The exchange theory of web3 governance (or ‘blockchains without romance’)

Working paper with Jason Potts, Darcy W E Allen, Aaron M. Lane and Trent MacDonald. Available on SSRN

Abstract: Blockchains have enabled innovation in distributed economic institutions, such as money (e.g. cryptocurrencies) and markets (e.g. DEXs), but also innovations in distributed governance, such as DAOs, and new forms of collective choice. Yet we still lack a general theory of blockchain governance. James Buchanan once described public choice theory as ‘politics without romance’ and argued instead for an exchange theory of politics. Following Buchanan, we argue here for an exchange view of blockchain governance. The ‘romantic’ view of blockchain governance is collective choice and consensus through community voting. The exchange view, instead, is focused on entrepreneurial discovery of opportunities for value creation in governance space through innovation in protocols (e.g. Curve, Convex, Lido, Metagov, etc) that facilitate exchange of coordination and voting rights, that are newly made possible through tools that enable pseudonymous, composable and permissionless governance actions. The exchange lens on web3 governance also helps illuminate how this emergent polycentric process can generate robustness in decentralised systems.

Crypto-macroeconomics

With Jason Potts and Sinclair Davidson. Book chapter, available at SSRN.

Abstract: This chapter presents a Wagnerian vision of macroeconomics as a hybrid of several schools of thought and analytic frameworks, including public choice theory, constitutional economics, complexity economics, and evolutionary economics. We then review recent economic analysis of emerging crypto-economic systems. Toward synthesis, we propose that Wagnerian macroeconomics is a useful framework to understand how blockchains and crypto assets provide economic infrastructure and institutions for new private order economies, a new research field we call crypto-macroeconomics. We explore four proposed subfields of crypto-macroeconomics: technology, constitutions, money, and policy.

On Coase and COVID-19

With Darcy WE Allen, Sinclair Davidson and Jason Potts. European Journal of Law and Economics volume 54, page 107–125 (2022)

Abstract: From the epidemiological perspective, the COVID-19 pandemic is a public health crisis. From the economic perspective, it is an externality and a social cost. Strikingly, almost all economic policy to address the infection externality has been formulated within a Pigovian analysis of implicit taxes and subsidies directed by a social planner drawing on social cost-benefit analysis. In this paper, we draw on Coase (1960) to examine an alternative economic methodology of the externality, seeking to understand how an exchange-focused analysis might give us a better understanding of how to minimise social cost. Our Coasean framework allows us to then further develop a comparative institutional analysis as well as a public choice theory analysis of the pandemic response.

Published here. Working version available at SSRN or in PDF here.

Towards a Digital CBD

With Darcy Allen and Jason Potts

The COVID-19 pandemic is both a public health crisis, and a digital technology accelerant. Pre-pandemic, our economic and social activities were done predominantly in cities. We connected and we innovated in these centralised locations.

But then a global pandemic struck. We were forced to shop, study and socialise in a distributed way online. This shock had an immediate impact on our cities, with visceral images of closed businesses and silent streets.

Even after COVID-19 dissipates, the widespread digital adoption that the pandemic brought about means that we are not snapping back to pre-pandemic life.

The world we are entering is hybrid. It is both analogue and digital, existing in both regions and cities. Understanding the transition is critical because cities are one of our truly great inventions. They enable us to trade, to collaborate, and to innovate. In other words, cities aggregate economic activity.

The Digital CBD project is a large-scale research project that asks: what happens when that activity suddenly disaggregates? What happens to the city and its suburbs? What happens to the businesses that have clustered around the CBD? What infrastructure do we need for a hybrid digital city? What policy changes will be needed to enable firms and citizens to adapt?

Forced digital adoption

This global pandemic happened at a critical time. Many economies were already transitioning from an industrial to a digital economy. Communications technologies had touched almost every business. Digital platforms were commonly used to engage socially and commercially. But the use of these technologies was not yet at the core of our businesses, it sat on the sidelines. We were only on the cusp of a digital economy.

Then COVID-19 forced deep, coordinated, multi-sector and rapid adoption of digital technologies. The coordination failures and regulatory barriers that had previously held us back were wiped away. We swapped meeting rooms for conference calls, cash for credit cards, pens-and-paper for digital signatures. There had been a desire for these changes for a long time.

These changes make even more frontier technologies suddenly come into view. Blockchains, artificial intelligence, smart contracts, the internet of things and cybersecurity technologies are now more viable because of this base-level digital adoption.

Importantly, this suite of new technologies doesn’t just augment and improve the productivity of existing organisations, they make new organisational forms possible. It changes the structure of the economy itself.

Discovering our digital CBD

Post-pandemic, parts of our life and work will return to past practices. Some offices will reopen, requiring staff to return to rebuild morale and culture. And those people will also flood back into CBD shops, bars and restaurants. They will, as all flourishing cities encourage, meet and innovate.

But of course some businesses will relish their new-found productivity benefits – and some workers will guard the lifestyle benefits of working from home. Many firms will never fully reopen their offices and will brag about their remote-work dynamic culture.

The potential implications for cities, however, are more complex. Cities will fundamentally have different patterns of specialisation and trade than a pre-pandemic economy. Those new patterns are enabled by a suite of decentralised technologies, including blockchains and smart contracts, that were already disrupting how we organise our society.

We can now organise economic activity in new ways. CBDs have historically housed large, hierarchical industrial-era companies. As we have written elsewhere, decentralised infrastructure enables new types of organisational forms to emerge. Blockchains industrialise trust and shift economic activities towards decentralised networks.

How do these new types of industrial organisation change the way that we work, and the location of physical infrastructure? What are the policy changes necessary to enable these new organisations to flourish in particular jurisdictions?

Economies and cities are fundamentally networks of supply chains, and that infrastructure is turning digital too. The pandemic has accelerated the transition to digital trade infrastructure that provides more trusted and granulated information about goods as they move. How can we ensure that these digital supply chains are resilient to future shocks? What opportunity is there for regions to become a digital trade hub?

Another impact of digital technology is that labour markets just became more global. The acquisition of talented labour is no longer bounded by physical distance. Our collaborations are structured around timezones, rather than geography.

Labour market dynamism presents unique opportunities, but will also require secure infrastructure both to validate credentials and to facilitate ongoing productivity. How can Melbourne, a world-class cluster of universities, place itself for this new environment?

A research and a policy problem

Building a digital CBD is fundamentally an entrepreneurial problem—a problem of discovering what these new digital ways of coordinating and collaborating look like. Our Digital CBD research program contributes to this challenge with insights from economics, law, political science, finance, accounting and more. We aim to use this interdisciplinary research base to make policy recommendations that help our digital CBD to flourish.

Building a grammar of blockchain governance

With Darcy Allen, Sinclair Davidson, Trent MacDonald and Jason Potts. Originally a Medium post.

Blockchains are institutional technologies made of rules (e.g. consensus mechanisms, issuance schedules). Different rule combinations are entrepreneurially created to achieve some objectives (e.g. security, composability). But the design of blockchains, like all institutions, must occur under ongoing uncertainty. Perhaps a protocol bug is discovered, a dapp is hacked, treasury is stolen, or transaction volumes surge because of digital collectible cats. What then? Blockchain communities evolve and adapt. They must change their rules (e.g. protocol security upgrades, rolling back the chain) and make other collective decisions (e.g. changing parameters such as interest rates, voting for validators, or allocating treasury funds).

Blockchain governance mechanisms exist to aid decentralised evolution. Governance mechanisms include online forums, informal polls, formal improvement processes, and on-chain voting mechanisms. Each of these individual mechanisms — let alone their interactions — are poorly understood. They are often described through sometimes-useful but imperfect analogies to other institutional systems with deeper histories (e.g. representative democracy). This is not a robust way to design the decentralised digital economy. It is necessary to develop a shared language, and understanding, of blockchain governance. That is, a grammar of rules that can describe the entire possible scope of blockchain governance rules, and their relationships, in an analytically consistent way.

A starting point for the development of this shared language and understanding is a methodology and rule classification system developed by 2009 economics Nobel Laureate Elinor Ostrom to study other complex, nested institutional systems. We propose an empirical project that seeks conceptual clarity in blockchain governance rules and how they interact. We call this project Ostrom-Complete Governance.

The common approach to blockchain governance design has been highly experimental — relying very much on trial and error. This is a feature, not a bug. Blockchains are not only ecosystems that require governance, but the technology itself can open new ways to make group decisions. While being in need of governance, blockchain technology can also disrupt governance. Through lower costs of institutional entrepreneurship, blockchains enable rapid testing of new types of governance — such as quadratic voting, commitment voting and conviction voting — that were previously too costly to implement at scale. We aren’t just trying to govern fast-paced decentralised technology ecosystems, we are using that same technology for its own governance.

This experimental design challenge has been compounded by an ethos and commitment to decentralisation. That decentralisation suggests the need for a wide range of stakeholders with different decision rights and inputs into collective choices. The lifecycle of a blockchain exacerbates this problem: through bootstrapping a blockchain ecosystem can see a rapidly shifting stakeholder group with different incentives and desires. Different blockchain governance mechanisms are variously effective in different stages of blockchain development. Blockchains, and their governance, begin relatively centralised (with small teams of developers), but projects commonly attempt to credibly commit to rule changes towards a system of decentralised governance.

Many of these governance experiments and efforts have been developed through analogy or reference to existing organisational forms. We have sought to explain and design this curious new technology by looking at institutional forms we know well, such as representative democracy or corporate governance. Scholars have looked to existing familiar literature such as corporate governance, information technology governance, information governance, and of course political constitutional governance. But blockchains are not easily categorised as nation states, commons, clubs, or firms. They are a new institutional species that has features of each of these well-known institutional forms.

An analogising approach might be effective to design the very first experiments in blockchain governance. But as the industry matures, a new and more effective and robust approach is necessary. We now have vast empirical data of blockchain governance. We have hundreds, if not thousands, of blockchain governance mechanisms, and some evidence of their outcomes and effects. These are the empirical foundations for a deeper understanding of blockchain governance — one that embraces the institutional diversity of blockchain ecosystems, and dissects its parts using a rigorous and consistent methodology.

Embracing blockchain institutional diversity

Our understanding of blockchain governance should not flatten or obscure away from its complexity. Blockchains are polycentric systems, with many overlapping and nested centres of decision making. Even with equally-weighted one-token-one-vote blockchain systems, those systems are nested within other processes, such as a github proposal process and the subsequent execution of upgrades. It is a mistake to flatten these nested layers, or to assume some layers are static.

Economics Nobel LaureateElinorOstrom and her colleagues studied thousands of complex polycentric systems of community governance. Their focus was on understanding how groups come together to collectively manage shared resources (e.g. fisheries and irrigation systems) through systems of rules. This research program has since studied a wide range of commons including cultureknowledge and innovation. This research has been somewhat popular for blockchain entrepreneurs, in particular through using the succinct design principles (e.g. ‘clearly defined boundaries’ and ‘graduated sanctions’) of robust commons to inform blockchain design. Commons’ design principles can help us to analyse blockchain governance — including whether blockchains are “Ostrom-Compliant” or at least to find some points of reference to begin our search for better designs.

But beginning with the commons design principles has some limitations. It means we are once again beginning blockchain governance design by analogy (that blockchains are commons), rather than understanding blockchains as a novel institutional form. In some key respects blockchains resemble commons — perhaps we can understand, for instance, the security of the network as a common pool resource — but they also have features of states, firms, and clubs. We should therefore not expect that the design principles developed for common pool resources and common property regimes are directly transferable to blockchain governance.

Beginning with Ostrom’s design principles begins with the output of that research program, rather than applying the underlying methodology that led to that output. The principles were discovered as a meta-analysis of the study of thousands of different institutional rule systems. A deep blockchain-specific understanding must emerge from empirical analysis of existing systems.

We propose that while Ostrom’s design principles may not be applicable, a less-appreciated underlying methodology developed in her research is. In her empirical journey, Ostrom and colleagues at the Bloomington School developed a detailed methodological approach and rule classification system. While that system was developed to dissect the institutional complexity of the commons, it can also be used to study and achieve conceptual clarity in blockchain governance.

The Institutional Analysis and Development (IAD) framework and the corresponding rule classification system, is an effective method for deep observation and classification of blockchain governance. Utilising this approach we can understand blockchains as a series of different nested and related ‘action arenas’ (e.g. consensus process, a protocol upgrade, a DAO vote) where different actors engage, coordinate and compete under sets of rules. Each of these different action arenas have different participants (e.g. token holders), different positions (e.g. delegated node), and different incentives (e.g. to be slashed), which are constrained and enabled by rules.

Once we have identified the action arenas of a blockchain we can start to dissect the rules of that action arena. Ostrom’s 2005 book, Understanding Institutional Diversity, provides a detailed classification of rules classification that we can use for blockchain governance, including:

  • position rules on what different positions participants can hold in a given governance choice (e.g. governance token holder, core developer, founder, investor)
  • boundary rules on how participants can or cannot take part in governance (e.g. staked tokens required to vote, transaction fees, delegated rights)
  • choice rules on the different options available to different positions (e.g. proposing an upgrade, voting yes or no, delegating or selling votes)
  • aggregation rules on how inputs to governance are aggregated into a collective choice (e.g. one-token-one-vote, quadratic voting, weighting for different classes of nodes).

These rules matter because they change the way that participants interact (e.g. how or whether they vote) and therefore change the patterns that emerge from repeated governance processes (e.g. low voter turnout, voting deadlocks, wild token fluctuations). There have been somestudies that have utilised the broad IAD framework and commons research insights to blockchain governance, but there has been no deep empirical analysis of the rule systems of blockchains using the underlying classification system.

The opportunity

Today the key constraint in advancing blockchain governance is the lack of a standard language of rules with which to describe and map governance. Today in blockchain whitepapers these necessary rules are described in a vast array of different formats, with different underlying meanings. That hinders our capacity to compare and analyse blockchain governance systems, but can be remedied through applying and adopting the same foundational grammar. Developing a blockchain governance grammar is fundamentally an empirical exercise of observing and classifying blockchain ecosystems as they are, rather than imposing external design rules onto them. This approach doesn’t rely on analogy to other institutions, and is robust to new blockchain ecosystem-specific language and new experimental governance structures.

Rather than broadly describing classes of blockchain governance (e.g., proof-of-work versus proof-of-stake versus delegated-proof-of-stake) our approach begins with a common set of rules. All consensus processes have sets of boundary rules (who can propose a block? how is the block-proposer selected?), choice rules (what decisions do block-proposers make, such as the ordering of transactions?), incentives (what is the cost of proposing a bad block? what is the reward for proposing a block), and so on. For voting structures, we can also examine boundary rules (who can vote?), position rules (how can a voter get a governance token?) choice rules (can voters delegate? who can they delegate to?) and aggregation rules (are vote weights symmetrical? is there a quorum?).

We can begin to map and compare different blockchain governance systems utilising this common language. All blockchain governance has this underlying language, even if today that grammar isn’t explicitly discussed. The output of this exercise is not simply a series of detailed case studies of blockchain governance, it is detailed case studies in a consistent grammar. That grammar — an Ostrom-Complete Grammar — enables us to define and describe any possible blockchain governance structure. This can ultimately be leveraged to build new complete governance toolkits, as the basis for simulations, and to design and describe blockchain governance innovations.

An economic theory of blockchain foundations

With Jason Potts, Darcy WE Allen, Sinclair Davidson and Trent MacDonald

Abstract: Blockchain (or crypto) foundations are nonprofit organizations that supply public goods to a crypto-economy. The standard theory of crypto foundations is that they are like governments with respect to a national or regional economy, i.e. raising a public treasury and allocating resources to blockchain specific capital works, education, R&D, etc., to benefit the community and develop the ecosystem. We propose an alternative theory of what foundations do, namely that the treasury they manage is a moat to raise the cost of exit or forking because the benefit of the fund is only available to those who stay with the chain. Furthermore, building and maintaining a large treasury is a costly signal that only a high quality chain could afford to do (Spence 1973). We review these two models of the economic function of a blockchain foundation – (1) as a private government supplying local public goods, and (2) as a moat to raise the opportunity costs of exit. We outline the empirical predictions each theory makes, and examine the implications for optimal foundation design. We conclude that foundations should be funded by a pre-mine of tokens, and work best when large, visible, transparent, rigorously managed, and with a low burn rate.

Available at SSRN.

Tracer: Perpetual Swaps

With Ryan Garner, Lachlan Webb, Jason Potts and Sinclair Davidson

Abstract: To date no platform offers permissionless market deployment of perpetual swaps. Existing offerings require governance approval and/or developer support to deploy new markets. Herein we propose a generalised perpetual swap protocol that avoids all third party requirements. The Tracer Perpetual Swap system is a Factory compatible template that offers customised market deployment without permissions. The smart contracts contain mechanisms that allow markets to operate at significantly lower cost to participants. We have designed a riskless liquidation mechanism via a slippage reimbursement receipt, rendering the act of liquidation risk-free and the cost to liquidated traders competitively inexpensive. As a result, users can trade at higher leverage and open positions with minuscule investment sizes. The Tracer Perpetual Swap is a piece of financial infrastructure that can be accessed by anybody with an internet connection. Using this infrastructure, any graphical user interface, financial institution or individual can access global market exposure in the decentralised economy.

Available at the Tracer website and in PDF here.

Tracer: Peer-to-Peer Finance

With Ryan Garner, Lachlan Webb, Jason Potts and Sinclair Davidson

Abstract: In this paper we introduce Tracer: peer-to-peer financial infrastructure for the decentralised economy. Tracer lowers the costs of participating in financial markets, using blockchain technology to enforce property rights and settle financial contracts without the need for a trusted
third party. Tracer’s Factory smart contract hosts an ecosystem of standardised financial contracts. The Tracer DAO can install proposed contract templates into the Factory, which can be accessed and deployed by anyone with a connection to the Internet. Once deployed, a contract is permissionless and not subject to DAO governance unless specified. A Reputation System allows users to identify financial risk and assess under-collateralised financial opportunities. Oracle financing is introduced as a novel model that incentivises the discovery and standardisation of new data for use in decentralised financial contracts. Tracer’s financial infrastructure stands to be the backbone of a secure, global financial network and provides strong foundations for future financial innovation.

Available at the Tracer website and in PDF here.

The Hart asset at the heart of your organisation

With Sinclair Davidson and Jason Potts

Abstract: What assets does a firm need to hold to develop a profitable business model? A ‘Hart asset’ is an asset that a firm cannot strategically afford a rival firm to own or control due to the risk of hold up, and therefore must be held within the firm, and upon which a profitable business model can be built. We tie the Hart asset to the problem of complementarities in profitable innovation, and conclude with an example Hart asset in digital platforms.

Available in PDF and at SSRN

The Cryptoeconomics of Cities, Data and Space

With Darcy W E Allen, Kiersten Jowett, Mikayla Novak, and Jason Potts. Published in in Cosmos + Taxis, Volume 8, Issue 8 + 9, 2020

Abstract: We explore the connection between new decentralised data infrastructure and the spatial organisation of cities. Recent advances in digital technologies for data generation, storage and coordination (e.g. blockchain-based supply chains and proof-of-location services) enables more granulated, decentralised and tradeable data about city life. We propose that this new digital infrastructure for information in cities shifts the organisation and planning of city life downwards and opens new opportunities for entrepreneurial discovery. Compared to centralised governance of smart cities, crypto-cities are more emergent orderings. This paper introduces this research agenda on the boundaries of spatial economics, the economics of cities, information economics, institutional economics and technological change.

Available at Cosmos + Taxis and in PDF here. Preprint available at SSRN. (Previously titled ‘Spatial Institutional Cryptoeconomics’)