Economics Working Paper Series

Working Paper No. 1608

Blockchain: the birth of decentralized governance

Benito Arruñada and Luis Garicano

April 2018

Blockchain: The Birth of Decentralized Governance

BenitoArruñada*andLuisGaricano**

April10,2018***

Abstract

Byallowingnetworkstosplit,decentralizedblockchainplatformsprotectmembersagainstholdup,buthindercoordination,giventhatadaptationdecisionsareultimatelydecentralized.Thecurrentsolutionstoimprovecoordination,basedon“premining”cryptocoins,taxingmembersandincentivizingdevelopers,areinsufficient.Forblockchaintofulfillitspromiseandoutcompetecentralizedfirms,itneedstodevelopnewformsof“soft”decentralizedgovernance(anarchic,aristocratic,democratic,andautocratic)thatallownetworkstoavoidbadequilibria.

Keywords:blockchain,platforms,networks,hold‐up,coordination,relationalcapital,incompletecontracts,decentralizedgovernance.

JELcodes:D23,L12,L22,L86.

*PompeuFabraUniversityandBarcelonaGSE.E‐mail:benito.arrunada@upf.edu.**IEBusinessSchool,LondonSchoolofEconomicsandCEPR.E‐mail:luis.garicano@gmail.com.***WethankEricBrousseau,MiguelEspinosa,andSpyrosTerovitisforvaluablecomments;JinLee,LuisRayoandparticipantsattheWorkshoponEconomicGovernanceofData‐drivenMarketsheldatTILEC(TilburgUniversity),theBlockchain,Law&PolicyWorkshopheldattheUniversityofAmsterdam,andseminarsatCUNEF(Madrid),theJRCoftheEuropeanCommission(Seville)andtheDepartmentofEconomics(UniversityofVigo)forusefuldiscussions;andtheresearchassistantshipofJuanBarenys.ThisworkreceivedsupportfromtheSpanishGovernmentthroughgrantECO2017‐85763‐R.

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1. Introduction

Thecontractualtechnologyonwhichthemarketeconomyisbasedhasevolvedoveraperiodoftwothousandyears.Blockchainpromisestooverhaulit,byallowingforthecreationofopen,distributed,secure,encryptedandprogrammabledigitalledgersandenablingsecureandfullydecentralized“P2P”trade.

Fulfillingthispromiserequiresdecentralizedblockchainplatformstoprovideoperatingstandards,acentralreputationforthewholeecosystem,andacommunicationprotocolthatallowsapplications(“Apps”)tocommunicatewitheachother.Butthesuccessofsuchdecentralizedplatformshingescruciallyonfindinggoodgovernancesolutionstoaligntheincentivesofallparticipants.

Specifically,allplatforms,centralizedornot,mustsolvetwoclassesofproblems:protectingtheinvestmentofplatformparticipantsfromhold‐upandcoordinatingadaptationandchange.Inthispaperwediscusshowdecentralized,blockchain‐based,platformssolvethesetwoproblemscomparedtotraditionalcentralizedones,andevaluatethegovernancesolutionscurrentlybeingproposedbydifferentplatforms.

Holdupproblemsareparticularlyprevalentincentralizedplatforms.Onceparticipantshavecommittedtotheplatform,switchingiscostly.Thisallowsthe“networkarchitect”(e.g.,AppleiniOSApps)toholdupapplicationdevelopers,forinstance,byimplementingchangesthatmaketheirpreviousinvestmentsobsolete.Theriskofbeingheldupleadsparticipantstounderinvest.Whenthenetworkarchitecthasasufficientlylonghorizon(again,likeAppleiniPhoneAppsorGoogleinAndroid),ithasanincentivetodevelopareputationforprotectingtheinvestmentsofitsapplicationdevelopers(andnotholdingthemup)thatenforcestherelationalcontract.Decentralizedplatformssuchasblockchaindrasticallyreducethepotentialforholdup,sincenetworkmemberscanalwaysrefusetointroduceanychange.Thisreduction,however,comesatthecostofincreasingcoordinationproblems.

Inbothtypesofplatforms,coordinationproblemsresultfromthefactthatplatformsmustensurethatcoresoftwareandapplicationdevelopershavetherightincentivestocooperateandadapttogethertoevolvingneeds.Incentralizedplatforms,thedecisiontochangeismadebythearchitect,whoignorestheprivatecostsofthedevelopersand,asaresult,tendstointroducetoomuchchange.Inadecentralizedplatformtheoppositehappens:individualapplicationdevelopers(andotherplatformmembers)havesomevetopowerthroughtheirfreedomtoupdate.Theymustthereforeagreetoanychange.Thisposesaproblemforchangesthatarenotwin‐win,thatis,anychangewhichisgoodforthewholenetworkbutcauseslossestosomeplayers.Decentralizedplatformswillfindthistypeofchangehardtoimplement.

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1.1. The roadmap

InSection2westudythekeycontractingdifficultiesincentralizedplatformsandtheirrelationalsolutions.Thenetworkarchitectcanunilaterallymaketheadaptationdecisionsoftheplatform.Itmayrequireexcessiveinvestmentsfrompartnersandtoofrequentadaptation,sinceitdoesnotfullyinternalizethecostsofsuchdecisions.However,anetworkarchitectwithsufficientrelationalcapitalcanuseittosafeguardagovernancestructurethatprotectsparticipantsintheplatformagainstitsownholdupandthusprovidethemwithadequateincentivestoinvest.Toilluminatetheseproblems,webrieflydescribethegovernanceoftheAppleandGoogleplatformsandtheirabilitytoprotectdevelopersfromholdupandadequatelyrespondtochange.

InSection3weconsiderblockchain‐basedplatforms.Inadecentralizedsetting,eachmemberofthenetwork(individualdevelopers,finalusersandotherpartners,suchasblockchainminers)canrefusetochange,whichprotectsherfromholdup.However,incentivestoadaptinacoordinatedmannerarelimited.Theremayexistmultipleequilibria,asinthetraditionalnetworkexternalityliterature(e.g.,KatzandShapiro,1985,1986;FarrellandSaloner,1985).Absentexplicitmonetaryincentivesorothergovernancesolutions,thesystemislikelytoyieldtoolittleadaptationorgenerateinefficient“splits”(whereonlypartofthenetworkadoptsaparticularprotocolchange).However,unlikeinstandards“wars”,wheretwostandardsbattleinawinner‐take‐allconfrontation,platformscanimplementgovernancerulestohandlethetrade‐offbetweenhold‐upandcoordinationasefficientlyaspossible.

Forinstance,considerthetwomaindecentralizedplatforms:theonesdevelopedontopofBitcoinandEthereum.WhileBitcoinisadigitalcurrencythatcanbeusedforstructuringsimplepredefinedtransactions,suchasescrowaccountsordocumentsigning,Ethereumwascreatedwiththeaimofmakingevenmorecomplextransactionseasier.Inparticular,itsprogramminglanguage(Solidity)supportscomplexlogicalfunctionslikeconditions,recursions,loops,go‐tos,macros,etc.CodifiedEthereum’stransactionscanbecalledrepeatedly,tosendandreceivefunds,toactasnewcurrencies,aswellastointeractwithothercontracts.Thesefeaturesmakeitsuitableforcoding“smartcontracts”—thosewhichareenforcedautomaticallybycomputercode.

Thegovernanceofbothplatformsisalsoverydifferent.Bitcoinisanextremelydecentralizedplatformwithverylittlegovernance.Ethereumisaconsiderablymorecentralizedplatformwheresomeadditionalgovernanceaimstoachievesomecoordinatedadaptation.

Itispreciselythesameabilitytoadoptchangesindividually—eventosplitfromthemainnetwork—thatprotectsAppdevelopersandothersfromexpropriationwhatmayleadtolargescalecoordinationfailures.Ineachofthesedecentralizedplatformswestudyhowtheyhandledasituationwheretheimplementationofachangeledtoalargecoordinationfailureandasplitinthenetwork,inconnectionwithwhatiscalledintheblockchaincommunitya“hardfork”.Weevaluate,ineachcase,thegovernancesolutionsthatarebeingcurrentlyproposedbythedifferentplatforms,examinetheirweaknesses,andproposesomefurthersolutions.

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Whileblockchaingovernanceinvolvessignificantshortcomings,westudysomeofthenewtoolsallowedbyblockchainthatmaybeusedtosolveincentiveconflicts.

First,platformdesignerscanrelyonthecomplementaritybetweencryptocurrencyandplatforms.Specifically,“pre‐mining”andotherwaysofallocatingcryptotokensandcryptocoinstodevelopersand,particularly,coredevelopers,mayalleviatecoordinationproblems.Wearguethatthisisonlyoflimitedvalue,andonlyearlyinthelifeoftheplatform.Theimpossibilityofimposing“vestingperiods”andotherrestrictionssubstantiallyweakensthistool.

Second,somenetworksareimplementingsolutionsdesignedtofacilitatecoordinationaroundthebestequilibrium.Weclassifytheseemergingsolutionsasanarchic,aristocratic,autocraticanddemocratic,byanalogytopolitical“hard”governanceintherealworld.Althoughthesesolutions“feel”likegovernance,ultimatelynetworkmembersalwayshavetheabilitytoimplementornotthesechanges,andthustheyarebetterunderstoodasdevicestofacilitatetheconvergenceofexpectationsthanasrealgovernancedevices.Henceouruseoftheterm“softgovernance”.

InSection4wecomparetherelationalcapitalneededbyoptimally‐governedcentralizedanddecentralizedplatforms.Weshowthatcentralizedplatformsrequirelessrelationalcapitalwhennetworkmembersarehighlyheterogeneous,whiledecentralizedonesarepreferredwheninvestmentsarehardtoverify.Thisresultspointthewaytotheinstancesinwhichweexpectoneortheothersolutiontoprevail.

Themainprecedentforourapproach,usingtheeconomicsofcontractsandorganizationtostudytheseplatformsisBresnahanandGreenstein(2014),whodiscussinformallymobilecomputingplatforms,andsuggestthatthekeytradeoffisthat,whileahierarchical,orcentralizedplatformissuperiorintermsofcoordinatingaresponsetochange,adecentralizedoneissuperiorforexplorationofnewproductsandideas.Ourdiscussionisdistinctinthatwefocusonadifferenttradeoff,betweeninvestment(holdup)andcoordination;weanalyzetheproblemintermsofrelationalcontracting;weproposeaformalmodelthatwebelievecapturesthistradeoffinthesimplestpossibleway;andfinallyourcasestudydiscussionhastodowiththeblockchainplatforms,notdiscussedintheirpaper.

Thereisalsoaburgeoningliteratureonbitcoinandblockchain.Böhmeetal.(2015)focusontheeconomicsofbitcoin.Theynotetwokeycosts:oneisthetechnologicalwaste,andthesecondisthecostassociatedwiththemarketconcentrationofintermediaries,notablyofminers.CataliniandGans(2016)studyblockchaineconomicsandarguethatitsmainbenefitsarethereductioninthesecostofverificationand(withtheadditionofbitcoin)ofthecostofnetworking.Atheyetal.(2017)discusstheprivacyparadox,wherebycryptocurrenciesofferpeoplethechancetoescapegovernmentsurveillance,butdosobymakingtransactionsthemselvespublicona“blockchain”.Theeffectofsmallincentivesmayexplaintheprivacyparadox,wherepeoplesaytheycareaboutprivacybutarewillingtorelinquishprivatedataquiteeasily.Biaisetal.(2018)undertakeafull,detailedtheoreticaldynamicanalysisoftheequilibriainablockchain.Ourworkisdistinctfromtheaboveinouremphasisonhowemerginggovernancesolutionsdealwithexistingproblems

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andpointingthewaytofuturegovernance,andincomparingtherobustnesstoincentiveconflictsofcentralizedanddecentralizednetworks.

Ourworkbuildsontworecentstreamsofliteratureinorganizationaleconomicsoncoordinationandadaptation(e.g.Desseinetal.2010)andonrelationalcontracts(Levin,2003).Wealsorelyonthelawandeconomicsliteratureonagencylawandthebirthofthecorporation(e.g.,HansmannandKraakman2000,Harris2000,Arruñada2010)tohighlightthatcomparisonsofcurrentblockchaingovernanceagainstcentralizedgovernanceisunfairtoblockchain:centralizedgovernanceappliesready‐madesolutionsprovidedbyacenturies‐oldevolutionofinstitutionalandorganizationalsolutions,whileblockchainisjuststartingasimilarprocessofevolutionarydiscovery.

ReadersfamiliarwiththesetopicsmaybeadvisedtojumpnowtoSection2,skippingtherestofthisIntroduction(Section1.2),inwhichwedescribeblockchaintechnology,itsmainplatforms(BitcoinandEthereum),itsapplicationtosmartcontracts,andoneofitskeyproblems—splitscausedbyhardforks.

1.2. Blockchain platforms: a primer

Weconceivea“platform”asthecombinationofsoftwareandhardwareresourcesenablingthefunctioningofanexchangenetwork.Inturn,a“network”isthecommunityofindividuals(includingcomputernodes)exchanginggoodsorservicesthroughagivenplatform.

Blockchainisatypeof(distributedledger)technologyinwhichrelatedtransactionsarebundledtogetherintoblocks.Theseblocksaremadepublictoallthenetworkafterbeinglinkedtooneanotherusing“hashes”whichtakeaninputstringofanylengthandconvertitintoafixed‐lengthstring.

Forourpurposes,thekeyeconomiccontributionofblockchaintechnologyisthatitallowsperson‐to‐person(P2P)transactionstotakeplacesafely.Itthereforeholdsthepotentialtodecentralizeanddisintermediateallsortsofmarketsandactivities.

Thisismostvisibleinthefirstapplicationofblockchain:thecreationofdecentralizedcurrencywithoutanyintermediary.

Foracurrencytobeastoreofvalueandmediumofexchange,itmustfulfillthreeconditions:(1)itmustbeeasytoverifyitsvalidityorauthenticity;(2)itmustbeimpossibletospendittwice;and(3)itmustberobusttoopportunisticmintingbyitscreatororitsowner.

Uptoblockchain,thesolutiontotheseproblemswastocentralizetheissuanceofcurrencyinatrustedintermediary—normallythestate.Bitcoinandallothercryptocoinsbasedonblockchainprovideadecentralizedalternative.Insteadofrelyingonanintermediary,theyrelyonapeer‐to‐peernetwork,inwhicheachnodereplicatesandencryptstheparticulartransaction,aswellasthefullhistoryofprevioustransactionsandsetsthemona“chain”linkedinapermanentandimmutableway,whichitthenmakespublic.Moreover,

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validationofatransactionrequiresconsensus:anytransactionwithmore(implicit)acceptancesbecomesthe“official”nextblockinthechain.

Inaddition,playershaveexplicitmonetaryincentivestochoosethetransactionthatwillengendermoreconsensus,animplicit“truthtelling”device:forthemtobenefitfromaddingablocktothechain,subsequentblocksmustbebuiltontopoftheirblock.

Inparticular,theinitialkeyplayersinthebitcoinblockchain“community”were:

(1) CoreDevelopers:Engineerswholaunchedtheinitiativeandthenoftenretainprivilegestomaintainandsuggestchangestothecoreprotocol.

(2) Miners:Ownersofcomputernodeswhodothecalculationstovalidatetransactionsinexchangeforablockreward(initiallyonly)and(later,increasingly)transactionfees.1Miningequipmentcaneasilyswitchtomineondifferentblockchains,makingminersunlikelycandidatesforholdup.

(3) Investors:Fundersofblockchainventureswhodirectlyfunddevelopmentand,initiallymainly,miningequipment.

(4) Users:Purchasersofthecryptocurrencytopayfortransactions,tostorevalueorforspeculation.

The emergence of “decentralized Apps” on Bitcoin and Altcoins

BitcoinwascreatedasacurrencybuthasunintendedlybecomeaplatformforblockchainApps:onceitenabledsecurepaymentsbetweenstrangers,thisremovedakeyobstacletothedevelopmentofP2Ptradeandencourageddevelopingtechniquesthat,buildingontopofthebitcoin’sblockchain,executesimple,“smart”,contractswithlowtransactionscosts.

Thesesmartcontractsapplyblockchaintechnologytoallowfortherecordingandverificationoftransactionsoveralltypesofassets.Beingbuiltdirectlyintoablockchain,theyareenforcedautomaticallywithoutintermediaries,thereforeapplyingthe“codeislaw”principledefinedbyLessig(1999).Essentially,claimsontheasset,likeabitcoin,circulatethroughthepeer‐to‐peernetworkthroughanencryptedchainofblocksinwhichthefullhistoryoftransactionsisrecordedandpreserved.

Smartcontractsarethebasicunitsofmorecomplexdecentralizedapplications(inblockchainjargon,“DApps”),which,insteadofrunningonacentralserver,asusualApps,relyonadecentralizedcomputernetworktoprovidesomespecificvaluableservice(forexample,asystemforsharingapartmentsorrentingcars).

1Minersaddblocksoftransactionstothechainintheformofthepublicdistributedledgeroftransactions,the“blockchain”.Toaddablock,theymustfirstcompilethepasttransactionsandthensolveahardmathematicalpuzzle.Thefirstminertosolvethepuzzleaddstheblockandisrewardedwithsomecryptocurrency,suchasbitcoin,oncetheproofofworkisverifiedbyothernodes.

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ThisproliferationofDAppsendedupcreating“overlay”networks(Monegro2014)builtupontopofBitcoin’sblockchain,usingittoprovideincentives,time‐stamptransactionsandvalidation,andbenefittingfromitsliquidity,reliabilityandnetworkeffects.Inthisway,Bitcoineasedtheentryofamyriadofapplicationsthatdidnotevenneedtobootstraptheirowncryptocurrencyand/orstartanewblockchain.

Suchad‐hocdevelopmentofDAppswas,however,plaguedwithcompatibilityproblemssimilartothosesufferedbyconventionalInternetnetworks(Kasireddy2017).EachDAppbuiltonthebitcoinchainstandsalone,andinordertocommunicatewithothersitmustadapttotheproprietarystandardssetbyotherapplicationsintheir“applicationprogramminginterfaces”orAPIs,thesoftwarethatsetsspecificmethodsofcommunicationbetweendifferentsoftwareelements.

The emergence of Ethereum and other blockchain platforms

TheseshortcomingsofBitcoin‐basedDAppsledtothedevelopmentofblockchainplatformssuchasEthereum,whichisnowthesecondmostimportantnetwork,wellaboveallothers.ItspurposeistofacilitatethedevelopmentofDAppsandtointegratetheninamuchmoreconsistentecosystemthanthosebasedonBitcoin(Narayananetal.,2016:263–70).

Specifically,blockchainplatformscreatevaluebysettingupstandardsandotherinputsessentialforDApps’developmentandoperation.Thisinvolvesbothoperatingstandards,includingmoney(“ether”inEthereum);acentralreputationforthewholeecosystem,whichispartlysharedacrossmanyDApps;and,mostimportantly,directnetworkeffectsthoughacommunicationprotocolthatallowsvaluetobecreatedbyconnectingapplications.

Inparticular,Ethereumdefinesitselfasacomputerplatformrunningallsortsofsmartcontracts.AllEthereum’sDAppsarerunonthesamevirtualmachine,usethesamelanguageandthesame“primitives”(e.g.,smartcontracts,accounts,addresses,etc.),relyonthesameblockchain,validatetheirtransactionsinthesameway,paythesameusefees,etc.

ComparedtoasituationinwhicheachDAppwouldstartindependentlyfromzero,blockchainplatformslowerentrybarriersbysharingfixedcosts,whichareincurredbythecore.However,thisalsomeansthatthisinvestmentinthecoremustbefundedandDAppdevelopersbecomemoredependentwithrespecttothecore,totheextentthatitiscostlyorevenimpossibletoswitchplatforms.Inparticular,thecore(potentiallyalso,someinfrastructureapps)mayholduptheapplicationdeveloperandappropriatethevalueoftheirinvestment.SuchaccumulationofmarketpowerbythedevelopmentcorecouldreducetheincentivestoinvestinDApps’developmentandintheirquality.

Moreover,thefactthatmultipleindependentDAppsshareacommoncoremeansthatdifficultiesmayarisewhenchangesinthiscoreneedtobeintroduced.

Thusincentivesmustbestructuredexantetocontainbothconflictswithagovernancestructure,providingboththecoreandDApps’developersadequateincentivestoinvestandadoptchangesefficiently.

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Coordinating change in blockchain: “hard forks” and splits

Suchgovernancestructuremustconsidertwosetsofconstraints,onepresentinalltypesofplatforms.Anotherspecifictothosebasedonblockchain.

Thegeneralconstraintisthefamiliarissuethatsolvingthecontractingproblemexanteiswell‐nighimpossiblemainlybecauseintenseuncertaintyandthesequentialarrivalofapplicationsmeanthatcontingenciescannotbeanticipatedandproperincentivescannotbedesignedexante.Thecontractmustthereforeberelational,asplatformsandapplicationswillbedistributingtheirgainsexpost.

Thespecificconstraintofblockchaingovernanceisduetothefactthatthedecisiontochangetherules—whatiscalleda“fork”—isintrinsicallydecentralized.Itcanbeinitiatedbyanyonewhoproposesanupgradeintheprotocolbutitfullysucceedsonlyifthewholenetworkadoptstheupgrade.

Therearetwotypesofforks.Ahardforkisanychangeinprotocolthatinvolvesforwardincompatibilitieswiththepreviousprotocol,sothattransactionthatareacceptedbythenewprotocolareinvalidintheoldoneandwillnotbeacceptedbynon‐upgradednodes.Conversely,asoftforkrestrictsthevalidationrule,sothatanytransactionthatisvalidinthenewprotocolwouldstillbevalidintheoldone.

Hardforksmaypursuedifferentobjectives,fromeliminatingsecurityhazardsinthecodetoimplementingnewfunctionsorevenreversingtransactions.Thelatterarethemostinterestingfromacontracttheoryperspective:blockchainenthusiastsseethemasanathema,astheydenytheimmutabilityprinciple.However,aswewillsee,byprovidingameansforefficientcontractbreachinextremecircumstances,theymayservetoefficientlycompletesmartcontractsthat—atleastbynow—remainnecessarilyincomplete.

Witheveryhardfork,thereisariskofasplitintwohalves,withtheownerofeachcurrencyunit,or“coin”,receivingtwonewcoins.Bothcurrenciesthenstartfunctioningasseparateentities,withtheirowndifferentsetsofrules(see,e.g.,Narayananelal.,2016:171–72).

Beforethewell‐publicizedsplitsfollowinghardforksthattookplaceinEthereumandBitcoinblockchainsin2016and2017,respectively,afewprecedentshadhappenedinwhatthenweresmallblockchains.2ThisincludedBitcoinitself,whichforkedin2010aftersomeonemintedbillionsofbitcoins.However,giventhatthenetworkwasstillsmall,itwaseasilyhandledwithoutmuchdifficulty.In2014,theMintPalexchangesufferedahackthatledtotwomillionUSDinVeriCointokensbeingstolen.Subsequently,developersreclaimedthefundsbywhatissaidtobethefirsthardfork.Alsoin2014,afterNxthadsuffereda1.75millionUSDtheft,developersalsoproposedahardfork,butitwasrejected.Mostofthefundswererecoveredthroughnegotiationsbutonlyafterpayingransomtothehacker.Ithasbeenallegedthatthedifferentoutcomeswerealignedwiththedifferentcausesofthehackingand,consequently,themeritsofthecases.

2Arruñada(2018)providesfurtheranalysisandsourcesonthesehardforks.

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Thepossibilityofsplitsindecentralizedplatformsdrasticallychangestheincentiveswithrespecttothosepresentintraditional,centralizedones(suchasApple’siTunesorGoogle’sPlayStore).Incentralizedplatforms,thearchitectunilaterallycanmakedesigndecisionsand“complete”thecontractswhenevercontingenciesariseforwhichnospecificactionwasforeseeninthecontract.Forinstance,Appleoftenaddsnewfeaturesorsoftwareupdatesthatinstantlyrenderspreviousinvestmentobsolete.3Thismayleadtoanincentiveconflictintheformofholdup,astheplatformarchitectmayignorethecostsincurredbyothers.

Inblockchain,theplatformarchitectmayplayalimitedrole,asinEthereum,ormayevenplaypracticallynorole(inBitcointhereis,infact,noarchitectassuch).Changesrequiretheindependentactionsofawiderangeofplayersandthusalargelevelofdecentralizationisinevitable:thenatureofthenetworkisthatallnodescanunilaterallydeterminewhichprotocoltheyrun,andwhethertheyupdateitornotistheirdecision.Thelargercosthereisthuscoordinatingchangesandavoidingbothdamagingnetworksplitsandinefficientdelaysasfeaturesthatarewelfareimprovingarenotadopted.

Thechallengeforblockchainnetworksliesindevelopingefficientmechanismsproducinganecessarily“soft”formofgovernancethattakesasgiventheultimatelydecentralizeddecision‐making(viapotentialsplits);but,bypromotingthegood“equilibria”,ensuresefficientnodes’coordinationwhenadaptingtonewcircumstances.

2. Coordination and hold up in centralized networks

Weconsiderthroughoutanetworkwithmanynodesthatmustadapttochange.Itconfrontstwoproblems(1)changehasasymmetricbenefits,forinstance,someusersbenefitfromitwhileothersdonot.(2)Thecostsofchangearepartlyprivate.

2.1. Spot contracting in a centralized network leads to hold-up by the architect of the nodes investments

Tofixideas,consideranetworkwithagivensetofnodes,eachofwhichenjoysanoperationalbenefitb(n)fromoperating,dependingonthesizeofthenetworkn.Thenetworkhasacentralplayer,suchasforinstanceAppleinthemobilephoneapplication

3Appleisquiteclearaboutitwhenitsaysthat“theproposedchangesaremassivelysource‐breakingforSwiftcode,andwillrequireamigratortotranslateSwift2codeintoSwift3code.”https://www.infoworld.com/article/3120171/open‐source‐tools/apple‐swift‐3‐forward‐looking‐but‐not‐backward‐compatible.html

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platform,orPayPalinpayments.Weshallcallthisplayerthe“networkarchitect.”4Theplayercontrolsanddeterminestheadoptionprotocol—bypushingabottomsheinstallsthenewprotocolonallnetworknodes.

Thenetworkarchitectappropriatesallnetworkvaluenetofthecompensationwtotheindividualnodes.Thusherprofitabilityisgivenby:

(1)

whereb’ n 0, 1 0.Whenallpossiblenodesjointthenetwork,itssizeisN.

Foreachnodetowillinglyparticipate,hisutilitymustbelargerthantheoutsideutility,whichwenormalizeto0,plusthesunkcostofdevelopingtheapplicationspecifictotheplatform,C.Thusthenetworkarchitectmustofferongoingvaluetothedeveloperatleastequaltothecostofparticipation‐givencompetition,w=C.Theutilityattainedbythedeveloperis

U 0 (2)

Supposealsothat,forthesakeofadaptation,thearchitectisgiventherighttomakechangesbycompensatingthemfortheverifiablecosts.Imaginenowthatanunforeseenopportunity(anunforeseencontingencyinthesenseofKreps,1990)forchangeoradaptationappearsafterthedevelopmentcosthasbeenincurred.Thisopportunityrequiresupdatingthenetworkprotocol.However,notallbenefitequallyfromit:a(random)subsetof nodesobtainabenefitfromthechangeof pernodeifitisimplemented,whereastherestofthenodes,thelosers,getabenefitΔ .Anynodewhoimplementsthechangeincursaprivatecost ∈ .However,onlyashare ofthesecostscanbeverifiedincourt.Weassumelargenetworkexternalities—b(N)islarge,

≫ , ≫ .

Firstbestimplementationrule:Atanyperiodt,itisefficientforthenewprotocoltobeadoptedif:

(1)Thevalueofthechangeislargerthanitscost:

α Δ α Δ (3)

Where istheshareofwinners, / and theshareoflosers / .

(2)Asplitofthenetwork,whereonlywinnersimplement,isinefficient:

4Wearesimplifying:eveninacentralizednetworktheremaybemorethanonearchitect,likeinthe“Wintel”casewheretwoarchitectsmustcoordinateupgradeswithoneanother(seeCasadesusandYoffie,2007).

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orequivalently:

(4)

Theexpressionisstraightforward:thelosersmustadoptthechangeoptimallyifthegaintothem, ,plusthegainfromaunifiednetworkislargerthantheiradoptioncosts.

Weassumefornowthatthenetworkeffectsaresufficientlyhighthatitisnotefficienttosplitthenetwork.

Assumption1.Splitsareinefficient.Networkeconomiesaresufficientlyhighthatitisnotefficienttosplitthenetwork—i.e., .

Inacentralizednetwork,thearchitecthasfullbargainingpowerandwillthereforeadjustthecompensationofthenodes(e.g.,Appdevelopers)toextracttheadditionalprofitability.Moreover,giventhatsomeofthecostsoftransitioningtoanewprotocolareunverifiabletheymaybeexpropriatedbythearchitect.Thecompensationofthedevelopersafterallofthemincurthecostktoimplementthenewprotocol(notethatinthisone‐periodworld

)willbe:

w w 1 1 (5)

Resultinginex‐postutilityforthedeveloper

U 1 1 0 (6)

However,thesunkcostofdevelopmentisincurredalready.Thusthenode(anappdeveloper)implementstheprotocolchange(ratherthanshuttingdownthenode)aslongastotalexpostcompensationispositive,thatis

1 0

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Theargumentisstandard(Williamson,1975;GrossmanandHart,1986):aslongasthesunkcostandconsequentquasi‐rentsaresignificantenough,holdupresultsandtheinvestmentispartiallyexpropriatedbythenetworkarchitect.Thenodewouldhavebeenbetteroffifshehadnotinvestedindevelopment.Thefearbythedeveloperthatshemaybeexpropriatedbythenetworkarchitectmayleadhertoignoreanypromiseshemaymakeandnotinvestindevelopingapps.

Result1[Holdup].Nodesinacentralizednetworkwillaccepttoundertakechangesthatwouldhavehadanexantenegativevalue.Thisholdupriskwillleadtounderinvestmentbyapplicationdevelopers.

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Considernowthedecisionbythenetworkarchitecttointroducetheupgrade.Let =1iftheprotocolchangeismade.Herprofitsare

Π (7)

Wherethearchitectappropriatesalloftheprofitfromthechangepluspartoftheagentsquasirents(thenon‐verifiableshareofcost).Thearchitect’sobjectiveistomaximizethevalueofthenetwork,netofcompensationtonodes.Becauseonlyashareγofthecostsisverifiable,heignorestherest(1‐γ ofthecost.Asaresult,thearchitectimposeschangesevenwhentheyleadtolargelosestothenodes:

∶Imposeprotocolchangeif: Δ Δ kDonotimposechangeif: Δ Δ

Result2[Acentralizednetworkimposestoomuchinvestmentandimplementstoomanychanges].Sinceacentralarchitectignorestheunobservablecostsofnodesthatarecommittedtothenetwork,acentralizednetworkimplementstoomanychanges.

Figure1:Theinefficiencyofcentralization:inefficientchangeisimposedbyarchitect

Nochangeisefficient,andchosenbycenter

Δ Δ k

k

ΔΔ

Δ Δk

Inefficiency:Excessivechange

Δ Δ

Efficientinvestmentinchange

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Figure1illustratesthisinefficiency.Inacentralizednetworkthearchitectchoosestoimposechangesaslongasthebenefitislargerthanafractionofthecost,whichleadstoexcessiveinefficiency.Thisinefficiencyisduetotheswitchingcostsincurredbythenodestogetherwiththesunkinvestmentstheyhavemade,specifictothisparticularnetwork.Aslongassunkcostsspecifictothesystemarelargeenough,(C> 1 ,theywillimplementthechange.Thismayleadtowelfarereducingchanges.

Examples.Traditionalwebandmobileplatformsarecentralized,asweexplainedintheintroduction.Although(forreasonsthatwillbecomeclearmomentarily)thesearetheexceptions,thepopularpresscontainsaccountsofexpropriationoftheinvestmentsmadebydevelopers.Forinstance,Appleoftenaddsnewfeaturesorsoftwareupdatesthat,beingbackwardsincompatible,mayrenderdevelopers’previousinvestmentsobsolete:“Swift3isagreatopportunitytostartfreshwiththelanguage,butifyouhaveexistingSwiftcodebases,bepreparedtorewrite—ordump—them”(Yegulalp2016).SomethingsimilarhappenswhenAppleupdatestheoperatingsystemofitsiPhones,inordertoenhancetheirfunctionalityandensuretheirsecurity,whichoftenmakesoldappsobsoleteandrequiresupdatingtheircode.Andupdatesdonotonlycoversoftwarebutalsoapps’marketingstandards:forinstance,thepromotionaltextsandkeywordsoftheapps.

Ontheotherhand,theoverallsuccess,includingmillionsofAppdeveloperswillingtoinvestinthesenetworks,suggeststhistypeofopportunisticbehaviorislessprevalentthanashorttermanalysissuggests.Thereason,ofcourse,isthatthefuturemattersalot,andallowsforareputationtodevelopthatprotectsspecificinvestments.

2.2. The solution to hold up in centralized network: Relational capital as a base for relational contracts

Thenetworkarchitecthasalotatstake.IfsheexpropriatestheAppdevelopers,theymaynotinvest,andthenetworkwillnottakeoff.Thelossofsuchfuturesurplusmayallowthenetworktoexistinthepresenceoftemptationsbythearchitecttoexpropriatedevelopers’investments.

Sinceunverifiablechangesarehoweverobservabletonetworkparticipants,apossiblesolutionisthat,whenthenetworkgetssetup,playersimplicitlyagreeonarelationalcontract:aself‐enforcingagreementthatspecifiesaruleforefficientlyupdatingthenetwork (anindicatorfunctionthatis1ifthechangeisimplemented),ageneralizedmulti‐periodversionofthewage, ,asaboveandabonuspayment toallthenetworkparticipants.Wedenotethecontractby , , .Forsimplicity,weshallrefertothecontractas .

Giventheseassumptions,thepayoffstotheentirenetwork(thecombinedsurplusavailabletoalloftheplayers)inamultiple‐periodzero‐discountsetupis:

∑ Δ Δ (8)

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Thefirsttermistheoperationalprofit.Thesecondterm Δ Δ capturestheadditionalvalueofefficientchangetothemembersofthenetwork.

Givenourassumptions,Theorem3ofLevin’s(2003)generalmodelholds,andwecanfindthefirstbeststationarycontractbysimplysearchingforcontractsthatimplementfirstbestinvestmentrulesandensuringthattherelationalcapitalislargeenoughtoenforcethem.Lettingthesurplusthatthepartiesenjoyoutsideofthecontract ,andthehighestpaymentthatthenodescanrequire ,wecanrestatethisresultintermsofourmodelas:

Lemma1.Arule thatgeneratesfirstbestsurpluscanbeimplementedwithastationarycontractifandonlyifthereisapaymentschedule suchthat 1when(3)holdsineveryperiod(firstbestadoptionofchanges)andthedynamicenforcementconstraintholds,meaning,atalltimes,thesurplusofcontinuinginthenetworkis

∑ (9)

Intuitively,weneedtoensurethatthereissufficientrelationalcapitaltopayforthelargestpossibledeviationbythearchitect.Essentiallyweneedtofindthemostcostlydeviationineachcase,andthenmakesurethatthenetworkarchitectownssufficientrelationalcapitalto,eveninthatcase,maketherelationshippersist.

Throughwhatfollows,wefocusonwhatamountofrelationalcapitalwouldbenecessarytosustainfirstbest.Thatisweassumethearchitectwantstoimplementthefirstbestdecision

∶1 Δ Δ0 Δ Δ

(sincewearelookingatstationarycontracts,wesuppressthetimenotation).Sincetheconflictconcernsthenetworkarchitect,whopartiallyignorestheprivatecostsofthenodes,weneedenoughrelationalcapitaltoprovidetherightincentivestothenetworkarchitect.Otherwise,thethreatofexpropriationwillleadtounderinvestment:nodes(e.g.,applicationdevelopers)willnotenterintoacentralizednetworkiftheyknowonlyashareγofexpostinvestmentwillbecompensated.

Thetotalbonusthatthenetworkarchitectmustpromiseinthiscaseis 1 γ kpernode.Thisbonusishighestwhenthenetworkarchitectisindifferentbetweenchangingthenetworkprotocolandnotchangingit,thuswhen:

Andthusthetotalrelationalcapitalrequired,is:

1 1

Totheextentthatrelationalcapitalislargerthanthatlevel,thecentralizednetworkmayattainefficientadaptation.

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Result3[Relationalcapitalinacentralizednetwork].Acentralizednetworkwithsufficientrelationalcapital(largerthanRC 1 )mayattainfirstbest.Thusthenecessaryrelationalcapitalislargerthemoreimportanttheunverifiablecostshare(1‐),andthelargerthevalueofthechanges.

Thusrelationalcapitalrequiredislargerthelargertheunobservableshareofcosts,thelargerthecostofthechangesandthelargerthesizeofthenetwork.

Remark(Reducingcostlyrelationalcapital):Governanceinacentralizednetworkaimingtoeconomizerelationalcapitalmustreducethenetworkarchitect’stemptationtoexpropriatethenodes.

2.3. Evidence on centralized governance with large relational capital: Google and Apple

Appleisthenetworkarchitectofaclosednetwork.ItoffersitsiOSoperatingsystemalongwiththeAppleAppStore(iTunes).Googleisthenetworkarchitectforanopenstandard,5thelesscentralizedAndroidoperatingsystem,alongwithitsGooglePlayStore.6Whileholdupfearsperiodicallyflare,particularlywithApple,bothAppleandGooglehaveenoughreputationto(normally)restraintheirabilitytoholdupmembersofthenetwork.

BothAppleandGooglesubsidizeinimportantwaysadaptationandprogramminginvestmentsbytheirdevelopers.First,AppleandGoogleverticallyintegratetheir“applicationsuites”containingcoreappspackagedwiththeoperatingsystemandincludingbydefaultnotonlythephonesoftwarebutthatfortextmessaging,email,calendar,etc.Moreover,theyprovidenoronlyadistributionchanneltoappsbutmanyessentialservices,includingdevelopmenttools,qualitycontrolandpolicingoffreeriders.Bothhelpdeveloperswithfreesoftware,moresothemorecentralizedAppleplatform(Bessarabova2017).Indeed,Appleprovidesaspecificprogramminglanguage(Swift)whichmakesprogrammingAppseasierthanatAndroid(forwhichdevelopersmustuseJavaandhavetowritemorecode),whichhasleadGoogletosupporttheKotlinlanguage.

5WithinAndroid,evensomethinganalogoustoaforktakesplacewhen,forinstance,apartlycompetitiveplatformsuchasAmazondevelopsthesoftwareforitsKindlebyaddingitsownproprietaryfeaturestotheopenversionofAndroid.6Theyaretheclearmarketleaders:GooglePlayhad2.8millionappsandAppleStore2.2millioninMarch2017,withtheothersfarbehind:Windows,0.669;Amazon,0.60andBlackberry0.2345million(“NumberofappsavailableinleadingappstoresasofMarch2017,”https://www.statista.com/statistics/276623/number‐of‐apps‐available‐in‐leading‐app‐stores/).

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Bothplatformsalsoprovideintegratedenvironments:Apple’sXCodepointsoutissuesrapidlythankstoitsbuilt‐inbackgroundcompilation,makingitsuperiortoAndroid’sStudio,whichrequiresaexplicitbuildingstage.Bothalsoprovidehelpandlearningmaterials.

EvenifbothplatformschargefixedfeestoAppdevelopers(anannualfeeof$99attheAppleStoreandanone‐time$25chargeatGooglePlay),thesefixedfeesareprobablymuchlowerthanthevalueformostdevelopersoftheimplicitservicestheyreceivefromtheplatform.

Appleismorecentralized,andthuswouldseemtohavegreaterincentivestoholdupdevelopers.However,consistentlywiththerelational‐capitalinterpretation,AppleisalsomoreactivethanGoogleinfilteringbadAppsoutandcontrollingAppimperfections,leadingtomorerejections.AtApple,adedicatedteamreviewsAppapplicationsaccordingtoadetailedsetofstandards(coveringfromchildrenprotectiontoreliability)andallowscommunicationincaseofrejection,whileGooglePlayrunsonlyautomatedtests,doesnotallowsuchcommunicationandwasslowtoreverseitspolicyoffreeAppplacement(solongastheAppisnotoffensiveorharmful)andstartpunishingpoorly‐madeApps(Dutta2017),apolicythathadledtoproliferationofuselessandinsecureApps,evenscams(Bell2014).Applealsoprovidesausers’reviewandratingservice(towhichdeveloperscanalsorespond)andpunishesoreventerminatesfreeriders(forinstance,spammersorthosewhomanipulatethereviewsandratings,stealusers’dataorincurinplagiarism,whichareremovedfromtheAppleStoreandexpelledfromitsDeveloperProgram).Bothplatformsalsoencouragesuccessby,e.g.,gettinggoodApps“featured”atthestoreorevenelected“AppoftheYear”or“FreeAppoftheWeek”.

Platforms’integrationofcoreApps,lowfixedpricesandtheirpolicingofApp’squalityisconsistentwiththeincentivesofdeveloperstounderinvest.First,verticalintegrationensuresmaximumcontrolofinvestment.Second,theabove‐mentioneddifferencebetweenthevalueoffreeservicesandthelowfixedfeeschargedtodevelopersallegedlysubsidizesthem,containingtheirincentivestounderinvestinthefaceofhold‐upandadaptationrisks.Thedifferencebetweenbothplatforms’fixedfeesisalsoinlinewiththeextentoftheservicestheyprovide.

Lastly,somethingsimilarcanbesaidaboutpolicing,asApple’sstricterreviewisalsoconsistentwithitpursuinggreaterreliabilityandhigherquality.Thiselicitscomplaintsfromdevelopersaboutruleambiguity,subjetiveness,slowspeed,poorquality(e.g.,Dave2015),aswellasrelyingonlittleevidenceandevenfavoringitsbusinesspartners(Yang,XinningandWaters2017).Obviously,thesecomplaintscanbeinterpretedeitherasasignthatAppleisinapositiontoexerciseholduporasasignthatitisperformingwellitspolicingfunctiontoavoidunderinvestmentandprecludefreeriding.Developersagreeexantetoassignunilateralreviewandtermination‐at‐willrightstoApple,whichmightwellbeoptimaltobothparties,givenApple’scentralposition,incentivesandknowledge,aswellasthecollectiveactiondilemmafacedbydevelopers.OtherearlyfeaturesofthereviewprocesspointoutthatAppletakesthisreviewtaskseriously:forinstance,itmadeavailableaninternalappealprocess.Afterall,AppleStoregeneratesmorerevenuefordevelopersthancompetitiveplatforms(Sims2015).Moreover,itwouldbeprobablysuboptimaltorelyonverificableevidenceandobjectivestandards,ascriticsdemand(Yang,Xinningand

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Waters2017,Dave2015).Thus,Applehasapointwhenassertingthat“Wewillrejectappsforanycontentorbehaviorthatwebelieveisovertheline.Whatline,youask?Well,asaSupremeCourtJusticeoncesaid,‘I'llknowitwhenIseeit’.Andwethinkthatyouwillalsoknowitwhenyoucrossit”(AppleInc.2017).

3. Blockchain networks: Coordination difficulties protect developers from hold-up

Thetechnologyofblockchain,asdiscussedinSection1,alterssubstantiallythecontractualpossibilitiesandthetradeoffbetweencoordinationandholdup.

3.1. Spot contracting: the possibility of splits protects specific investments

Considernowadecentralizednetworkwhereineachperiodanodemustdecidewhetherornottoacceptaproposedchange.Eachagentmustdecideonherownwhethertoadoptthechange,accordingtoherownpreferences.Crucially,the losersmaysplitandcreateanothernetworkiftheyareforcedtoimplementindividually‐damagingupdates.Supposefornow(weremovethisassumptionbelow)thatsuchloserscanactinacoordinatedway.Theirnetworkwillhaveasize andthusgenerateanoutsidevalueforeachofthemofb(N‐m).Thisprovidesthemwithanoutsideutilitywhichworksastheirreservationvalue.Ontheonehand,itimpliesthatmanyprofitablechangeswillnotbeimplemented.Ontheotherhand,itentirelyeliminatesthethreatofholdupthreat,aswewillmakeclearimmediately.

Assumingbynowperfectcoordinationamonglosers,thechangetakesplaceiflosersprefertoobtainthebenefitsofthelargernetwork, ,plustheirsmallgainfromthechange, ,tostayingwiththecurrenttechnology,whichyieldsthebenefitsofthesmallernetwork,

,andavoidsthecostofadaptationk:

Δ k (10)

Thatis,inaspotdecisionbyafullydecentralizednetwork,thenodeswiththeleasttogaindictatetotherest.Onlywin‐winchangesareimplemented.

Whencomparedtotheefficientconditiontoprecludeasplit,whichwecanrewrite,fromassumption1,as

0

thenode’sindividualdecisiondoesnotconsidertheadditionalvalueofthenetworkeffecttothewinningnodes.Torestate,inadecentralizednetwork,acoordinatedchangethatiswelfareimprovingonlytakesplaceifalltheloserspreferit,whichisahighlydemandingthreshold.

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Potentially,adecentralizednetworkcouldbestructuredtodecideadoptingthechangebyamajorityrule.Theprobleminblockchain(andthisiswhatmakesitdecentralized)isthatindividualnodesarealwaysabletorenegeonanycommitmenttoabidebythevoting—splitsarealwayspossiblebecauseinblockchaintheindividualadoptionofagivenpieceofsoftwarebyanodeisnotverifiable.

Result4[Decentralizednetworksonlyimplementwin‐winchanges].Win‐losechangesarehardtoimplementinadecentralizednetwork.Losersmayblockthechange,leadingtoalargelossofvalueduetolossofcoordinationgains.Theselossesfromcoordinationarelargerthelargerthenumberoflosers.

Figure2:Theinefficiencyofdecentralization:Toomuchinertia

3.2. Multiple equilibrium and expectations management

Intheprevioussubsection,weassumedforsimplicitythattheloserscanacttogetherinadoptingornottheproposedchanges.Morerealistically,inafullydecentralizedsetting,suchcoordinationamonglosersisnotpossible:boththelosersandthewinnersmustactaccordingtowhattheyexpectallotherplayerswilldo.

Althoughafullydynamicanalysisofthepossibleequilibriaispossible(see,fortheblockchaincase,Biaisetal.2018),asimple,static,analysisallowsustocapturethemainfeaturesofthisproblem.

Δ “Nochange”isefficient

Δ Δ Δ

Inefficiency:Excessiveinertia:

butΔ

k

Profit

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Result5.[MultipleNashEquilibria].SupposeAssumption1holds,sothatitisefficienttohaveonechainandimplementthechange.ThenthereexistvaluesofksuchthatthereexistthreeNashequilibria:

1.Successfulfork:Allnodesacceptthechange,asinglenetworkofsizeNensues.

2.Split:Losersstayontheoldnetwork,nowofsize(N‐m),winnerscreateanewnetworkofsizemwiththenewprotocol

3.Nochange:Allnodesstayonthecurrentnetworkofsizen,nochangeisadopted.

Proof.

1.Considertheproblemofasinglelosingnode,whoknowsthatallothernodesacceptthenewprotocol.Shedecidestoacceptaswellif:

Δ 1

Whichisalwaystrue,sincenetworkeffectsare“large”byassumption, 1 0and≫ .Networkeffectsensurethatbeingtheonlyholdoutisneveroptimal.Thusthere

isalwaysan“allchange”equilibrium.(Notethat,afortiori,thisisevenmoretrueforawinningnode).

2.Toseethattheremayexistequilibriawithsplits,supposethatthemwinningnodessplitandadoptthechangewhilethe(N‐m)losingnodesstayontheoldprotocol.Thisisanequilibriumaswellaslongasanodewhoisaloserdoesnotprefertoadoptthechange,7

k Δ ,

andawinningnodedoesnotprefertoabandonthechange,

Δ k

Bothmaybetrueforintermediatekaslongasthesplittinggroupisneithertoolargenottoosmall:

Δ k Δ b

Toseethatthisconditionholdsforsomeparametervalues,supposem=N‐m.Then.

3.Toseethat“noprotocolchange”mayalsobeanequilibrium,notethatifallnodesstayintheoldequilibrium,thepayoffforthesinglechangerispositiveif:

Δ 1 k

Δ k

7Notethattosimplifyslightlyweassumeanodeissmallsoaddingittothenetworkdoesnotchangethepayoff 1 , 1 .

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Again,with“large”networkeffects,b(N)≫ thisconditionneverholdsand“staying”isalwaysaNashequilibrium.

Insum,inadecentralizednetwork,wegenerallyfindmultipleequilibria.Whenchangeisefficientandnetworkeffectsareimportant,atleastalwaystwo(allchangeandnoonechanges)andpotentiallythree,wheneverasufficientlysizeablegroupoflosersexist.

3.3. Evidence on splits and inertia in blockchain

Examplesofthetwomostvaluablenetworks,BitcoinandEthereum,showthetwosidesofthecoinwehavejuststudied.OnBitcoin,difficultiesincoordinatingadaptation.OnEthereum,theprotectionoftheinterestsandinvestmentsofnetworkmembers(mainlydevelopers,asminers’investmentsarenotchain‐specificbuteasilyredeployable)throughthepossibilityoftheirundertakingsplits.

BitcoinCashSplit.AtBitcoin,decisionstakeplacethroughtheinteractionbetweenthemainconstituencies(coredevelopers,miners,users),whoseproposals,miningandinvestmentdecisionsdetermine,viaahardorsoftfork,anychangeintherulesandprices.Beforelaunchingimportantproposalsthereisusuallysomebargainingandinkeycasessomeagreementshaveevenbeenformalized.However,participantsarenotcommittedtotheseagreementsatthetimeofadoptingthechangeintheprotocol.8

Inthesummerof2017,theBitcoincommunitywastryingtoreachaconsensustosolvethetechnical,economicandideologicalconflictbetweenminers,whowantedbiggerblocksizes,andcodedevelopers,whostressedsecurity.Thechoicehadseriousconsequencesforthedifferentparticipants,includingblockchainapplicationswithdifferentbusinessmodels:“Many[blockchainstartups]havebusinessmodelsthatwouldbeaffectedbyhowtheblock‐sizeproblemissolved.Blockstream,afirmthatemployssomeBitcoinCoredevelopers,builds‘sidechains,’thesortofsecondarysystemthatwouldbemoreindemandifbitcoinitselfdoesn’tstartacceptingmoretransactions.Ontheotherhand,there’sBitPay,whichhassoldmerchantstheideaofbitcoinasalow‐feeretailpaymentsystem,andforwhomthestrangledstateofthebitcoinblockchainhasbeenaseriousheadache.”(Morris2017).

Thisheterogeneityofpreferencesamongusersmeantthatsomebutnotallnodesincorporatedthehardforkupgradelaunchedbyasmallandwellcoordinatedcoalition,andasplittookplace,withthecreationofanothercoin(named“BitcoinCash”),leadingtotwoincompatiblenetworks.Thesolutionwasthereforedeterminedinthemarketandledtotwodifferentdesigns:Afewdaysafterthefork,ithadminedthefirst8BMblock.

Interestingly,atthetimeofthesplit,therewerefearsthatthiswoulddamagethetotalvalueofthesystembut,thesefearsdidnotmaterialize.(Totalvaluefelllaterbutthislater

8Forinstance,the“NewYorkAgreement”relatedtotheSegwit2xupdate(Dinkins2017).

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fallcannotbeimputedtothesplit).EventhoughBitcoinpriceshadsoared,BitcoinCashbecamethefourthcryptocurrencybymarketcapitalization,fluctuatinginthefollowingtwomonthsaround10%ofthatofBitcoin,withapricearound12%ofthatofBitcoin;datawhichadmittedlywasprobablynotinformativegivenitsrelativelackofliquidity.9Thissuggeststhatthesplitmayhaveindeedprotectedtheinterestsoftheminority.

TheEthereumClassicsplitin2016.TheDAO(anacronymthatstoodfor“DecentralizedAutonomousOrganization”)wasasortofventurecapitalfundwithinEthereumtowhichanyinvestorcouldcontributeether(Ethereum’scryptocurrency),thuspurchasingsharesandvotingrights,whichtheythenusedontheprojectstheydecidedtosupport.InJune2016,afterithadraisedupto$250millionfromthousandsofbackers,itemergedthatsomeonehadusedabuginitscodeto“siphon”fromitsoriginalownersabout$60millionworthofether.Afterusingsimilartacticstofightaso‐calledDAOwarforweeks,theEthereumteamdecidedtoimplementahardforkthat,oncethechangesproposedbytheEthereumteamwereadoptedbyminers,bysimplyupgradingtheirsoftware,wouldeffectivelydeletetheallegedlyfraudulenttransactionsandrefundthemoneytoitspreviousowners.

However,thisdeniedtheimmutabilitythatwaspredicatedofsmartcontracts,whichweresupposedtomakeenforcementautomaticanddisputeresolutionunnecessary.TheEthereumteamwasaccusedofconflictofinterestsand,inparticular,ofsupportingtheconclusivenessoftransactionsonlywhenitservedtheirinterests.Underthismalevolentinterpretation,theywerewillingtoendangerimmutabilitytoprotecttheirinvestment.Alternatively,abenevolentinterpretationisthat,byendangeringabitofimmutabilitytheynotonlyprotectedtheirinvestmentbutalsothebroaderlong‐terminterestofthewholecommunity.Inthelaw‐and‐economicstermsmentionedabove,theywereaimingfor“efficientcontractualbreach.”

Atlast,thecommunitywassplitandsomeimportantminersandexchangesstartedbackinganalternativecurrency,called“EthereumClassic”(ETC),whichreliesontheoriginalblockchain.10Thosewhoheldetheronitretainedtheirrights,butforthefundsstolenintheDAOattack.Oneofthebeautiesofhard‐forksplits,isthattheevolutionofbothcoinsinthemarket,intermsmainlyofpriceandvolume,providesanimperfectbutindependentmeasureoftherelativevalueofthetwosetsofrules.11

9CalculatedonOctober2,2017,withdataobtainedfromhttps://coinmarketcap.com/.10Laterincidentshavetriggeredsomewhatsimilarcontroversiesandtheissuesremainfarfromsolved(e.g.O’Leary,2018).11IntheDAOcase,theevolutionofmarketpricesmayoffersomesupporttoandefficient“contractualbreach”hypothesis.Certainly,EthereumClassicsurvivedbuttenmonthslater,itsmarketcapitalizationwasonly4.88%ofEthereum.Evenifitspricehadincreasedbetweenthosetwodatesbyamultiplecloseto13,thiswasmuchlessthatEthereum’s24.4.Giventhat,atthatpoint,themaindifferencebetweenthetwocoinswastheoriginalconflict,themarket(and,crucially,theexchanges,asClassicwasonlytradedbyafewof

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Inertiainprotocolchanges:Segwit2x.Multipleinstancesoftheinertiaofblockchainnetworkscanbereported.ConsiderforinstancetheupdateSegwit2x,whichwouldincreaseblocksizeandallowtheBitcoinnetworktolowerfeesandbecomemorereliablewasreadyforNovember16,2017.Thedebateontheneedtoallowthenetworktoscaleuphasbeengoingonforthreeyears.12Thecommunitywasdividedaboutitsconvenience.Promotersfinallyabandonedtheupdate,fearinganothersplit,afterobservingpricesinthenewfuturesmarketforcryptocoinsaswellasothersignalshintinglackofconsensus.

3.4. Improving blockchain governance: pre-mining and soft governance

Blockchainnetworksfollowseveralstrategiestotacklethemainconflictsthatthepreviousmodelhighlights.Theyaredesignedtominimizethenumberoflosersanddisplayavarietyofgovernancedevicestoencouragenodestoreachgoodequilibriaandavoidbadequilibria—inshort,theyaimtofacilitatethecoordinationofwinnersandhinderthatoflosers.13

Pre-mining

Practicallyeverynewblockchainplatformhasbeenlaunchedtogetherwithacryptocurrencythroughan“InitialCoinOffering”(ICO).Usuallyinexchangeforaestablishedcoinsuchasbitcoinorether,foundersissuewhatiscalled“tokens”whichareadigitalassetsthatcanbeusedasameansofpaymentintheplatform,tobuyorsellproductsorservices.

them)wasapparentlynotveryappreciativeoftheconservativenessofEthereumClassicwithrespecttoimmutability.Moreover,EthereumClassic’sclaimsofcode‐as‐lawweresomehowdiluted,as,atleastforfraudcases,itreliesonstandardlegalrecourse—whatcouldalsobeunderstoodasaformofthird‐partycontractcompletion—andblockchainintegrityisdissociatedfromself‐enforcement.Basedondatafromhttps://coinmarketcap.com/(August13,2017).12“Bitcoin’sscalingdebatehasbeengoingonandtheneedtoseizethisopportunityofincreasingcapacitybeyondwhatisprovidedbySegregatedWitness(SegWit).”https://www.forbes.com/sites/ktorpey/2017/10/31/heres‐why‐bitcoin‐businesses‐are‐pushing‐for‐a‐protocol‐change‐without‐clear‐consensus/#33a1eca27b40.13Giventhetwo‐sidednatureofitsmarkets,centralizedplatformsalsofacemultiple‐equilibriumproblems,andtheymustmanagethem,forinstance,byrelyingoncoordinationbiastodecidebetweensubsidizingbuyersorsellers(HalaburdaandYehezkel2016).Theproblemforblockchainplatformsismuchmorecomplex:therearemultiplelevelsofplatforms,withadditionalkeyplayers(mainly,miners)and,mostessential,designdecisions(e.g.,whomissubsidizedbywhom)aredecentralized.

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TheICOofteninvolvespre‐miningandalsosellingtokensatadiscountedpriceorevengrantingvaluableoptionstonetworkparticipants,inordertofacilitatetheformationofacommunity,gettingliquidityinthesystem,facilitatingtradingandparticipationforprogrammersandserviceproviders.SometokensareevensoldbeforetheICO,inhighlydiscounted“tokenpre‐sales.”

Therearecomplementaritiesbetweenthecryptocurrencyandtheplatform.14First,andmostobviously,launchingaplatformincreasestheviabilityofthecurrency,whichbecomesamediumofexchangeinthatplatform,sothattransactiondemandanchorstosomeextentthevalueoftheplatform.

Second,thecryptocurrencyalsobenefitstheplatform.Pre‐miningthecryptocurrencyallowsfoundersandthoseallowedtopre‐minetocapitalizeonthefuturevalueoftheplatformandthusalignstosomeextenttheirinvestmentincentiveswiththoseofthenetwork.Byprovidingthepromotersofthenewplatformwithsomecoins,anddistributingthemstrategicallysothatpotentiallosersholdcoins,thereforeweakeningtheconstraintthat to:

where istheincreaseinthevalueofthecoin“stash”inthehandsofsuchloser.Totheextentthat islarge,wecangetclosertoefficientadoption,particularlysincemanycriticalchangesandinvestmentsareimplementedintheearlystagesofthenetwork.

Forinstance,Ethereumcountswithagoverningnon‐profitfoundation(StiftungEthereum)whichhas“thepurposeofmanagingthefundsthatwereraisedfromtheethersaleinordertobestservetheEthereumanddecentralizedtechnologyecosystem”(Ethereum2017).ThefoundationholdsasubstantialamountofetherthatwaspreminedbeforetheICOalignsitsincentiveswiththeaimofmaximizingthevalueoftheEthereumecosystem.

However,evenifthisinitialallocationofcoinswasinitiallyright,itcannotprovidealongtermsolutiontothecoordinationproblem.First,itisunclearexantewhothelosersfromfuturechangeswillbe.Second,itseffectivenessdecreaseswiththelapseoftime.Indeed,newcomers(suchasfuturedevelopers)donotholdanyofthepre‐minedcoins.Perhapsmoreimportantly,foundersandearlyholdersaretemptedtosell,asthevestingandsalerestrictionstypicalofIPOsarenoteasytoimplement.

Someplatformshaveintroducedexplicitformalmechanismstoovercometheselimitations.Forinstance,theabovementionedEthereum‐basedDAOissuedaDAOtokenthatallowedtokenholderstovoteonprojectsandreceiveashareontheprofitsfromthem.However,sucheffortshavehadlimitedsuccess,notleastbecausetheSEChasruledthatsuchtokens

14Thisisnotentirelynew:largecentralizedplatformssuchasFacebookandAmazonhaveintroduced,privatedigitalcurrencies(seeGansandHalaburda,2015).

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aresecuritiesandthustheirsaleneedstoberegulatedassuch(thatis,likeanIPOofstock).15

Remark[LifeCycle].Acryptocurrencyoranyexplicitprofitparticipationeconomizesonrelationalcapitalbyallowingnetworkstorewardmembersevenintheabsenceofcashflow.Weexpectthemtobemostimportantearlyonintherelationship.

Soft governance

Themultiplicityofequilibriaopensthedoortousing“softgovernance”tofacilitatedecisionmaking.Theideaisnotto“order”or“decide”asinstandardcentralizedgovernance,oftennoteventoleadbuttomerelynudgeplayerstocoordinateonthegoodequilibria.

Theeffectivenessofthesemechanismsof“decentralizedgovernance”isintrinsicallylimited,becauseofthesimplefactthatinablockchainnetwork(evenwithon‐chaindecisionmechanisms)splitsarealwayspossible,subjectonlytotheconditionofthemachievingenoughsupportinthecommunity.Sinceindividualnodeskeeptherighttorunornotupdates,allthesesoftgovernancedevicescandoistocoordinatetheexpectationsofallparticipantsontheequilibriumselected,reinforcingtheexpectationthateveryoneelsewillchoseaccordingly.Therefore,insteadofallocatingdecisionrightsacrossparticipants,softgovernancemerelyallocatesnudgingrightsamongthem.

Softanarchy:LackofgovernanceatBitcoin.AtBitcoin,thereispracticallynoexpostsoft(orhard,forthatmatter)governanceassuch.Ithasnotevenhadaleader,asitssupposedfounder(whoremainsanonymous)retiredsoonafteritscreation.Decisionstakeplacethroughtheinteractionbetweenthemainconstituencies(coredevelopers,miners,users),whoseproposals,miningandinvestmentdecisionsdetermine,viaahardorsoftforkanychangeintherulesandprices.Usually,beforelaunchingimportantproposalsthereisbargainingandinkeycasessomeagreementshaveevenbeenformalized.

15SecuritiesandExchangeCommission,SecuritiesExchangeActof1934,ReleaseNo.81207,July25,2017:“ThisReportreiteratesthesefundamentalprinciplesoftheU.S.federalsecuritieslawsanddescribestheirapplicabilitytoanewparadigm—virtualorganizationsorcapitalraisingentitiesthatusedistributedledgerorblockchaintechnologytofacilitatecapitalraisingand/orinvestmentandtherelatedofferandsaleofsecurities.Theautomationofcertainfunctionsthroughthistechnology,“smartcontracts,”orcomputercode,doesnotremoveconductfromthepurviewoftheU.S.federalsecuritieslaws”.

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However,participantsarenotcommittedtotheseagreementsatthetimeofadoptingthechangeintheprotocol.16

Moreover,thelackofcentralizedgovernanceindecentralizednetworkssuchasBitcoinmakesitdifficulttoproperlyfinanceprotocoldeveloperswhentheyarefundedexternally(Wirdum2016).Initially,Bitcoinwascreatedbyvolunteers.Thisbecameunsustainablewhenfounderslostinterestandthedemandsforprotocolupdateskeptincreasing.Thecorefoundationhasbeenfinancedwithdonationsandsponsorships,followingthestepsofopen‐sourcesoftware(Evans,HagiuandSchmalensee,2006:403–408),butthishasalsobeencriticizedforallowingforfreeridingbynon‐contributorsandexacerbatingpotentialconflictsofinterest(Wiecko2017).17

Softautocracy:LeadershipatEthereum.Unlikeatbitcoin,andinspiteofthelackofcentralization,Ethereumreliesstronglyontheexistenceofa“benevolentleader”,itsfounderVitalikButerin,whocrowdfundedissuinganewcryptocurrency(“ether”)inAugust2014whenhewas19‐yearold.Hehasdescribedhisfunctionsas“Constantlykeepaneyeoutastowhatusersarelookingfor,andmakesurethatwearesatisfyingpeople'sconcerns.Betransparentaboutwhatwe'redoing.Havefrequentdevelopercallsbetweenthevariousclientdeveloperteamsandresearchers,andpublishtheminutesandaudioasmuchaspossible.Iftherearecontroversialchoicesorhardtradeoffstobemade,presentthetradeoffanddoourbesttogivethecommunityaninput.Foranythingtrulycontroversial,trytogaugecommunityconsensusviacarbonvoteorsimilartoolsaswellasotherpolls”.18Moreover,Buterinhasaimedtoinstillanethosinthenetwork,a“strongcultureofmutualrespectandtolerance”.19

ThevisibleandactivepresenceofButerinintheEthereumcommunityisatestimonytotheimportanceheattachestotheimportanceofcoordinatingexpectations:HeisafrequentparticipantinRedditdiscussions,andoftenpostslongerandsubstantivearticlesonhiswebsite,discussingthemainstrategicdecisionstobemadebyEthereum.Relationalcapital

16Forinstance,the“NewYorkAgreement”relatedtotheSegwith2xupdate(Dinkins2017).17AtEthereumandothernetworksbycontrast.AtEthereumandatDash,forinstance,10%rewardgoestodevelopers.18ForanonlineredditdiscussionofEthereumversusBitcoingovernance,see“HowIsEthereumGovernanceDifferentfromFlawedBitcoinGovernance?”EthereumSubreddit,https://www.reddit.com/r/ethereum/comments/5ybocd/how_is_ethereum_governance_different_from_flawed/.19E.g.,“HowdoestheEthereumcommunityfeelthatitcanovercome/isovercomingthegovernanceproblemthatiskillingBitcoin?”EthereumSubreddit,(https://www.reddit.com/r/ethereum/comments/61tpul/how_does_the_ethereum_community_feel_that_it_can/).

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seemstobepresenthereinatleasttwodirections.First,thesharingvaluableknowledgeincreasesButerin’sreputation.Second,hisreputationinturnreinforceshisauthorityandpowerastheleaderofthecommunity.

Softaristocracy:Contributorsandmasters.ThemassivesplitcausebyTheDAOin2016tookplaceinspiteofthestrongleadershipofButerin.Thishasledtoavarietyofproposals.

Forinstance,theYellowPaperCommittee,proposedbyGavinWood,acofounderandoneofitsthreetopEthereumdevelopers,arguesfor“ablockchain‐basedorganization[structuredasaDAO]tomanagetheevolutionoftheEthereumprotocolspecification”(Wood2016),concentratingdecisionrightsonthetechnicalelite:Thewidercommunityof“middlewaredevelopers,applicationdevelopers,infrastructureprojects,commercialendeavorspoweredbyEthereum,substantialholdersofetherandaffiliateorganizations”wouldformanEthereumGeneralAssembly(EGA)as“aforumtohelpair,clarifyandformalizetheviewsofthecommunity.”Then,ahighlyselectivegroupofcontributors(thosewhohadcontributedanindependentimplementationoftheprotocolintheprevioussixmonths)wouldformtheEthereumImplementersGroup(EIG),whowouldratifychangestotheconstitutionandthespecification.Nosinglepersonorentitywouldbeallowedtoinfluencemorethan25%ofthetotalmembership.EachEIGmemberwouldhaveavoteandathree‐monthvetorightattheEIG.ThewholeEGAwouldhavearighttovotebutwouldnotenjoyvetorightsattheEIG.TheEIGchair,wouldsubmitpotentialchanges(so‐calledEIPs,forEthereumImprovementProposalsdescribingthestandardsfortheplatform)totheEIGthroughatwo‐stepbudget‐allocationprocessforcodedevelopment,whichwouldthenbedecidedbytheEIG’svoting.Revealingly,thechairmightalsoproposemodestexpendituresforaccommodationandtravel,butnotsubsistence,toEIGmeetings.

Anotheraristocraticsolutionbasedoncreating“masternodes”,hasbeenimplementedbyDash,whichdefinesitselfasa“privacy‐centricdigitalcurrencywithinstanttransactions”basedonBitcoinsoftware.Italsoaimstointroduceleadershipbya“technicalelite”,asortofaristocraticdemocracyofnodesforgovernanceandbudgeting,inwhichitattemptstocollocatedecisionrightswithlongtermincentives.20Specifically,masternodesareinvestedinthefutureofthecurrency.Inparticular,itistheywhoallocatefundsamongproposeddevelopmentchangesanddecideonprotocolchanges.Tomakedecisions(establishingthebudgettopayforthecoreteam,contractorsandothercosts;increasingblocksize,etc.),eachmasternodeoperatorhasonevote.Masternodesarealsoessentialtoachieveanonymization.Anyonecanbecomeamasternodebyownershipof1,000Dash

20Sources:Miller(2016),Wiecko(2017),DashWhitePaper(https://dashpay.atlassian.net/wiki/spaces/DOC/pages/1867864/What+is+a+masternode).https://dashpay.atlassian.net/wiki/spaces/DOC/pages/1867864/What+is+a+masternode.

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andarepaidbythenetworkwith45%oftheblockrewardthatusedtogotominers(another10%goforthebudget).Ithassuccessfullyhandledanumberofhardforkswithoutsplits.

Softdemocracy.Severalnetworksarealsotryingtodirectlycoordinatetheentirecommunitywiththehelpofsmartcontracts.

AnexampleisButerin’sproposaltoreplacethecurrent“difficultytimebomb”for“amoregeneral‘governancegadget’forhardforks”.The“DifficultyTimeBomb”isanexponentialincreaseindifficultyimplementedinEthereumonSeptember7,2015,toincentivizeeverybodytoswitchtothenewblockchainoncethehard‐forkmovingitfromProof‐of‐WorktoProof‐of‐Stakeisimplemented,thusavoidingtheriskthatthechainisduplicated.(Giventhegreaterdifficulty,minerscouldnotcopeandtheblockchainwouldfreeze,hencethe“IceAge”name).21Instead,underButerin’salternative“Bomb2.0”proposal,participantswouldvotebysendingetheronahardforkand,onceenoughpeopleapprovedit,thehardforktakesplaceautomatically.Itwouldstillbe“abicameralmodel:aforkrequiresconsentfrombothholdersanddevsbecausedevshavetofindtheforkacceptableenoughtobewillingtowriteupthecode”(Buterin2016).

Similarly,Tezosdefinesitselfas“theself‐amendingcryptographicledger”.Thisstartup,whichraised$232MinJuly2017,featureson‐chaingovernancetoachieveasmoothupgradingofitsprotocolinsteadonrelyingonhardforks(Xie2017).Theprocessworksbyhavingdeveloperssubmitupgradeproposals,whichincludeacompensationfordevelopers’work.Thiscompensationshouldprovideincentivesandavoidconflictsofinterests.Holdersoftheapplicationcoins(“tezzies”)thendecidebydelegatedproofofstake,whichshouldbecheaper,asitdoesnotwasteelectricity;providebetterincentives,includingpenalties;andallowtransferofvotingrightstothosewithtimeandknowledge.(Aswithcorporate“emptyvoting”bymeansoffinancialderivatives[HuandBlack2007],itisdoubtfulifthisdelegationofvotes—nowpopularinmanyinnovativegovernancestructuresinblockchain—couldexacerbateconflictsofinterests,asitseparateseconomicandpoliticalrights).FundsraisedinthecrowdsalewillbemanagedbyaSwissfoundationwithcanvetoproposalsinthefirstyearbuthasnotothercontroloverthesubmissionandupgradeprocess.Moreover,itscontinuitywillbedecidedbytheon‐chaingovernancesystem.22

AsimilarsolutionistheEVMDfinity,asisternetworkofEthereum,whichwouldprovideforitsappsanautomaticanddecentralizeddecisionsystem:a“BlockchainNervousSystemwithprivilegedcontrolovertokenownership”,whichwouldbeusedinsteadofthe

21Basedon“WhatistheEthereumIceAge?”CryptoCompare,July5,2017,https://www.cryptocompare.com/coins/guides/what‐is‐the‐ethereum‐ice‐age/.22Interestingly,inspiteofthisefforttoimprovegovernance,Tezossufferedinearly2018anastygovernancecrisis(Dale2018).

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automatic“codeislaw”ofEthereum(Williams2017a).Itisdesignedtopreventhackingandaimstofreeze“miscreantsmartcontractsthatharmtheinterestsofthoseusingtheplatform”(Williams2017b).Itwouldrelyonquasiproofofstake(“miningclientsconnecttothenetworkusinga‘miningidentity’thatisacquiredbymakingasecuritydepositintokens”).

4. Comparing optimal centralized and decentralized networks

Whenwillacentralizedoradecentralizednetworkbepreferred?Thechoicedependsontheirabilitytoresistopportunism—whatonecouldcalltheircontractual“robustness”.Thishinges,inturn,ontherelationbetweenthefuturevalueofstayinginthenetwork(therelationalcapital)andtherenegingtemptationtokeyplayersorcoalitionsofplayers.

Acentralizednetwork,whichwestudiedinSection2,confrontsarelativelysimpleproblem:precludingtherenegingtemptationofthenetworkarchitect,whomayotherwiseexpropriatethespecificinvestmentsofthenodes.

Adecentralizednetworkconfrontsamorecomplexproblem,asanalyzedinSection3:preventingthetemptationofsplitsfrom“coalitionsoflosers”.Moreover,inacentralizednetworkrelationalcapitaliseasiertovisualizeintermsofreputationandfuturegainsfromtradebecausemostofitisowned(asthemodelassumed)bythenetworkarchitect—itiscentralizeditself.Incontrast,relationalcapitalisdispersedacrossthewholecommunityinadecentralizednetwork.

Weproceednexttocompare,optimally‐designedcentralizedanddecentralizednetworks—meaningbyoptimaldesignthattheyareabletoprecludetheiressentialproblemsof,respectively,holdupsandsplits.Obviously,thetermsofthiscomparisonareexceedinglygeneroustobothstructures,sinceweassume,first,thatthetaskofoptimallycompensatinglosersisitselfcostless.Secondly,inthecentralizednetworks,thereisnosingleindividualarchitectwhocentralizesallrelationalcapital,butawholesetofhierarchicallayersofprincipalandagentswiththeirownincentiveproblems.Aftermakingthecomparisonbetweentheseidealizedoptimaltypes,wewillexaminemoredeeplyinSection4.3howdifficultisforeachtypeofnetworkstoreachsuchoptimalityintherealworld.

4.1. An optimal decentralized network

Theglueholdingtogethertheblockchainisitsfuturevalue.Atanystage,acoalitionofmembersmaytrytosplitandformaseparatenetwork,byrefusingtoimplementaprotocolchange.Inadecentralizednetwork,loserswhoimplementachangeloseeach .Forthemnottobetemptedtosplit,thenetworkrelationalcapitalmustbelargerthantheworstcasescenario.Thatisthepointwherethe

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networkasawholefacesthelargestrenegingtemptation.Theworstcasescenario(andthusthehighestrenegingtemptation)iswherethecostofadaptingtothenewtechnologyishighest,andmakesadoptionmarginallyprofitable,thatiswhen

α Δ α Δ k (11)

Let ,therelationalcapitalofadecentralizednetwork,bethenetpresentvalueofthefuturegainsfromthenetworkForthisrelationalcapitaltobelargerthantheworstrenegingtemptationoftheN‐mloserswemusthave.23

N m α Δ Δ (12)

Result6[Relationalcapitalindecentralizednetwork].Therelationalcapitalneededinadecentralizednetworkislargerthehighertheheterogeneityinbenefitsamongnetworkmembers,andthelowerthelargerthenetworkeffect.24

4.2. Which of the optimal networks requires less relational capital?

Thus,anoptimally‐designeddecentralizednetworkwillbepreferredifitneedslessrelationalcapital:

RCD<RCC

α α Δ Δ 1

23Wearenotbeingexplicitabouthowthepaymentsareactuallymade.Weshallcomebacktothispointlater.Fornow,supposethereisatimelinethatincludesfirstavoteonachange,thenarealizationofwinnersandlosers,thenabonusforloserspaidbywinners.Theearningsofthewinnersfromthechange,inthisworstcasescenario,are0:

Δ Δ Δ Δ 1 )=0

24Whensplitsarepossible,therearetworelevantcases:inefficientsplitandinefficientstatusquo.Giventhatkisrandom,relationalcapitalisneededinbothtypesofsituationbutalwaystocompensatelosersinordertoreachtheassumedunanimous‐changefirstbest.Inbothcases,RCisthesameasintheno‐splitcase.Therefore,contemplatingsplitsdoesnotchangeanythingiftherelationalmechanismiseffectiveinprecludinginefficientchange.

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Orequivalently

α 1 α Δ (13)

Proposition1.Networkchoice.Anoptimally‐designeddecentralizednetworkwillbepreferrediffnetworkeffectsarelarge,ifthegainsforthelosersarelarge(sothatchangesarewinwin).Centralizednetworksarepreferredistheriskofholdupbythenetworkarchitectissmall((1‐γ issmall),thatiswhenadoptioncostsareeasytoverify.

4.3. Comparing real networks

Comparingidealeconomicoptimaisfruitfulonlytoacertainpoint(Coase1960).Toexplorehowlikelycentralizedanddecentralizednetworksaretoreachsuchideals,wemustcomparethemfromastaticandanevolutionaryperspective.

Avoidingholdupandoptimizingchangenotonlyrequiresthatthenetworksownenoughrelationalcapitaltobeabletocompensatelosers.Themodelassumesthatcompensatinglosersisequallycostlessinthetwotypesofnetworks.Thisassumptionseemstodepartfromrealityparticularlyinthecaseofdecentralizednetworks,sinceitimpliesthatitiscostlesstomakeoptimalpaymentsbetweenpotentiallylargenumbersofdecentralizedwinnersandlosers(footnote23).TheempiricalanalysisofSections2and3indeedconfirmsthatdecentralizednetworksexperienceseriousdifficultiestostructuresuchpayments.Theythereforesufferanadditionaldisadvantageinthisdimension,asmayhavebeensuspectedfromnothavingasinglecentralpayerandrepositoryofreputationorreputationalcapital,moregenerally.

Butcentralizednetworksalsosufferfromincentiveconflictswhichremainhiddeninourmodel.Thisissimplybecausewemodeledbothnetworkarchitectsassimple“blackboxes”whoseinternalorganizationcostswealsoassumedtobezero.However,inrealitythetwotypesofarchitectcouldhardlybemoredifferent.Thearchitectofacentralizednetworkisahugefirmwhichintegratesmanyfunctionswhiledecentralizednetworkarchitectsareatmosttinyteams.Centralizednetworkseconomizeonthecostsoforganizingthenetworkbyincreasingthecostsoforganizinginternally,thefirms‐versus‐marketstradeoffdiscoveredbyCoase(1937).Therefore,byapplyingthesameblack‐boxassumptiontothetwoarchitects,ourmodelgrantscentralizednetworksanunrealisticadvantage.

Forinstance,centralizedarchitectsexhibitmultipleagencylevels,whichreducestheeffectivenessofanygivenamountofrelationalcapital,asagents’interestsareimperfectlyalignedwiththoseofthefirmandmaybetemptedtocheatonnodesfortheirpersonalgain.Centralizedarchitectsthereforeeitherspendcapitaltryingtoalignagents’interestsandhavetodeployadditionalrelationalcapitaltoprecludeholdup.Suchmultilevelprincipal‐agentproblemsarequiteprevalent,asanenormousrecentliteraturehasshown.

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Lastly,fromanevolutionaryperspective,centralizednetworkslikelyreceivemoreinstitutionalsupportandbenefitmorefromaccumulatedmanagerialknowledge,whicharebynowlessdevelopedandthereforelessadaptedtothenewdecentralizationP2Ppossibilitiesthatblockchainhasjustopenedup.25Notethatittookcenturiestodeveloptheinstitutionsandorganizationalsolutionsappliedfortheeffectivegovernanceofcentralizedrelationalcapital—thatis,acorporationwithmultiplelevelsofagentsactingasthearchitectandthencontractingeffectivelyasasingleunitwithamyriadofnetworkmemberswhichmayinturnbebigfirmsthemselves.26Neithercurrentlyavailableinstitutionsnororganizationaltechniquessuitthedemandsofdecentralizedgovernance,whichisinitselfawhollynewphenomenon.

Therefore,weshouldnotbetooharshwhenjudgingthecurrentstateofdecentralizedgovernanceinblockchainnetworks.Instead,weshouldpaymoreattentiontoitsabilitytoimproveovertimeandevolvesolutionstoitscurrentproblems.Consideringtheevidenceinsection3.4,theindustryseemstobestartingaHayekiandiscoveryprocess(Hayek1982).Timewillsayifandhowfastareparticipantsabletofindgovernancesolutionsthatbesteconomizeonrelationalcapitalbydistributingbothcapitalanddecisionrightsinawaythatencouragesgoodequilibria.

5. Conclusions: Centralization trade-offs and the deficit of governance in decentralized networks

Contrarytowhatsomeearlyblockchainparticipantsbelieved(applyingthe“codeisthelaw”principleinLessig1999),evensmartcontractsareandwillremainincomplete.Moresowhenthecontractrefersnottoasimpleexchangeofgoodsandservicesbuttosuch

25Thefactthatdecentralizednetworksarelessregulated(forinstance,theICOs)mayfavoritsfinancesintheshortrunbutdoesnothelpandmayevenhindertheirgovernance.Onthisregard,lackofenablingregulationmaybeaserioushandicap,asitwasattheinceptionofthemoderncorporation(Harris2000,Arruñada2010).26Withrespecttolegalsolutions,firmsrelyheavilyinready‐madesolutionsthatwenowgiveforgrantedbuttookthousandsofyearstodevelop,suchastheprotectioninremofgood‐faiththird‐partyacquirers,agencylawenablingagentstocommittheirprincipals,legalpersonalitytohandleconflictsbetweenpersonalandcorporatecreditorswithoutendangeringlegalentities,and,quiterecently,corporategovernancetoenableseparationofownershipandcontrol(e.g.,HansmannandKraakman2000,Arruñada2012).Similarly,withrespecttoorganizationaltechniques,littlecouldfirmsachievewithout,e.g.,double‐entryaccounting,divisionalization,transferpricingortheasymmetricallocationofdecisionrightscharacteristicoffranchising(e.g.,Chandler1977,Arruñada,GaricanoandVázquez2001).

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complexandconflictiveinteractionsasthosewehavesketchedhere(mainly,theprotocolgoverningtheblockchain).

However,unlikeincentralizednetworks,inadecentralizednetworknodes’investmentsareautomaticallyprotectedfromexpropriationbythefactthatanychangerequirestheirconsent.

Inparticular,byachievingenoughsupportfromothernodes,theyarealwaystheoreticallyabletoforceasplitandthusunanimityisrequiredtochangenetworkprotocols.However,thisneedforconsensuscomesatthecostofhinderingadaptationandcoordinatedchange.Giventhatdifferentequilibriaarepossible,blockchainnetworksmaystallinanoutdatedsolutionorrepeatedlysplitasdifferentsubgroupsofagents,developersandminers,havingdifferentobjectives,seektoimpose,throughsheerforceofcommitment,theirpreferredsolutionontheentirenetwork.Thiscouldfatallyweakentheblockchainmodel.Therefore,indecentralizednetworks,the“subeconomy”(Holmstrom,1999),allthegovernancetoolsavailabletoorganizations,shouldbebroughttobearonensuringcoordinatedadaptationandchange.Akeyelementhereisthatthiswillnotbestandardgovernancebut“soft”decentralizedgovernance.

Giventhesetradeoffs,weexpectdecentralizednetworkstobepreferredwhentherisksofexpropriationarehigh,astheirdecentralizationautomaticallyprotectsmemberinvestorsfromexpropriation.Conversely,whenheterogeneityishigh,centralizedplatforms,whicheasilyadoptchanges,aremorelikelytosupportefficientcontracting.

Afterexploringhowemergingsolutions,suchaspre‐miningcoinsandothersoftgovernancetoolshelptodealwiththeincentiveproblemspresentinthesenetworks,wehaveconcludedthatcurrentdecentralizedgovernanceisveryfarfromsolvingthemadequately.Comparedtotheadvantagesthat,forinstance,stockownershipandoptionsconfertotheemergingnetworkthatisanewcorporation,expostalignmentisquiteprimitive.Coinsortokens,forinstance,areyetwoefullyinadequate—no‐onecanbeforcedtohoardcoinsinordertoalignhisincentives,anyonecansellthemasneeded,orworse,foundershaveincentivestodosoinsearchofdiversification.

Butthereismeritindecentralization,andweareinthepresenceofaveryyoung,competitiveandwell‐endowedevolutionaryprocesssearchingforbettersolutions.Moreover,thereisanimportanttechnicalreasontobehopeful:blockchainnetworksareunlikelytofallintothetrapsofinferiorequilibriacharacteristicofnetworkindustries,withtheirlockinandtippingfeatures.Thereasonisthatblockchainoffersanewsetoftoolsthat,effectivelyused,holdthepotentialtoavoidthesebadequilibria,aswediscussed.Thekeydifferenceisthat,whileeachgamewithnetworkexternalitiesisaone‐offgame,inblockchainweobservegameswithmultiplestages(manyprotocolupdates),wherethepotentialforcompetitionwithothernetworksprovidesincentivesforcoordinatingongoodequilibria,andforevolvingthosedecentralizedgovernancetoolsthatarebetteratselectinggoodequilibria,aswediscussedinSection3.4.

Wesubmitthattheplatformthatbestsolvestheseincentiveproblemswillhavealargeadvantageinthisrace.RightnowtheplatformthathastravelledfurthestinthisroadisEthereum,wheretheEthereumFoundationistaskedwithcoordinatingdecisionsinthenetwork.However,asthesplitofEthereumClassicshowedin2016,evenEthereumis

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unabletodealeffectivelywithconsensualchange.Otheremergingplatformsarecompeting,aswediscussinthemaintext,onallofthesedimensions.

Inthispaperwehavefocusedontheorganizationaldifficultiesthatblockchainfacestoachieveoptimaladaptation.Butblockchainalsoraisesrelatedbounded‐rationalityandsocialwelfareconsiderations.Itisparticularlyworthexploringifindividualswouldreallywanttoliveinaworldofsmartcontracts,inwhichtheyaloneareexpectedtotakethefullresponsibilitysuchcontractsentail.(Notethat,withoutintermediaries,thewholevalueofassetsandtransactionshingesonlyonindividualspreservingandproperlyusingtheircryptographickeys).Whenfreedomcomeswithresponsibility,individualsoftenprefertogiveupfreedom,andtrueP2Ptradingthroughblockchainrequiresmaximumindividualresponsibility.

Thisboundedrationalitylimitationmightthereforedecidewhereblockchainendsupenjoyinggreatercomparativeadvantage:likelymoreforsmall‐valuetransactions(e.g.,relatedtotheInternetofThings)thanforthosedealingwithlarge‐valueassetssuchasrealestate.Moreover,itmightalsodefinethesupposedcapacityofblockchaintodefusethecurrentthreatthatInternetgiantspose.Ifandonceblockchainnetworksachieveeffectivedecentralizedgovernance,theywillstillfaceasteepslope—intermsofindividuals’boundedrationality—tofulfillthepromiseofoutcompetingthosegiants.Butthisisaproblemforfuturework.

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