Tag: blockchain and cryptocurrencies

A better design for defi grant programs

With Darcy WE Allen

The blockchain and defi sector should understand more about how real world grant giving bodies function. Nowhere is this clearer than in the recent debate about UniSwap and its new $20 million Defi Education Fund.

In the real world, grant giving is a lot like venture finance. It is an entrepreneurial activity involving the discovery of new information, new opportunities, and new ideas. It helps realise those opportunities and ideas and is rewarded for doing so.

The fact that grants are done with a for-purpose goal while venture finance is done with a for-profit goal only makes a difference at the margin. The best grant giving bodies in the world work very hard to ensure that the custodians of funds have incentives tightly aligned to the overall objectives of the body. Some even use external independent auditors to see whether grants align to objectives, and penalise the program’s management if they do not. These rules bind the grant makers, allowing the grant seekers to innovate and discover how best to achieve the programs objectives.

Admittedly, it can be sometimes hard to see the entrepreneurial and discovery nature of grant programs. Academic research grants tend to be highly bureaucratic processes with layers of committees and appointed experts collating and judging grant proposals at arms-length from the funders.

But ultimately this bureaucracy has a purpose. Those systems of rules might seem inefficient, but they have been designed to align the dispersal of funds with the objectives of the fund. In the case of the Australian Research Council, all those committees are intended to fulfil the objectives of the Department of Education’s scientific mandate through discovery and investment. (Let’s not get hung up about how effective these government programs are.)

At the other end of the spectrum is Tyler Cowen’s Emergent Ventures grant program, where almost all decision-making is Cowen’s judgement. But this too is a structure designed to align objectives with fund dispersal. The objectives of the fund are to allow Cowen to use his knowledge to support “high-risk, high-reward ideas that advance prosperity, opportunity, and wellbeing” — and by all accounts the program is an incredible success.

Two approaches to defi grants

Right now we broadly have two models of grant giving in the defi space. The first is small centralised grant committees. These tend to be small groups of authoritative community leaders with near absolute control of large treasuries assessing and granting funds to desirable projects. These leaders may be elected or appointed, but either way they are using their authority in the community to legitimate their decisions. They may have a deep understanding of their ecosystem and its funding needs. An obvious problem with this is the risk that committee leaders opportunistically fund projects based on personal relationships, rather than ecosystem value.

The alternative model — and the most common one — is putting all grant proposals up to a vote of all relevant stakeholders, that is, holders of a governance token. Designing structures for effective collective decision-making is one of the hardest problems in political science. It is no surprise that some decision-making in the nascent blockchain governance world have been controversial.

But there’s a fundamental problem with this democratic model to grant making: it makes very little sense to believe that a full distributed democratic community can make the sort of entrepreneurial decisions that we expect from both venture finance and grant giving bodies themselves. Why would we expect a diverse, pseudonymous community of governance token holders to coordinate around extremely uncertain entrepreneurial decisions?

Throwing every proposal to a mass vote is the worst of all worlds. First, every proposal ultimately becomes a public vote about the objectives of the program itself. Should the treasury’s funds be used for marketing, or research, or to build new infrastructure? Grant recipients, and the ecosystem that relies on them, are left with inconsistency and unpredictability.

Second, there is little reason to believe that a mass vote will reveal the best investments. Highly decentralised voting may protect against opportunism, but it isn’t likely to surface information about entrepreneurial investment opportunities — exactly what is needed for successful grant-giving. This precise information-revelation problem is the motivation and intuition between mechanisms such as quadratic funding, futarchy, and commitment voting.

A better grant program design

This is a solvable problem. Treasuries should give budgets to individual ‘philanthropists’. Those philanthropists then make entrepreneurial investments to align the compensation of those entrepreneurs with the success of their invested projects.

The full set of tokenholders sets the objective of the grant program, or an individual round. These objectives would shift as a given ecosystem and the broader industry develops — for instance from funding oracle feeds, to bridging infrastructure, to policy change. Grants are broken into funding rounds. The length of those rounds, say a year or two, must be long enough that there are observable outcomes from grant projects. Rounds could be sequential or overlap.

Each round, a set of philanthropists (say, five) are chosen (elected or appointed) and given discrete budgets. The number of philanthropists for a given round could also be decided by all tokenholders.

Once the funds are dispersed to each philanthropist, they run separate and independent grant programs. They must have credible autonomy: with their own rules, their own application processes, and their own interpretation of the objectives of the overall grant program.

At the end of the round, the full set of tokenholders rank each of the five philanthropists according to how successful (how much value was added, how closely they aligned to objectives) their grants were. The philanthropists are compensated for their work based on that ranking, with the top-ranked getting the most reward.

In this way the grants program is designed to both fund projects, and to incentivise decision-making philanthropists to do a good job.

Our proposal drives the same sort of competitive, entrepreneurial energy that we see in venture finance into defi grant distribution.

Through grant program design we can encourage effective decision-making through feedback loops, while maintaining decentralisation (the risk that philanthropists will behave badly is limited to the length of a grant round) and giving philanthropists a personal stake in the success of the grants that they have distributed (encouraging them to support and shepherd them to fruition).

Grant program design matters a lot

It might be easy to dismiss grant program design as a sideshow in the blockchain industry, marginally interesting but ultimately not a central part of the success of any particular protocol. It would be wrong to do so.

Analogies in blockchain are difficult. But if DAOs are like corporations, then grant programs are how they do internal capital allocation — and as Alfred D. Chandler Jr. has shown, internal capital allocation has determined the shape of global capitalism. Alternatively, if blockchain ecosystems are like countries with governments, then when we talk about grant programs we’re talking about public finance — they are how we pay for public goods and deploy scarce resources in a democratic context.

Ultimately, the sustainability and robustness blockchain ecosystems require effective use of resources. The success of grant programs will form a critical part of the success of blockchain and dapp protocols. They should seek to harness the same entrepreneurial energy and effort that has driven the rest of the blockchain industry.

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 culture, knowledge 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.

Setting the reserve price for the Tracer DAO Gnosis auction

With Peyman Khezr

Introduction: Selling multiple units of a homogeneous good in an auction is one way of determining the market price. Uniform-price auctions have been used in many real-world markets because of their price discovery property: All winning bidders pay the same price (either highest losing bid or lowest winning bid). The question is how a seller could compute an optimal reserve price in a uniform price auction. First we should note that literature suggests a positive reserve price is usually better than no reserve price as it reduces the chance of underbidding by bidders. However, to compute the reserve price for a uniform price auction there are no clear criteria. In this note we follow the criteria given for the second-price auction as the best approximate of the uniform-price auction.

PDF available here

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.

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.

Rentseeking in blockchain governance: the awkward transition from market decisionmaking to non-market decisionmaking

Abstract: Blockchains and applications built on blockchains are decentralised ecosystems that are nonetheless built by centralised firms. The typical launch and maturity of a blockchain ecosystem involves the transition from an entrepreneurial institutional arrangement characterised by market decisionmaking to a decentralised one characterised by non-market decisionmaking. This paper considers how to assess rentseeking in the context of blockchain governance. Rentseeking in blockchain implementations and ecosystems occurs when participants seek rewards or privileges in excess what would be considered a market contribution after a certain threshold of decentralisation. The paper considering two controversies in blockchain governance – the Zcash founders’ reward and the SushiSwap developer fund – which involved the intertwining of mechanisms to fund public goods with mechanisms to compensate founders for their entrepreneurial effort. The paper finds that the normative ideal of decentralisation in blockchain governance has a parallel function to the normative ideal of liberal governance in political systems.

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.

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.

Response to Questions on Notice: Senate Select Committee on Financial Technology and Regulatory Technology

With Darcy W.E. Allen and Aaron M. Lane

Response to questions on notice at Senate Select Committee on Financial Technology and Regulatory Technology.

The capital gains taxation regime as it applies to cryptocurrency
is no longer appropriate

The Australian Taxation Office’s position that cryptocurrency is an asset for capital gains tax purposes and that every exchange between two cryptocurrency tokens should be treated as a “disposal” creates substantial regulatory compliance burdens on taxpayers, hinders fintech adoption, and achieves no policy objective.

This treatment of tokens poses unique challenges for cryptocurrency users. As each tokento-token exchange is treated by the ATO as a capital gains tax event, taxpayers are required to record gains or losses in the Australian dollars. However, token-to-token exchanges often occur at multiple times removed from Australian dollar-denominated markets. For many cryptocurrency tokens, liquid token-AUD exchange markets do not exist. In addition, the volume and complexity of some of these token exchanges make precise accounting of gains and losses on a per-transaction basis unrealistic, even for honest taxpayers seeking to fully ensure compliance.

Token-to-token exchanges of cryptocurrencies and other digital assets are foundational to the development of the digital economy, contributing to price and business model discovery. The current capital gains tax treatment to token-to-token exchanges imposes significant and unnecessary uncertainty and regulatory burden on cryptocurrency users, investors and the blockchain industry more generally.

The capital gains tax regime may have been appropriate five years ago when the cryptoeconomy was smaller, less complex and when there were relatively few places to make token-to-token exchanges. However, recent developments make the current policy regime inappropriately narrow and imposing. For example, the rise of decentralised finance (‘defi’) means that token-to-token exchanges are now commonly occurring through a vast ecosystem of decentralised protocols that operate at multiple levels removed from Australian dollar-denominated markets and provide no easy-to-use tools for the granular record keeping required by the ATO.

Additionally, the tokens that are being exchanged are also changing as the cryptoeconomy has developed. Defi activity can result in tokens being locked up in exchange for ‘governance’ tokens. Tokens that represent claims on other tokens through smart contracts – often necessary to acquire in order to participate in economic activity across multiple blockchains – can trade at a premium or discount. Treating these token-to-token swaps as capital gains events serves no policy purpose, and adds significant ambiguity and uncertainty to the Australian tax system.

The current regime also risks cryptocurrency users accumulating an Australian dollar-denominated tax liability that might be tied up in illiquid tokens.

The committee should understand that compliance with this regime in the Australian public is likely to be very low and the risk of taxpayers making errors in attempting to comply with the current legislation is very high.

Recommendation:

We recommend that CGT events be limited to exchanges where it is reasonable to comply with the capital gains tax regime. These would be when:

  • Cryptocurrency is exchanged with fiat currency (most commonly the Australian dollar),
  • Cryptocurrency is used in the acquisition or disposal of a tangible good or service, or a non-fungible token (such as a piece of digital art). Depending on the CGT classification of the respective token (for example a personal use asset or collectable), these transactions may yield the normal concessional treatments.

The burden of demonstrating compliance with these rules would remain with the taxpayer. This approach would significantly simplify the capital gains tax regime while reducing regulatory burdens, encourage innovation and the expansion of blockchain and cryptocurrency jobs in Australia, and be revenue neutral to the Commonwealth government.

The managed investment scheme regime doesn’t suit autonomous (algorithmic) financial products

A managed investment scheme (MIS) is an investment structure where a “responsible entity” manages investments for unit holders. In summary, the Corporations Act 2001 (Cth) provides that a MIS will exist where (i) members contribute money or money’s worth as consideration to acquire rights to benefits produced by the scheme; (ii) any of the contributions are to be pooled, or used in a common enterprise, to produce financial benefits, or benefits consisting of rights or interests in property, for the members; and (iii) the members do not have day-to-day control over the operation of the scheme. Generally, a MIS is required to be registered with ASIC if it has more than 20 members. A registered entity is required to be a public company and hold an Australian Financial Services License.

There is a significant risk facing blockchain companies in Australia that the MIS regime will be inappropriately applied, particularly as it pertains to decentralised finance (‘defi’) products. There is approximately US$41.5 billion worth of tokens in the defi ecosystem. Inappropriate and high cost regulation threatens the viability of the defi industry in Australia and will send entrepreneurs and job-makers overseas.

For example, popular defi applications include a class of automated market makers (AMMs) that allow users to make token-to-token exchanges outside ‘traditional’ centralised exchanges like Binance or Coinbase. Investors pool tokens in these automated exchanges, earning profit through fees. The pool automatically prices exchanges in a way that rebalances the pool, guaranteeingthat each asset is always available.

It is likely an AMM would be considered a MIS within the legal definition outlined above. However, there are several regulatory problems in applying the MIS regulatory framework to defi products like AMMs:

  • These schemes have no manager – that is, there is no responsible entity on whom the obligations of a financial services licence could be meaningfully imposed or exercised. The scheme – and thus the return on the investment – is determined entirely algorithmically.
  • Automated market makers like this have no responsible agent. Amendments to the protocol (for example, varying the fee for investors) are entirely controlled by the voting behavior of governance token holders (typically investors).

Applying the rules governing managed investment schemes to these autonomous and algorithmic financial products is a category error.

In any case, treating a defi product as an MIS would not achieve the government’s policy goals. Defi products are censorship resistant and fully digital. Australian investors are able to interact with defi products developed around the world at almost zero cost. Regulatory avoidance is trivially easy because these products can be freely “forked” (that is, their code copied, modified, and re-deployed permissionlessly). Applying the MIS framework to Australia-built defi products means that Australian companies are highly reluctant to innovate in this frontier fintech field.

The committee might consider amending the government’s enhanced fintech sandbox or develop a new blockchain technology specific sandbox to deal allow for defi products. However, we do not recommend this approach. One problem is that the current sandbox rules (such as limitations on the amount of money invested, or persons involved) would be inappropriate for defi because of the absence of centralised management, the ease of forking, and the quantum of funds. For example, automated exchanges have no mechanism to limit the size of the total pool (doing so would potentially reduce the stability of the pool) and even if limits were implemented they could be avoided through forking the pool and re-deploying it. Furthermore, if regulators were to determine that the defi product no longer compliant with the sandbox rules, given the uncensorable nature of blockchain, there would be no mechanism by which regulators could insist that the product could cease trading.

Recommendation:

We recommend that the Corporations Act be amended to exempt “autonomous financial products” from the existing definition of a MIS. To qualify as an autonomous financial product, the product needs to be:

  • Fully algorithmically deterministic (that is, all investment decisions are made by an algorithm rather than a responsible human entity);
  • Governance decisions are sufficiently decentralised and made solely by those who have invested; and
  • Fully open source, with its code published on a recognised platform (such as
    GitHub), allowing investors to scrutinise the code themselves.

This change would be straightforward and is consistent with the existing legislative approach of the Act. While legislative change is preferred to provide certainty, we note that this approach could also be achieved through regulation as section 9 of the Act provides a mechanism for the Regulations to declare that a scheme is not a MIS.

PDF version with references and footnotes available in here.