value—that brings users, investors, miners and other actors in the ecosystem together, says Nabilou.
He reaches the conclusion that the governance of the bitcoin network is the polar opposite of that of conventional FMIs. Instead of being imposed from above, as in the standard FMI model, bitcoin’s governance is diffuse and ‘downwardly accountable’, Nabilou writes.
“The users of bitcoin are in charge,” he says.
“Not the miners and not the developers, even though they have their say in bitcoin governance. Ultimately, those who implement bitcoin—those downloading and using the software—are the ones making the difference.”
Keep up with New Money Review content: sign up here for our newsletter
Click here for a full list of episodes of the New Money Review podcast: the future of money in 30 minutes
