ESG Series - Governance Part 1: Bitcoin and Governance

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Learning Outcomes

In this piece, you will learn the following concepts regarding governance and its application to Bitcoin:

• What governance is
• What the drivers of good and bad governance are
• Bitcoin’s governance structure
• How Bitcoin’s governance structure differs from that of other non-Bitcoin crypto-assets, and
• Two case studies illustrating the effectiveness of Bitcoin’s governance structure

What is Governance?

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Oftentimes within the Environmental-Social-Governance (ESG) framework, Governance can take a back seat to the Environmental and Social elements because they are seen as having farther reaching or more relevant impacts. On the other hand, some of the biggest disasters in human history, such as the Chernobyl Nuclear Accident, can be purely attributed to failures in governance. In general terms, governance refers to the process of how decisions are made and implemented. Within the context of a certain business or government, by developing and maintaining a governance structure, the goal would be to help create a better organisation or government through improving factors such as flexibility and inclusion, company culture and the day-to-day sustainability of operations. A company or government’s governance structure can be optimised through pulling several levers, most notably the distribution of the rights of various members of the company, and optimising logistics and decision-making processes.

It is essential for a company to have strong governance practices since they lead to fewer instances of bribery, fraud and corruption occurring within the company. Without effective governance practices, companies and governments can become plagued by a lack of intellectual and cultural diversity at all levels, and fall prey to having poor compliance procedures, which can give rise to fraud, reputational damage and outright collapse.

What Constitutes Good Governance?

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From a business perspective, there are 9 key common characteristics commonly cited to be indicative of good governance practices. They are as follows:,

• 1 - Participation: constructing strong boards of people with a variety of skills, talents, abilities, experiences and perspectives.
• 2 - Consensus-oriented: developing a broad consensus that serves the best interests of organisations and the communities they operate in.
• 3 - Accountability: boards being accountable and responsible for decisions that affect individuals and societies alike.
• 4 - Transparency: no information being obscured from anyone, and everyone knowing what is happening.
• 5 - Responsive: being able to respond in a business-like timeframe.
• 6 - Equitable and inclusive: everyone having an equal opportunity to participate, and everyone’s opinions being heard equally.
• 7 - Strategic vision: everyone having direction and knowing what to do at a given time.
• 8 - Discipline: being committed to the governance procedures, and following its rules.
• 9 - Independence: having mechanisms in place to avoid any conflicts of interests occurring within the board or management team.

The World Bank cites 6 key indicators of governance in government:

• 1 - Voice and accountability: this measures the extent to which citizens can participate in government and society.
• 2 - Political stability and absence of violence/terrorism: this measures the perception of potential political instability and terrorism.
• 3 - Government effectiveness: this measures how well a government is perceived to be performing.
• 4 - Regulatory quality: this measures a government’s ability to develop unbiased regulations and policies.
• 5 - Rule of law: this measures how well the citizens within a society abide by the rules set out by their government.
• 6 - Control of corruption: this indicator measures the extent of corruption in a society.

In contrast, one need only look to the numerous failures of corrupt institutions and banana republics in history to see that they are near text-book opposites of the “good governance” checklists presented above.

The Governance of Bitcoin

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Bitcoin’s governance protocol is its Proof-of-Work (PoW) consensus mechanism. In general terms, PoW works by Bitcoin miners racing to solve a cryptographic puzzle, where the winner is rewarded with newly mined bitcoins and transaction fees. Bitcoin’s proof-of-work consensus mechanism ensures effective governance since it is impossible to cheat the Bitcoin blockchain system due to the cost involved in doing so, it ensures honesty due to Bitcoin’s inherent economic incentives, and it allows anyone to participate regardless of one’s race, gender or age. The PoW consensus mechanism itself was invented in 1993, but is most widely known for its use by Satoshi Nakamoto in 2009 to underpin Bitcoin.

Why Proof-of-Work?

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Due to their decentralised nature and peer-to-peer design, blockchains such as cryptocurrency networks require a method through which to achieve both consensus and security. Without a consensus mechanism, decentralised networks would neither be able to maintain consensus, as the actors on the network would all be incentivised to act in their own benefit and submit entries that benefit them, nor be secure, as the network would be susceptible to hostile takeovers.

As a consensus mechanism, PoW aims to secure the network by making it too resource-intensive to try to overtake the network. Other consensus mechanisms, such as proof-of-stake (PoS) and proof-of-burn, are less resource-intensive, but are subject to a greater chance of attack.

Why Not Other Consensus Mechanisms?

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As opposed to PoS, PoW is the best consensus mechanism and governance measure for Bitcoin.

A key weakness of PoS (as opposed to PoW) is its lack of resilience as a consensus mechanism in the face of Black Swan events, which are events that are extremely rare and difficult to predict. An example of a Black Swan event would be an asteroid directly hitting the Earth, which would knock a significant part of the network offline. When dealing with critical systems such as the consensus mechanism of a global, decentralised cryptocurrency, thinking about worst-case scenarios is imperative. The superiority of PoW over PoS when a Black Swan event occurs can be viewed through two scenarios.

The first scenario occurs when the entire Bitcoin network is forced to go offline for a certain period of time, and then reboots later. Currently, Bitcoin’s nodes, which use PoW, would self-organise and gravitate towards the blockchain that has the largest amount of accumulated PoW. Conversely, if Bitcoin used PoS instead, the nodes would not be able to identify which chain is the correct blockchain, since PoS has no metric to determine which chain is correct.

The second scenario occurs when private keys are stolen. With respect to PoW, this is essentially attaining control over the majority of the network hash rate, theoretically allowing the attacker the ability to double-spend coins, and re-write the history of the blockchain. However, to attain a majority of the network and therefore be able to double-spend, the attacker would have to spend a lot of money.

The amount of money that would have to be spent to gain the ability to double-spend bitcoin tokens can be illustrated through a practical example. The pieces of information that will be necessary to compute this figure include:

• The cost per terawatt-hour (TWh) of electricity
• The energy (TWh) needed to control the majority of the network hash rate
• The efficiency (kW/TH) of mining equipment used
• Energy to electricity conversion ratio

To compute the expenditure necessary to control the majority of the network hash rate, the following formula will be used:

Cost = Cost of electricity ($/TWh) x Total network hash rate (TH/s) x Mining efficiency (kW/TH) x Hours per year x Energy to electricity conversion ratio x Kilowatt to terawatt conversion factor (kWh/TWh)

From here, the most generous assumptions will be made to generate the absolute cheapest value for the cost of being able to double-spend in the bitcoin protocol. Currently, the cheapest source of electricity is onshore wind electricity, which costs USD $0.03/kWh, or USD $30,000,000/TWh. The total network hash rate as of 18 January 2023 is 295 EH/s, or 295,000,000 TH/s. Here, we will assume that only the most efficient mining equipment will be used, which has a mining efficiency of 0.02 kW/TH. In Monochrome’s E in ESG series, we computed that Bitcoin has a 53% energy to electricity conversion ratio.

Therefore, the cost of controlling the majority of the network hash rate is:

Cost = 30,000,000 ($/TWh) x 295,000,000 (TH/s) x 0.02 (kW/TH) x 24 (hours/day) x 365 (days/year) / 53% / 1,000,000,000 (TWh/kWh)

Cost = USD $2.93B

Therefore, the total cost of being able to double-spend in the bitcoin protocol is $2.93 billion at the very cheapest, which assumes that the most efficient mining equipment and energy were used, both of which are assumptions that can never hold true due to the limited supply of Bitcoin miners and onshore wind energy.

Furthermore, PoW would still function in the way it was designed, as only one chain would still be considered valid. Furthermore, rewriting the history of the blockchain would be even more unlikely, as one would have to use the same amount of energy used to catch up to and overtake the prevailing chain. On the other hand, gaining a majority stake of the network hash rate on a cryptocurrency underpinned by PoS would allow the attacker the privilege of double-spending, and therefore unlimited power.

Overall, assuming that there are two comparably-sized chains identical in every way except for that one runs PoW and the other PoS, the PoW chain would protect the past and future to a degree that far surpasses the PoS chain. PoW protects the past by forcing the attacker to use an improbably large amount of time and energy to rewrite the history of the blockchain, and protects the future through the presence of an objective and automatable metric that can be used to select the correct blockchain.

Bitcoin Governance Case Studies

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There are two notable case studies relating to Bitcoin’s governance that exemplify the efficiency and equity of Bitcoin’s governance processes; these being the introduction and activation of SegWit and Taproot within the Bitcoin protocol through Bitcoin user-activated soft forks (UASF).

A UASF involves the coordinated activation of Bitcoin soft forks by a majority of nodes, rather than miners alone. For a soft fork to occur, participating nodes must represent the “majority” - these are users, exchanges and businesses with significant influence over the Bitcoin economy.

The first example of a successful UASF occurred in 2017, which resulted in the modification of the transaction format of Bitcoin to “segregated witness”, or SegWit. SegWit was proposed since it helped address a transaction malleability bug within the transaction format of Bitcoin, and lower transaction costs by increasing how much transaction data could fit into each block.

Ultimately, it was the decision of the user community to decide whether to implement SegWit into Bitcoin’s protocol, as certain nodes committed to representing the views of the users. Since the majority of miners did not adopt the SegWit update immediately, many Bitcoin users installed a client that threatened to ignore any blocks that refused SegWit after a certain date. This persuaded miners to accept the SegWit update, which goes to show that Bitcoin’s users have the final say with regards to proposed updates. If a proposed change is not supported by a majority of users, then it will not be implemented.

Another example of a successful soft fork relates to the Taproot upgrade in 2021. The Taproot upgrade aimed to improve the privacy and efficiency of the network over a large scale, by allowing multiple signatures and transactions to be batched together. In this case, Bitcoin miners signalled support for Taproot, with a 90% consensus being reached on 12 June 2021.

These case studies exhibit how Bitcoin’s governance is akin to the laws of physics; they apply to everyone, regardless of one’s race, religion or gender. Bitcoin’s governance structure cannot discriminate since it is simply unable to, for it is not a human-backed structure and is instead an open-source code which anyone can verify.