Abstract: Blockchain applications are increasingly experimenting with novel governance mechanisms that address issues that are important for their community: resistance to voter fraud in the form a Sybil attack; resistance to the formation of a plutocracy within the community; and, the ability to express preference intensity. In this paper, we take a closer look at these issues confronting decentralized governance. Our contribution is three-fold: first, we lay some analytical foundations for the formal modelling of the necessary and sufficient conditions for a voting system to be resistant to a Sybil attack; second, we show that a voting mechanism with a single instrument for expressing preference intensity, such as the quantity of tokens, cannot simultaneously achieve resistance to both Sybil attacks and plutocracy formation; and third, we design a voting mechanism, bond voting, that is Sybil resistant and offers a second instrument of voting influence (time commitment) for plutocracy resistance.
This essay follows an RMIT Blockchain Innovation Hub workshop on defi. Contributions by Darcy WE Allen, Chris Berg, Sinclair Davidson, Oleksii Konashevych, Aaron M Lane, Vijay Mohan, Elizabeth Morton, Kelsie Nabben, Marta Poblet, Jason Potts, and Ellie Rennie. Originally a Medium post.
The financial sector exists solely to smooth economic activity and trade. It is the network of organisations, markets, rules, and services that move capital around the global economy so it can be deployed to the most profitable use.
It has evolved as modern capitalism has evolved, spreading with the development of property rights and open markets. It has grown as firms and trade networks became globalised, and supercharged as the global economy became digitised.
Decentralised finance (defi) is trying to do all that. But just since 2019, and entirely on the internet.
Any business faces the question of “how do I get customers to pay for my product?” Similarly consumers ask the question, “Where and how can I pay for the goods and services I want to buy?” For the decentralised digital economy, defi answers this question. Defi provides the “inside” money necessary to facilitate transactions.
But what in traditional, centralised finance looks like banks, stock exchanges, insurance companies, regulations, payments systems, money printers, identity services, contracts, compliance, and dispute resolution systems — in defi it’s all compressed into code.
From a business perspective trade needs to occur in a trusted and safe environment. For the decentralised digital economy, that environment is blockchains and the dapps built on top.
And as we can see, defi doesn’t just finance individual trades or firms — it finances the trading environment, in the same way that taxes finance regulators and inflation finances central banks. If blockchain is economic infrastructure, defi is the funding system that develops, maintains and secures it.
These are heavy, important words for something that looks like a game. The cryptocurrency and blockchain space has always looked a little game-y, not least with its memes and “in-jokes”. The rise of defi has also had its own cartoonified vibe and it has been somewhat surreal to see millions of dollars of value pass through tokens called ‘YAMs’ and ‘SUSHI’.
Games are serious things though. A culture of gaming provides a point around which all participants can coordinate activity and experimentation — what we’re seeing in defi is the creation of a massive multiplayer online innovation system. The “rules” of this game are minimal, there are no umpires, and very little recourse, where the goal is the creation and maintenance of decentralised financial products, and willing players can choose (if and) to what extent they participate.
Because there is real value at stake, the cost of a loss is high. Much defi is tested in production and the losses from scams, unethical behaviour, or poor and inadequately audited coding are frequent.
On the other side, participation in the game of defi is remarkably open. There are few barriers to entry except a small amount of capital that players are willing to place at risk. Once fiat has been converted into cryptocurrency, the limit on participation in decentralised finance isn’t regulatory or institutional — it is around knowledge. (Knowledge is a non-trivial barrier, excluding people who could be described as naive investors. This is important for regulatory purposes.)
This is starkly different from the centralised financial system, where non-professional participants have to typically go through layers of gatekeepers to experiment with financial products.
The basic economics of defi
The purpose of defi is to ensure the supply of an ‘inside money’ — that is, stablecoins — within decentralised digital platforms and to provide tools to manage finance risks.
In the first instance defi is about consumer finance. It answers basic usability questions in the blockchain space: How do users of the platform pay native fees? Which digital money is deployed as a medium of exchange or unit of account on the platform?
In the second instance defi concerns itself with the operation of consensus mechanisms — particularly proof of stake mechanisms and their variants. The problem here is how to capture financial trust in a staking coin and then how to use that trust to generate “trust” on a blockchain. Blockchains need mechanisms to value and reward these tokens. Given the (potential) volatile nature of these tokens, risk management instruments must exist in order to efficiently allocate the underlying risk of the trading platform.
As we see it, the million yam question is whether the use of these risk management tools undermine trust in the platform itself. It is here that governance is important.
Which governance functions should attach to staking tokens and when should those functions be deployed? Should they be automated or should voting mechanisms be used? If so, which voting mechanisms and what level of consensus is appropriate for decision making.
Finally defi addresses the existence of stablecoin and staking tokens from an investor perspective. Again there are some significant questions here that the defi space has barely touched. How do these instruments and assets fit into existing investment strategies? How will the tax function respond? How much of existing portfolio theory and asset pricing applies to these instruments and assets?
Of course, we already have a complex and highly evolved centralised financial system that can provide much of the services that are being built from the ground up in defi. So why bother with defi?
The most obvious reason is that the blockchain space has a philosophical interest in decentralisation as a value in and of itself. But decentralisation addresses real world problems.
First, centralised systems can have human-centric cybersecurity vulnerabilities. The Canadian exchange QuadrigaCX lost everything when the only person with access to the cryptographic keys to the exchange died (lawyers representing account holders have requested that the body be exhumed to prove his death). Decentralised algorithmic systems have their own vulnerabilities (need we mention yams again?) but they are of a different character and unlike human nature they can be improved.
Second, centralised systems are exposed to regulation — for better or worse. For example, one of the arguments for UniSwap is that it is more decentralised than EtherDelta. EtherDelta was vulnerable to both hackers (its order book website was hacked) and regulators (its designer was sued by SEC).
Third, digital business models need digital instruments that can both complement and substitute for existing products. Chain validation instruments and the associated risk management tools presently do NOT have real world equivalent products.
Fourth and finally, the ability to digitise, fractionalise, and monetise currently illiquid real-world assets will require a suite of instruments and digital institutions. Defi is the beginning of that process.
In this sense, the defi movement is building a set of financial products and services that look superficially familiar to the traditional financial system using a vastly different institutional framework — that is, with decentralisation as a priority and without the layers of regulation and legislation that shape centralised traditional finance.
Imagine trying to replicate the functional lifeforms of a carbon-based biochemical system in a silicon based biochemical system. No matter how hard you tried — they’d look very different.
Defi has to build in some institutions that mimic or replicate the economic function provided by central banks, government-provided identity tech, and contract enforcement through police, lawyers and judges. It is the financial sector + the institutions that the traditional finance sector relies on. So, initially, it’s going to look more expensive, relative to “finance”. But the social cost of the traditional finance sector is much larger — a full institutional accounting for finance would have to include those courts and regulations and policymakers and central banks that it relies on.
Thus defi and centralised finance look very different in practice. Consider exchanges. Traditional financial markets can either operate as organised exchanges (such as the New York Stock Exchange) or as over-the-counter (OTC peer-to-peer) markets. The characteristics of those types of market are set out below.
Defi exchanges represent an attempt to combine the characteristics of both organised exchanges and over-the-counter markets. In the very instance, of course, they are decentralised markets governed by private rules and not (necessarily) public regulation. They aim to be peer-to-peer markets (including peer-to-algorithm markets in the case of AMM).
But at the same time they aim to be anonymous (in this context meaning that privacy is maintained), transparent, highly liquid, and with less counterparty risk than a traditional OTC market.
Where is defi going?
Traditional finance has been developing for thousands of years. Along with secure private property rights and the rule of law, it is one of the basic technologies of capitalism. But of those three, traditional finance has the worst reputation. It has come to be associated with city bros and the “Wolf of Wall Street”, and the Global Financial Crisis. Luigi Zingales has influentially argued that the traditional finance system has outgrown the value it adds to society, in part because of the opportunities of political rent seeking.
This makes defi particularly interesting. Defi is for machines. Not people. It represents the automation of financial services.
A century ago agriculture dominated the labour force. The heavy labour needs of farming are one of the reasons we were poor back then. As we added machines to agriculture — as we let machines do the farming — we reduced the need to use valuable human resources. Defi offers the same thing for finance. Automation reduces labour inputs.
Automation of course has been increasingly common in financial systems since at least the 1990s. But it could only go so far. A lot of the reason that finance (and many sectors, including government and management) resisted technological change and capital investment, was at the bottom, there had to be a human layer of trust. Now that we can automate trust through blockchains, we can move automation more deeply into the financial system.
Of course, this is in the future. Right now defi is building airplanes in 1902 and tractors in 1920. They’re hilariously bad and horses are still better. But that’s how innovation works. We’re observing the creation of the base tools for entrepreneurs to create value. Value-adding automated financial products and services comes next.
We rarely think about supply chains – those immensely complex networks of production and logistics that structure the economy.
That has changed. Early in the COVID-19 crisis, we learned that Australia imports much of its basic medical equipment like facemasks and other protective gear. As borders were being closed importing this high-demand equipment got suddenly very hard.
Now there is an unsurprising clamour for the government to take more of an interest in how our supply chains actually work, and to use the traditional tools of protectionism to encourage domestic production of medical equipment and pharmaceuticals.
Prime Minister Scott Morrison said in April that “we need to look very carefully at our domestic economic sovereignty”.
But neo-protectionism to secure Australia’s supply chains would be a grave mistake – and it fundamentally gets the supply chain challenge wrong.
First, the obvious but necessary point. We actually had a protectionist economy for most of the twentieth century. And we didn’t build facemasks. We built cars. We built cars because cars had a certain romance in the twentieth century and Labor and the union movement wanted to lock in prestigious manufacturing jobs for their supporters.
This has always been one of the central planks of the case against protectionism. The choice of what industries to protect is not made by all-knowing and benevolent leaders, but by self-interested politicians. They get to the top of their profession not because they are skilled production managers or supply chain coordinators, but because they’re great at navigating political factions and going on television.
Of course, our national leaders will come out of this crisis more focused on the risk of future pandemics, and more motivated to prepare our economy for this now-known risk. But as they say in the military, generals too often prepare for the last war, not the next one. We don’t need an economic system that is prepared for a crisis that looks exactly like COVID-19. We need an economic system that is prepared for an unexpected crisis – which, definitionally, could be anything.
Indeed, it is the fact that the pandemic was unexpected to most in government that makes the strongest case for free trade. The crisis has caused a lot of market disruption. But global supply chains have adjusted remarkably well to new demands and routed around new constraints. For example, airlines have been doing temporary conversions of passenger planes to cargo planes – particularly important because medical equipment, which in normal times would be leisurely transported by ship, needs to get to new COVID-19 hot spots urgently.
Protectionism invariably makes the industries it protects brittle and highly politicised, not agile and adaptable to sudden economic shocks. And it is a fantasy to suggest that a small, wealthy, highly-educated nation like Australia could or should ever be self-reliant in the production of all low-value goods that might be needed in unexpected crises.
There are things the government can do to be prepared for the next crisis. Rather than making essential products, we can buy them and store them. This requires no more foresight than full-blown protectionism and is a lot cheaper. The idea of keeping extensive national stockpiles of equipment for emergencies is uncontroversial. By all accounts, the National Medical Stockpile has been an immensely valuable asset during COVID-19.
With our RMIT colleague Marta Poblet, we have been looking at the problems consumers had getting reliable information on supply chain security in the first weeks of the crisis.
Before the pandemic, Australian industry was interested in using new technologies (such as blockchain, 5G communication, and smart devices) to better combat food fraud in export markets or to how to prove to their customers that their products were organic or fair trade certified.
But the pandemic revealed a more basic problem with about supply chain information. Consumers were not worried about quality or fraud. They were worried there were not enough goods available to meet demand at all – hence the panic buying of toilet paper, hand sanitizer, and dried pasta.
This panic buying looked a lot like the sort of panic withdrawals you see in a bank run. If depositors aren’t convinced their bank is solvent, they rush to be the first to get their money out. And as we saw, Scott Morrison was no better able to convince shoppers that there were adequate domestic supplies of toilet paper in March 2020 than South Australian premier Don Dunstan was able to convince the customers of the Hindmarsh Building Society that there were adequate funds to cover deposits October 1974 — despite standing in the street outside its headquarters with a megaphone.
In moments of high-stress consumers just don’t trust the political assurances they are given. Do we really blame them?
Ultimately within a few weeks supply chains adjusted. Coles and Woolworths lifted their toilet paper sale limits.
But the toilet paper panic symbolises the choice we now face when it comes to supply chain resilience. To go protectionist would be to trust our supply chains to the same political class that we simultaneously accuse of being underprepared for COVID-19. Or we could lean into free trade and open markets. We should encourage entrepreneurs to adapt rapidly to new circumstances, to experiment with new technology, and let them figure out how to operate in a disrupted global economy.
Australia has a long history of protectionism. Let’s try to remember what we learned.
Abstract: During a pandemic or other disaster, public visibility of the supply chain can be useful for controlling the symptoms of coordination failure, such as panic and hoarding, that arise from the desire for quantity assurance by various sectors of the economy. It is also important for efficient coordination of the logistics required to tackle the disaster itself, with vital information flows to centralized agencies leading the response as well as to decentralized agents upstream and downstream in a supply chain. Publicly visible information about the supply chain at the time of a crisis needs to be secure, timely, possibly selective in terms of access and the nature of information, and often anonymous. Recent advances in distributed ledger technology allow for these characteristics to be met. Building digital infrastructure that permits visibility of the supply chain when needed (even if dormant during normal times) is essential for economies to be more resilient to black swan events.