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.

Repugnant innovation

With Darcy WE Allen and Sinclair Davidson. Available at SSRN

Abstract: Repugnant innovation is a form of evasive entrepreneurship that occurs in repugnant markets. Repugnance is an informal institution – controlled by long-lived norms, attitudes, customs and traditions – and repugnant innovation acts to shift institutions at the lowest level of the institutional stack. The paper considers three examples of repugnant innovation: e-cigarettes, online gambling, and webcam modelling. Each repugnant innovation challenges the complex mixture of material and moral concerns that contributes to repugnance in their respective markets. The paper adds to and expands on a body of evidence about innovation in apparently unsupportive institutional environments.

Trust and Governance in Collective Blockchain Treasuries

With Darcy WE Allen and Aaron M Lane. Available at SSRN

Abstract: Blockchain treasuries are pools of digital assets earmarked for funding goods and services within a blockchain ecosystem that have some public purpose, such as protocol upgrades. Ecosystem participants face a trust problem in ensuring that the treasury is robust to opportunism, such as theft or misappropriation. Treasury governance tools, such as expert committees or stakeholder voting, can bolster trust in treasury functions. In this paper we use new comparative economics to examine how treasury governance mechanisms minimise different types of costs, thereby bolstering trust. We interpret case studies of innovative treasury governance within this framework, finding that the costs shift throughout the lifecycle of an ecosystem, and those subjective costs are revealed through crisis. These changes lead ecosystem participants to choose and innovate on treasury governance.

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 fundingfutarchy, 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.

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.

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.

Submission to Select Committee on Financial Technology and Regulatory Technology (Response to Interim Report and Second Issues Paper)

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

A submission to the Senate Select Committee on Financial Technology and Regulatory Technology (‘Committee’) following the tabling of the Committee’s Interim Report and the publication of the Second Issues Paper, focusing on the regulatory implications of blockchain technology.

Available in PDF here.

The Political Economy of Australian Regulatory Reform

With Darcy WE Allen, Aaron M Lane and Patrick A. McLaughlin. Published in Australian Journal of Public Administration, 18 September 2020

Abstract: The problem of regulatory accumulation has increasingly been recognised as a policy problem in its own right. Governments have then devised and implemented regulatory reform policies that directly seek to ameliorate the burdens of regulatory accumulation (e.g. red tape reduction targets). In this paper we examine regulatory reform approaches in Australia through the lens of policy innovation. Our contributions are twofold. We first examine the evolutionary discovery process of regulatory reform policies in Australia (at the federal, intergovernmental and state levels). This demonstrates a process of policy innovation in regulatory mechanisms and measurements. We then analyse a new measurement of regulatory burden based on text analytics, RegData: Australia . RegData: Australia uses textual analysis to count “restrictiveness clauses” in regulation—such as “must”, “cannot” and “shall”—thereby developing a new database. We place this “restrictiveness clauses” measurement within the context of regulatory policy innovation, and examine the potential for further innovation in regulatory reform mechanisms.

Available at Australian Journal of Public Administration. Working paper available at SSRN