DeFi governance needs better tokenomics

With Sinclair Davidson, published in Coindesk, 13 April 2021

The controversy surrounding the launch of the Fei stablecoin protocol last week reveals a lot about DeFi’s problems with tokenomics. We know what a governance token offers its holders – the right to vote on changes to fees, and the protocol itself. But what should these rights be worth? 

The Fei protocol is engineered to maintain stability against the U.S. dollar by charging a penalty for selling and a bonus for buying the Fei token when it is below the $1 peg. It is an innovative design, albeit highly experimental. But as Fei has drifted further and further from the peg since launch, early buyers found themselves in the unfortunate position of being unable to liquidate their positions without taking substantial loss. 

By the end of the week, Fei suspended the penalties and rewards to try to stabilize the protocol. Until then, these mechanisms were functioning exactly as intended. Careful investors would have seen everything spelled out in the Fei white paper.

We might say this is a simple “buyer beware” story. But it is complicated by the simultaneous airdrop and distribution of Fei’s governance token, TRIBE, that was intended to allocate control rights over the protocol itself. In practice, buyers were trading an appreciating asset (ETH) for a stablecoin (FEI) to get access to the real prize: TRIBE.

In the crypto and DeFi industry many think that governance is just about voting. Voting is important of course – it is the governing part of governance. But it is only a part. In the traditional corporate world, governance rights come with a complex and coherent set of rights and obligations clearly tied to the underlying value of the firm. 

Share ownership represents a right to the cash flow of the company, and a residual claim over the company’s assets if, for whatever reason, it is wound up. The structure of these rights are the result of hundreds of years of evolution in corporate governance. 

If voting rights and the rights over the cashflow and the assets of the firm are misaligned, there can be perverse results. In crypto, we shouldn’t just want governance token-holders to vote. We should want them to vote well  making governance choices that are shaped by their interest in increasing the value produced by the protocol, and their knowledge that they will benefit directly from those choices. 

The initial “investors” in Fei are not really investors in FEI at all. They are customers who spent ETH to buy FEI. And there is an important difference between being a customer and an owner. The difference between being able to complain – to Tweet about how you’ve been wronged – and the ability to do something to recover your money. Because of the design of Fei’s “protocol controlled value” pool of ETH, FEI holders have no residual ownership claim over the ETH, just the right to sell their new FEI on a secondary market.

What governance rights FEI holders have is only as a result of being airdropped TRIBE, a fork of Compound’s COMP token. Like COMP and many other DeFi governance tokens, TRIBE gives voting rights, but does not allocate cash flow rights. 

True, TRIBE holders might in the future vote for protocol amendments that allocate those rights. Even so, the token at best represents an option to participate in unspecified governance that might result in cash flow, but might not. 

The crisis happened because an unexpectedly large number of people bought into FEI to get TRIBE, and then tried to sell out of FEI. That’s understandable: nobody wants to hold a stablecoin in a bull market. This rush for the exits triggered Fei’s penalty and reward nosedive. 

There is a subtle but critical lesson here. If the unique selling proposition of your crypto-economic system is predictability and stability – as it must be for a stablecoin – having the initial demand for that coin driven by a highly speculative governance token that will offer ambiguous future rights is asking for trouble. 

Indeed, it is a lesson that ought to be considered by all token designers in the DeFi world, not just stablecoins. The decision not to specify how value accrues to governance tokens is not just risky for investors. It is risky for the protocol itself.

For example, online chatter suggests that if Fei’s future had been put to a governance vote over the course of the week, there would have been substantial support for distributing its enormous ETH treasury back to FEI buyers. This would have recouped individual losses, but probably also have wound the protocol up entirely.

The Fei protocol is trying to do a lot of innovative work at once. If it turns out to be a success, it won’t have been the only successful protocol that had a rocky bootstrapping phase. But it should offer future protocols a critical lesson in tokenomics. 

Governance tokens are one of the most interesting innovations in DeFi. They seem to offer a fast path to decentralization, handing over control from entrepreneurs to a distributed community as quickly as possible, at, after, or even before launch. But the role of governance cannot be an afterthought – a bolt-on that can be pushed to a governance token and left to unknown future decision-makers.

Governance is the philosophical and economic heart of the blockchain and cryptocurrency industry. After all, decentralization is nothing if not the decentralization of governance. As Fei shows, dumping protocol governance onto a speculative token with unclear cash flow and ownership rights introduces a lot of instability into already ambitious protocols.   

Social media has huge problems with free speech and moderation. Could decentralised platforms fix this?

Published at The Conversation. With Marta Poblet and Elizabeth Morton

Over the past few months, Twitter took down the account of the then-President of the United States and Facebook temporarily stopped users from sharing Australian media content. This begs the question: do social media platforms wield too much power?

Whatever your personal view, a variety of “decentralised” social media networks now promise to be the custodians of free-spoken, censorship-resistant and crowd-curated content, free of corporate and political interference.

But do they live up to this promise?

Cooperatively governed platforms

In “decentralised” social media networks, control is actively shared across many servers and users, rather than a single corporate entity such as Google or Facebook.

This can make a network more resilient, as there is no central point of failure. But it also means no single arbiter is in charge of moderating content or banning problematic users.

Some of the most prominent decentralised systems use blockchain (often associated with Bitcoin currency). A blockchain system is a kind of distributed online ledger hosted and updated by thousands of computers and servers around the world.

And all of these plugged-in entities must agree on the contents of the ledger. Thus, it’s almost impossible for any single node in the network to meddle with the ledger without the updates being rejected.

Gathering ‘Steem’

One of the most famous blockchain social media networks is Steemit, a decentralised application that runs on the Steem blockchain.

Because the Steem blockchain has its own cryptocurrency, popular posters can be rewarded by readers through micropayments. Once content is posted on the Steem blockchain, it can never be removed.

Not all decentralised social media networks are built on blockchains, however. The Fediverse is an ecosystem of many servers that are independently owned, but which can communicate with one another and share data.

Mastodon is the most popular part of the Fediverse. Currently with close to three million users across more than 3,000 servers, this open-source platform is made up of a network of communities, similar to Reddit or Tumbler.

Users can create their own “instances” of Mastodon — with many separate instances forming the wider network — and share content by posting 500-character-limit “toots” (yes, toots). Each instance is privately operated and moderated, but its users can still communicate with other servers if they want to.

What do we gain?

A lot of concern around social media involves what content is being monetised and who benefits. Decentralised platforms often seek to shift the point of monetisation.

Platforms such as Steemit, Minds and DTube (another platform built on the Steem social blockchain) claim to flip this relationship by rewarding users when their content is shared.

Another purported benefit of decentralised social media is freedom of speech, as there’s no central point of censorship. In fact, many decentralised networks in recent years have been developed in response to moderation practices.

Mastodon provides a set of guidelines for user conduct and has moderators within particular servers (or communities). They have the power to disable, silence or suspend user access and even to apply server-wide moderation.

As such, each server sets its own rules. However, if a server is “misbehaving”, the entire server can be put under a domain block, with varying degrees of severity. Mastodon publicly lists the moderated servers and the reason for restriction, such as spreading conspiracy theories or hate speech.

Some systems are harder to moderate. Blockchain-based social network Minds claims to base its content policy on the First Amendment of the US constitution. The platform attracted controversy for hosting neo-Nazi groups.

Users who violate a rule receive a “strike”. Where the violation relates to “not safe for work” (NSFW) content, three strikes may result in the user being tagged under a NSFW filter. If this happens, other users must opt in to view the NSFW content, for “total control” of their feed.

Minds’s content policy states NSFW content excludes posts of an illegal nature. These result in an immediate user ban and removal of the content. If a user wants to appeal a decision, the verdict comes from a randomly-selected jury of users.

Even blockchain-based social media networks have content moderation systems. For example, Peepeth has a code of conduct adapted from a speech by Vietnamese Thiền Buddhist monk and peace activist Thích Nhất Hạnh.

“Peeps” falling afoul of the code are removed from the main feed accessible from the Peepeth website. But since all content is recorded on the blockchain, it continues to be accessible to those with the technical know-how to retrieve it.

Steemit will also delete illegal or harmful content from its user-accessible feed, but the content remains on the Steem blockchain indefinitely.

The search for open and safe platforms continues

While some decentralised platforms may claim to offer a free for all, the reality of using them shows us some level of moderation is both inevitable and necessary for even the most censorship-resistant networks. There are a host of moral and legal obligations which are unavoidable.

Traditional platforms including Twitter and Facebook rely on the moral responsibility of a central authority. At the same time, they are the target of political and social pressure.

Decentralised platforms have had to come up with more complex, and in some ways less satisfying, moderation techniques. But despite being innovative, they don’t really resolve the tension between moderating those who wish to cause harm and maximising free speech.

Financial rules for the algorithm age

Published in the Australian Financial Review

A lot has changed in cryptocurrency since the last bull run in 2017. And these changes have made the regulatory regime that emerged in Australia since the invention of bitcoin look decidedly creaky – if not completely incoherent – and a serious barrier to fintech innovation and investment.

For the most part, Australian policymakers have preferred to squeeze digital assets into existing regulatory frameworks rather than create new frameworks.

For tax purposes, cryptocurrency has been treated as a traditional financial asset subject to capital gains tax – unless it is used in regular transactions, then it is treated like currency. An initial coin offering, where tokens are sold to early investors and users, is generally treated as a share offering or managed investment scheme.

This was the right approach. Entrepreneurs may not have loved the heavy compliance burdens, but at least those burdens were well understood. And we have avoided regulatory disasters like New York’s “BitLicense”, which led to cryptocurrency firms fleeing the city almost the moment it was introduced.

But where in 2017 cryptocurrency users and investors were limited to a relatively small number of digital assets trading on a couple of centralised exchanges, a new class of decentralised finance (DeFi) products have enabled the development of complex financial products and services that are completely decentralised. DeFi completely undermines Australia’s regulatory approach to cryptocurrency and blockchain.

Everything from loans to derivatives to exchanges are being rebuilt as autonomous digital products outside the traditional finance system. These are not niche innovations. Some estimates have upwards of $50 billion locked up in DeFi products right now.

Consider one of the most innovative financial services in the DeFi space: automated market makers. These AMMs allow users to trade one digital asset for another without going through a traditional central orderbook. Investors – “liquidity providers” – put assets into a pool. People who wish to trade one asset for another make exchanges with the pool, which reprices each asset automatically to keep the pool in balance. Investors get fees and bear risk if the external price of the assets change.

AMMs are a brilliant innovation and a regulatory nightmare. Let us start with tax. The Australian Taxation Office treats any token-to-token exchange as a capital gains event, where profits and losses incur a tax liability is incurred, just like a normal exchange of financial assets. This regime makes sense for traditional finance. But it creates huge burdens for DeFi.

Imagine a relatively simple DeFi investment – putting bitcoin in an AMM. First, you have to bring your bitcoin onto a smart contract network like ethereum. Bitcoin can only truly exist on the bitcoin blockchain, so you vouchsafe your coins with a provider who then mints a digital representation of your bitcoin on the ethereum network. You deposit this “wrapped bitcoin” token (and usually another token) into the AMM. You get a receipt – just another token – that represents your share of the pool.

Each of these exchanges are capital gains events. None of them are denominated in Australian dollars. Even the most diligent DeFi user will inevitably make mistakes when trying to account for the capital gains and losses. Few users even realise they are actually performing a token-to-token exchange when they make AMM investments. It is hard to describe the capital gains treatment of DeFi as a functioning part of the tax system at all.

The tax regime may be a compliance nightmare, but at least it is navigable. There are even harder compliance questions in our imagined DeFi investment. For instance, what actually is an AMM, in law? It looks a lot like a managed investment scheme – that is probably what ASIC will think. Like a traditional managed investment scheme, investors pool money in return for profits and don’t have day-to-day control of the investments. But if an AMM is a managed investment scheme … well, it doesn’t have a manager. Algorithms can’t hold financial licences. Nor on a censorship-resistant blockchain can they be shut down.

There are solutions to these problems. Capital gains events should be limited to when cryptocurrency is converted to fiat or used to buy goods or services. My colleagues Darcy Allen, Aaron Lane and I have called for a new exemption to the managed investment scheme framework – what we call “autonomous investment products”. Where a product is entirely algorithmic, has no ongoing responsible party, and is completely open source and auditable by investors, the heavy compliance burdens of a managed investment scheme don’t make sense.

But these solutions will almost certainly require legislative change. Until now, Australia’s cryptocurrency policy has been made via regulatory guidance. That approach has reached its use-by date. Fintech innovation can’t be left to suffocate under regulatory uncertainty and incoherence.

After GameStop, the rise of Dogecoin shows us how memes can move markets

Published in The Conversation with Jason Potts

One of the most difficult problems in finance right now is figuring out the fundamental economic value of cryptocurrencies. And the past week has complicated this further.

For many cryptocurrency investors, the value of Bitcoin is based on the fact it is artificially scarce. A hard cap on “minting” new coins means there will only ever be 21 million Bitcoin in existence. And unlike national currencies such as the Australian dollar, the rate of release for new Bitcoin is slowing down over time.

Dogecoin, a cryptocurrency that takes its name and logo from a Shiba Inu meme that was popular several years ago, have a cap. Launched in 2013, there are now 100 billion Dogecoin in existence, with as many as five billion new coins minted each year.

But how can a currency with a seemingly unlimited supply have any value at all? And why did Dogecoin’s price suddenly surge more than 800 per cent in 24 hours on January 29?

At the time of publication, the “memecoin” was worth about $5.6 billion on the stockmarket.

Dogecoin is one of the original “altcoins”: cryptocurrencies released in the few years after the pseudonymous Satoshi Nakamoto first released Bitcoin into the wild.

From a technical perspective, Dogecoin isn’t very innovative. Like many early altcoins, it’s based on the original source code of Bitcoin.

Or more technically, it’s based on Litecoin, which in turn was based on Bitcoin — but with some small modifications such as faster transactions and the removal of the supply cap. But Dogecoin is much more interesting when seen through a cultural lens.

The cryptocurrency was created by software engineers Billy Markus and Jackson Palmer — although Palmer, an Australian, has since walked away from the project. They branded it with the Doge meme partly to be funny, but also to distance it from Bitcoin’s then questionable reputation as a currency for illicit transactions.

Now, Dogecoin has outlasted almost all the early derivative altcoins and has a thriving community of investors. In 2014, Dogecoin holders sponsored the Jamaican bobsled team. Soon after, they sponsored a NASCAR driver.

Elon Musk, the world’s richest man, is among the cryptocurrency’s high-profile advocates. In December last year, a tweet from Musk sent Dogecoin’s price soaring.

Reddit threads proclaim Dogecoin’s value as a new global currency. Musk himself shared a similar sentiment a few days ago. Speaking on the app Clubhouse, he said:

Dogecoin was made as a joke to make fun of cryptocurrencies, but fate loves irony. The most ironic outcome would be that Dogecoin becomes the currency of Earth in the future.

But Dogecoin is best thought of as a cultural product, rather than a financial asset. The reality is few cryptocurrency users hold it as a serious investment or to use in regular transactions. Instead, to own Dogecoin is to participate in a culture.

People buy it because it’s fun to have, is inherently amusing and comes with a welcoming and enjoyable community experience.

If we start thinking of the cryptocurrency as a cultural product, last week’s sudden jump in Dogecoin’s price makes sense. The boost came just after a meme-centric community managed to drive the share price of videogame retailer GameStop from US$20 to US$350 in mere days.

This swarm behaviour was unlike anything seen before — and it frightened global financial markets.

One particularly interesting aspect of the Reddit forum r/WallStreetBets — which coordinated the attack on the hedge fund that had effectively bet on GameStop’s share price falling — was how many users were having fun.

It’s no surprise activity surrounding Dogecoin has a similar vibe; it was designed to be fun right from the start.

Some people participate in financial markets as a form of consumption — meaning for entertainment, leisure and to experience community — just as much as they do for investment.

Cultural assets such as Dogecoin are hard to systematically value when compared to financial assets, a bit like how we don’t have a fundamental theorem for pricing art.

Almost by definition, the demand for a memecoin will fluctuate as wildly as internet culture itself does, turning cultural bubbles into financial bubbles. RMIT professor and crypto-ethnographer Ellie Rennie calls these “playful infrastructures“.

By inspecting Dogecoin closely, we can learn a lot about the interplay of technology, culture and economics.

Moreover, cryptocurrencies are extraordinarily diverse. Some are built for small payments or to be resilient holders of value. Others protect financial privacy or act as an internal token to manage smart contracts, supply chains or electricity networks.

Under the hood, Bitcoin and Dogecoin look almost exactly the same. Their code differs in only a few parameters. But their economic functions are almost entirely opposite.

Bitcoin is a kind of “digital gold” adopted as a secure hedge against political and economic uncertainty. Dogecoin, on the other hand, is a meme people add to their digital wallet because they think it’s funny.

But in an open digital economy, memes move markets.

Time to reject Trump’s legacy and to back free trade and immigration

Donald Trump’s failure to win a second term as president isn’t just important for the future of the United States. It has significant implications for centre-right politics in Australia too.

At least since the Cold War the centre-right has been an alliance between conservatives and classical liberals. Sometimes this alliance has been awkward. But the result has been a balance between relatively free market economics and relatively conservative social policy that we broadly associate with John Howard, Ronald Reagan, and Margaret Thatcher.

The Trump administration represented for many on the right a sharp ideological break with the past. Out went conservative-liberal fusionism. In came working class populism and a suite of starkly different policy priorities: anti-trade, anti-immigration, anti-big business, and anti-tech.

Virtually the moment polls closed in 2016, conservatives around the world started talking excitedly about the virtues of populism, the opportunities of ‘conservative nationalism’, and building their own domestic version of Trump’s America First.

Electoral realignment has led to intellectual realignment. One influential manifesto was published in the conservative magazine First Things in 2019. Titled “Against the Dead Consensus”, it declared that the “pre-Trump conservative consensus” had collapsed and it was time to reject globalism and “warmed-over Reaganism”. A bunch of new think tanks and political magazines have been established with names like American Compass and American Greatness to capture the Trump-era zeitgeist.

On the other side, some traditional fusionist institutions like the Weekly Standard have collapsed, only to be replaced by Trump sceptical publications like The Dispatch and The Bulwark.

Perhaps we should not overstate the ideological change. The Trump administration enacted many traditional Republican policies – appointing those originalist judges, pursuing all that deregulation and the deep corporate tax cuts.

But they set up the two big debates we’re going to see in the centre-right for the next few years. First: could have any Republican president gotten these policies through, or could it only have been someone as confrontational and singular as Donald Trump?

Second: might the political capital spent on tax cuts and deregulation have been better spent on more working class-focused policies like infrastructure investment and paid family leave? Some are already claiming Trumpism didn’t fail – Trumpism was never really tried. If the conservative-liberal consensus is dead, did the Trump administration trip over its corpse?

The result of these debates will have ramifications in Australia. For the most part, the Morrison government has avoided major ideological realignment in the Trump era. The Prime Minister played around with Trumpy language last year when he warned about “negative globalism”. But there’s a big difference between opposing ‘negative’ globalism (by which our prime minister was criticising corrupt international institutions) and the sort of globalism that Donald Trump is opposed to (immigration, free trade, and the network of traditional alliances). Anyway, who could support “negative” globalism?

Ultimately the Morrison government has tried to paint a soft populist tint over its traditional policy agenda. It still claims its free trade agreements as an achievement, for instance (although it has been notably less talkative about those agreements since 2016).

Even if Morrison had wanted to explicitly follow the Trump path, he would have struggled to do so. A small, open, productive economy like Australia is highly dependent on free trade and migration for our prosperity.

One issue where we might say that the Australian right has been influenced by Donald Trump is on China. But these last four years have seen the heavy oppression of the Uyghur minority in Xinjiang, the loss of free Hong Kong, and Xi Jinping’s tightening grip on the Chinese state. It is hard to imagine an alternative history in which Australia was not aware of these events.

The big question for us is whether the old conservative-liberal alliance can be rebuilt. If the Trump administration has permanently severed that alliance, the deep interactions between centre-right intellectuals and activists across the Pacific Ocean mean it will inevitably be severed in Australia too.

And when that happens, we will be faced with a serious long-term challenge for our economic wellbeing.

Unless the Democratic Party or the Labor Party pick up the classical liberal agenda of free trade, deregulation, low taxes, and openness to immigration, then that policy mix – and the prosperity it has created – is at risk.

What we think we know about defi

This essay follows an RMIT Blockchain Innovation Hub workshop on defi. Contributions by Darcy WE Allen, Chris Berg, Sinclair Davidson, Oleksii Konashevych, Aaron M Lane, Vijay Mohan, Elizabeth Morton, Kelsie Nabben, Marta Poblet, Jason Potts, and Ellie Rennie. Originally a Medium post.

The financial sector exists solely to smooth economic activity and trade. It is the network of organisations, markets, rules, and services that move capital around the global economy so it can be deployed to the most profitable use.

It has evolved as modern capitalism has evolved, spreading with the development of property rights and open markets. It has grown as firms and trade networks became globalised, and supercharged as the global economy became digitised.

Decentralised finance (defi) is trying to do all that. But just since 2019, and entirely on the internet.

Any business faces the question of “how do I get customers to pay for my product?” Similarly consumers ask the question, “Where and how can I pay for the goods and services I want to buy?” For the decentralised digital economy, defi answers this question. Defi provides the “inside” money necessary to facilitate transactions.

But what in traditional, centralised finance looks like banks, stock exchanges, insurance companies, regulations, payments systems, money printers, identity services, contracts, compliance, and dispute resolution systems — in defi it’s all compressed into code.

From a business perspective trade needs to occur in a trusted and safe environment. For the decentralised digital economy, that environment is blockchains and the dapps built on top.

And as we can see, defi doesn’t just finance individual trades or firms — it finances the trading environment, in the same way that taxes finance regulators and inflation finances central banks. If blockchain is economic infrastructure, defi is the funding system that develops, maintains and secures it.

These are heavy, important words for something that looks like a game. The cryptocurrency and blockchain space has always looked a little game-y, not least with its memes and “in-jokes”. The rise of defi has also had its own cartoonified vibe and it has been somewhat surreal to see millions of dollars of value pass through tokens called ‘YAMs’ and ‘SUSHI’.

Games are serious things though. A culture of gaming provides a point around which all participants can coordinate activity and experimentation — what we’re seeing in defi is the creation of a massive multiplayer online innovation system. The “rules” of this game are minimal, there are no umpires, and very little recourse, where the goal is the creation and maintenance of decentralised financial products, and willing players can choose (if and) to what extent they participate.

Because there is real value at stake, the cost of a loss is high. Much defi is tested in production and the losses from scams, unethical behaviour, or poor and inadequately audited coding are frequent.

On the other side, participation in the game of defi is remarkably open. There are few barriers to entry except a small amount of capital that players are willing to place at risk. Once fiat has been converted into cryptocurrency, the limit on participation in decentralised finance isn’t regulatory or institutional — it is around knowledge. (Knowledge is a non-trivial barrier, excluding people who could be described as naive investors. This is important for regulatory purposes.)

This is starkly different from the centralised financial system, where non-professional participants have to typically go through layers of gatekeepers to experiment with financial products.

The basic economics of defi

The purpose of defi is to ensure the supply of an ‘inside money’ — that is, stablecoins — within decentralised digital platforms and to provide tools to manage finance risks.

In the first instance defi is about consumer finance. It answers basic usability questions in the blockchain space: How do users of the platform pay native fees? Which digital money is deployed as a medium of exchange or unit of account on the platform?

In the second instance defi concerns itself with the operation of consensus mechanisms — particularly proof of stake mechanisms and their variants. The problem here is how to capture financial trust in a staking coin and then how to use that trust to generate “trust” on a blockchain. Blockchains need mechanisms to value and reward these tokens. Given the (potential) volatile nature of these tokens, risk management instruments must exist in order to efficiently allocate the underlying risk of the trading platform.

As we see it, the million yam question is whether the use of these risk management tools undermine trust in the platform itself. It is here that governance is important.

Which governance functions should attach to staking tokens and when should those functions be deployed? Should they be automated or should voting mechanisms be used? If so, which voting mechanisms and what level of consensus is appropriate for decision making.

Finally defi addresses the existence of stablecoin and staking tokens from an investor perspective. Again there are some significant questions here that the defi space has barely touched. How do these instruments and assets fit into existing investment strategies? How will the tax function respond? How much of existing portfolio theory and asset pricing applies to these instruments and assets?

Of course, we already have a complex and highly evolved centralised financial system that can provide much of the services that are being built from the ground up in defi. So why bother with defi?

The most obvious reason is that the blockchain space has a philosophical interest in decentralisation as a value in and of itself. But decentralisation addresses real world problems.

First, centralised systems can have human-centric cybersecurity vulnerabilities. The Canadian exchange QuadrigaCX lost everything when the only person with access to the cryptographic keys to the exchange died (lawyers representing account holders have requested that the body be exhumed to prove his death). Decentralised algorithmic systems have their own vulnerabilities (need we mention yams again?) but they are of a different character and unlike human nature they can be improved.

Second, centralised systems are exposed to regulation — for better or worse. For example, one of the arguments for UniSwap is that it is more decentralised than EtherDelta. EtherDelta was vulnerable to both hackers (its order book website was hacked) and regulators (its designer was sued by SEC).

Third, digital business models need digital instruments that can both complement and substitute for existing products. Chain validation instruments and the associated risk management tools presently do NOT have real world equivalent products.

Fourth and finally, the ability to digitise, fractionalise, and monetise currently illiquid real-world assets will require a suite of instruments and digital institutions. Defi is the beginning of that process.

In this sense, the defi movement is building a set of financial products and services that look superficially familiar to the traditional financial system using a vastly different institutional framework — that is, with decentralisation as a priority and without the layers of regulation and legislation that shape centralised traditional finance.

Imagine trying to replicate the functional lifeforms of a carbon-based biochemical system in a silicon based biochemical system. No matter how hard you tried — they’d look very different.

Defi has to build in some institutions that mimic or replicate the economic function provided by central banks, government-provided identity tech, and contract enforcement through police, lawyers and judges. It is the financial sector + the institutions that the traditional finance sector relies on. So, initially, it’s going to look more expensive, relative to “finance”. But the social cost of the traditional finance sector is much larger — a full institutional accounting for finance would have to include those courts and regulations and policymakers and central banks that it relies on.

Thus defi and centralised finance look very different in practice. Consider exchanges. Traditional financial markets can either operate as organised exchanges (such as the New York Stock Exchange) or as over-the-counter (OTC peer-to-peer) markets. The characteristics of those types of market are set out below.

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Defi exchanges represent an attempt to combine the characteristics of both organised exchanges and over-the-counter markets. In the very instance, of course, they are decentralised markets governed by private rules and not (necessarily) public regulation. They aim to be peer-to-peer markets (including peer-to-algorithm markets in the case of AMM).

But at the same time they aim to be anonymous (in this context meaning that privacy is maintained), transparent, highly liquid, and with less counterparty risk than a traditional OTC market.

Where is defi going?

Traditional finance has been developing for thousands of years. Along with secure private property rights and the rule of law, it is one of the basic technologies of capitalism. But of those three, traditional finance has the worst reputation. It has come to be associated with city bros and the “Wolf of Wall Street”, and the Global Financial Crisis. Luigi Zingales has influentially argued that the traditional finance system has outgrown the value it adds to society, in part because of the opportunities of political rent seeking.

This makes defi particularly interesting.  Defi is for machines. Not people. It represents the automation of financial services.

A century ago agriculture dominated the labour force. The heavy labour needs of farming are one of the reasons we were poor back then. As we added machines to agriculture — as we let machines do the farming — we reduced the need to use valuable human resources. Defi offers the same thing for finance. Automation reduces labour inputs.

Automation of course has been increasingly common in financial systems since at least the 1990s. But it could only go so far. A lot of the reason that finance (and many sectors, including government and management) resisted technological change and capital investment, was at the bottom, there had to be a human layer of trust. Now that we can automate trust through blockchains, we can move automation more deeply into the financial system.

Of course, this is in the future. Right now defi is building airplanes in 1902 and tractors in 1920. They’re hilariously bad and horses are still better. But that’s how innovation works. We’re observing the creation of the base tools for entrepreneurs to create value. Value-adding automated financial products and services comes next.

Australia’s Confused Tech Regulators Are Cracking Down on Google for Using Links

Published in Reason, 10 September 2020

Economists have long warned that a great deal of regulation that is supposedly in the public interest acts in practice as a transfer of wealth from one private interest to another. Policy makers are usually demure enough to hide this. It is rare that rent-seeking is as explicit and open as the Australian government’s current attempt to expropriate money from Facebook and Google—money that will be directly paid to the traditional news outlets that these tech companies have disrupted.

This is much more than just a regional policy fight; what is happening in Australia tells us a lot about how the changing economics of media are feeding the bipartisan war on the tech industry in the United States and globally. Much of what is dressed up as populist anti-tech policy is in fact an attempt by legacy media companies to weaponize confused regulators against their competitors.

The Australian government wants Facebook and Google to sign onto what they call a “News Media Bargaining Code,” which will require tech companies to pay news organizations when news content is “included” on the digital platforms. The exact price to be paid is meant to be negotiated by media companies and digital platforms. The rationale offered by Australian antitrust regulators is that there is a “bargaining power imbalance” between tech and media companies, hence the need for government action to get negotiations started. 

You may be tempted to read that paragraph again. Don’t bother. The government’s argument is euphemistic and its reasoning is obscure. The most obvious problem is that neither Facebook nor Google “include” news content on their platform. The dispute is not about intellectual property theft; all tech companies are doing is linking to news sites. Facebook allows users to share links. Google offers links through its general search function as well as its Google News search service. The upshot is that the Australian government wants Facebook and Google to pay news organizations for the privilege of linking to their content. 

Unsurprisingly, Facebook has said if it is forced to pay it will simply block Australians from sharing news links. Google might also shut down its Google News service—that’s what happened when a similar policy was introduced in Spain in 2014.

Much like the U.S., the Australian media sector is in economic freefall. And like the U.S., both Australian progressives and conservatives have been regarding tech companies with increasing skepticism. We usually think of anti-tech skepticism as ideological—conservatives are at odds with socially liberal Silicon Valley types while progressives look at Silicon Valley as the new robber barons. But in Australia, it is strikingly obvious how the economic collapse of traditional media causes anti-tech sentiment.

Throughout the 20th century, the newspaper business model was simple: Newspapers sought to match readers with advertisers. Advertising paid for journalism, which attracted readers, which then attracted more advertising, and so on. The more readers the better. So newspapers tried to appeal to the median reader. 

The history of the media in the last two decades is the slowly unfolding consequences of advertising migrating from the print media to the internet. This creative destruction not only undermined business models that paid for mass-market journalism, but reshaped how public debate is conducted. The growth in media partisanship in recent years could be because media outlets no longer try to appeal to the median reader—they try to engage a passionate few who will stump up a subscription fee. That is, media partisanship has economic causes.

The other consequence is political backlash against the big tech companies. 

For generations, the art of politics involved serenading the local press, getting an audience with the regional media mogul, or building a relationship with a sympathetic journalist who could be relied on to get a political message out. 

Now those friendly moguls and journalists are on the backfoot, shocked by the extraordinary growth of the digital platforms that seem to have ripped both the economic high ground from under them. And the political class is starting to respond to the new media normal the best way they know how: with threats of regulation.

It is easy to laugh at the odd populist attempts to tame digital platforms, such as Sen. Josh Hawley’s (R–Mo.) 2019 proposal to ban autoplay videos and infinite scrolling. But the Australian experience shows that the greater threat to digital platforms comes from antitrust regulators, dressed up in bizarre claims about “bargaining power imbalances.”

Antitrust policy in the 21st century is particularly vulnerable to this sort of strange thinking. Antitrust was conceived in a world of monolithic corporate hierarchies—factories that built physical things and distributed those things using physical infrastructure like rails and ports. Digital platforms are hard to understand through the traditional antitrust lens. 

The more users a digital platform has—the more it dominates a market segment—the more valuable that platform is to those users. We want to use the social media network that everyone else is using. And to get more users, platforms often provide access to one side of the market for free. For regulators used to hunting for predatory pricing, this just looks weird. At the same time these digital markets are highly dynamic; firms tend to dominate them, but not for long. This too leaves regulators in a bind. They’ve spent more than a century warning of the dangers of monopolies, but now they’re struggling to identify the actual harm these digital platform “monopolies” are causing.

Australian regulators are confused as to what to do and have proposed everything from regulating Facebook and Google’s algorithms, to enacting new privacy laws, to giving more money to public broadcasters.

It’s clear that U.S. regulators are confused too. In early September, The New York Times reported that while the Department of Justice plans to imminently bring an antitrust case against Google’s parent company, Alphabet, there is much internal disagreement about what the grounds of the government complaint should be. 

As the Australian experience shows, this combination of confused regulators and aggrieved, politically connected industries is a dangerous thing.

What we’ve learned from working with Agoric

With Sinclair Davidson and Jason Potts. Originally a Medium post.

Since 2017 we (along with our colleague Joe Clark) have been working with Agoric, an innovative and exciting smart contract team, who are about to launch a token economy model we helped design.

At the RMIT Blockchain Innovation Hub we’ve long been thinking about how blockchain can drive markets deeper into firms, resolving the electronic markets hypothesis and giving us new opportunities for outsourcing corporate vertical integration.

What we’ve discovered from working with the Agoric team is the possibilities of driving markets down into machines. Mark Miller’s groundbreaking work with Eric Drexler explored how property rights and market exchange can be used within computational systems. Agoric starts economics where we start economics — with the institutional framework that secures property rights.

This has been one of the most intellectually stimulating collaborations of each of our careers, and has shaped much of how we think about the economics of frontier technologies.

We first met the Agoric team through Bill Tulloh at the Crypto Economics Security Conference at Blockchain @ Berkeley in 2017, just as we were forming the RMIT Blockchain Innovation Hub. CESC was the first serious attempt we were aware of to bring the blockchain industry and social science together — such as our disciplines of economics and political economy.

In the presentation to CESC, we applied some of Oliver Williamson’s thinking to understand the economic properties of tokens and cryptocurrencies.

Bill — who had thought along similar lines — came over to chat during a break. We met again at the 2018 Consensus Conference in New York. Bill introduced us to Mark Miller. What started out as a quick chat to say hello over breakfast turned into a long discussion about Friedrich Hayek, Don Lavoie, and market processes in computer science. Through Bill and Mark we then met Kate Sills and Dean Tribble.

It is true that economic thinking is everywhere in the blockchain and cryptocurrency community. There’s a lot of lay reasoning about Austrian economics, monetary policy, central banks, and inflation. These ideas have brought a lot of people into the cryptocurrency space. Some of the thinking that brought them here is good economics (we’re very passionate about how Austrian economics can inform the blockchain industry ourselves — see here and our colleague Darcy Allen here) but unfortunately a lot of it is not-so-good economics. Many developers have self-taught economics, many have intuited economics from first principles, and we have observed a combination of brilliant insight, economic fallacy, and knowledge gaps.

Developers, however, tend to be very good at game theory; if only because unlike our colleagues in academia, the blockchain community is testing the assumptions of game theory and applying it in the real world for business models with real value at stake. Reality can be bracing. Only invest what you can afford to completely lose. This is still a highly experimental industry.

But economics has much, much more to contribute to our understanding of the blockchain economy than just Hayekian monetary theory and textbook game theory. Our friends at Agoric know this — they already had an economist in their team. They know and understand that it isn’t enough to have good code — to succeed, you need to have economically coherent code.

To that end, we have developed a new field of economics: institutional cryptoeconomics. In this field, we apply the transaction cost economics of Ronald Coase and Oliver Williamson to explore blockchain as an economic institution competing with and complementing the schema of firms, markets, states, clubs and the commons.

The economic foundation of our institutional cryptoeconomics is broad and solid. In addition to economics Nobel laureates like Hayek, Ronald Coase, and Oliver Williamson, we have also incorporated the work of other laureates such as Herbert Simon, Douglass North, Elinor Ostrom, and Jean Tirole into our blockchain research. Then we’’ve drawn on should-have-been-laureates such as Joseph Schumpeter, William Baumol, Armen Alchian, and Harold Demsetz are included. Economists such as Andrei Shleifer and Israel Kirzner could still win a Nobel.

Merton Miller — himself an economics laureate — once argued that there was nothing more practical than good theory. Our experience working with Agoric has convinced us of the value of very good theory. We have had plenty of help — actual practitioners trying to solve immediate real-world problems are hard task masters. Ideas cannot remain half-baked — they must be fully explained and articulated. Working with Agoric has been an intellectually intense, extended interactive academic seminar where ideas are taken from vague hunch to ‘how can this be implemented’ and back again. From whiteboard to business model.

As academics we have learned which ideas, models and tools are of immediate use and value in the blockchain world. There have been some surprises here. Whoever would have thought that edgeworth boxes would have a practical real world application? Or indifference curves? But here we are. When building an entire economic ecosystem — the Agoric economy — we have had to draw upon the full breadth of our economic training. We suspect that having an economics team on board will become an industry standard in the years to come.

We have benefited as educators too. Of course, explaining complex ideas to highly intelligent laypeople is a large part of our day job. The stakes, however, are much higher. The Agoric team aren’t seeking information to pass a class test. They are seeking information to pass a market test — that the market will grade. As another favorite economist of ours Ludwig von Mises explained, consumers are hard task masters.

Our own students particularly have benefited from our Agoric experience. We now have a deeper understanding of industry needs and thought in the blockchain space. We know which ideas interest them and which don’t. The Agoric team questioned us closely on some topics. Our students will know how to answer those questions.

It also turns out that financial engineering is far more important than we thought it would be when we first started working on blockchain economics. The work with Agoric has coincided with the defi boom — a richly anarchic and innovative movement within the blockchain space. As a consequence, the blockchain for business degree programs that we have launched at RMIT have huge dollops of finance in them.

We share with Agoric a vision of the future where technology leads to an improvement in human flourishing and an enhancement of our capacity to lead full lives.

In a new book published by the American Institute for Economic Research we’ve argued that blockchain and other frontier technologies offer us the tools to actively take back liberties we may have lost.

With Agoric, it is incredibly exciting to be able to actually build the economy of the future that we’ve been studying.

How to understand the credentialing industry

With Jason Potts. Originally a Medium post.

Let’s take a birds’ eye view of the Australian economy. What do we produce? In order: iron ore, coal, and credentials.

Tertiary education is Australia’s third-largest export industry. And Australia is the third-largest education exporter in the world, behind the US and UK.

The world’s skilled labour markets are dependent upon proof of identity, experience and skills, including education qualifications, trade certification and occupational licensing. The smooth operation of these markets relies on the technical infrastructure that supports those credentials: a continually updated, reliable, trusted and efficient public registry of qualifications and skills.

We call this intersection of the education sector and access points into global labour markets the credentialing industry.

We’re university academics, but the credentialing industry encompasses much more than universities. In fact, it’s about more than just education. A surprisingly large fraction of the economy supplies and deliver credential services.

  • High school education and equivalencies (completion certification)
  • University credentials (course credits, graduate certificates, diplomas, bachelors degrees, higher degrees)
  • Vocational education credentials and trade certifications (hairdressing, electrician, builder, etc.)
  • Industry and professional association based qualifications (e.g. accounting [CPA, ACA], law [the Bar], finance [FINSIA], etc.)
  • Proficiency qualifications (languages, driving, etc.)
  • Occupational licenses (surgeons, pilots, dentists, teaching, etc.)

Credentials prove skills and qualities, and trusted claims of skills and capabilities are an input into contracts and jobs. They are an institutional token that carries trusted information that facilitates transactions in almost every labour market, many service markets, and all professional markets in an economy.

As the economy becomes more complex, the workforce will need to be more highly skilled and globally oriented. This means that credentials will be a more important output (from the credentialing industry) and input (into labour markets).

Credentials are a key institution in a modern economy. The more complex and developed the economy, the more it depends on efficient and effective credential infrastructure and production.

These certifications benefit consumers, facilitating trust in professional and trade services, and employers, facilitating trusted information about skills and capabilities. The more complex the economy, the more important and valuable are credentials.

But what exactly is a credential? Credentials are a type of institutional technology that is produced by the education sector, by professional and trade associations, and by government, often jointly.

So from a public policy perspective, it can be hard to tell where the rules that govern the credential come from — are they from government regulation, or the private imposition of standards by a professional association. Richard Wagner calls these sorts of intermingling public/private rules entangled political economy.

From a technology perspective, a credential is a bundle of:

  • Identity (who does it attach to)
  • Registry (what is the content of claims made)
  • Assessment and evaluation (how have they been verified, and by whom)
  • Storage, maintenance and recall (an effective transactional database)

A credential has institutional and technical properties:

  • Trust and transparency
  • Security and auditability
  • Transactional value in use

A credential is essentially an entry in a ledger. But centralized credential technology has limitations in all of the above dimensions. Blockchain technology presents an opportunity to revolutionise the credential sector by offering a more effective, scalable and secure platform for the production and use of credentials.

For Australia, innovation in blockchain credentials, will benefit a major export industry, increasing administrative efficiency and facilitating adoption of digital technology in tertiary education, as well as improve the functioning of labour markets in Australia and around the world, increasing the quality of job matching and lowering the cost of employment. We expect blockchain adoption in the credentialing industry is expected to drive economic growth, exports, and jobs.