Governance for innovation Part 2: what can we learn from the rise of cryptoeconomics?

This is the second article in a series exploring ‘governance by design’, specifically when the design or purpose is to enable and sustain innovation. In the first article, I considered how, starting in the 1960s, venture capitalists (VCs) brought a distinctive approach to the classic form of hierarchical corporate governance of the early-stage firm. Observing the distinctives of the VC approach, I proposed the first two principles for governance by design: achieving risk alignment among key stakeholders; and proportionality in risk management. 

In this second article, I want to focus the spotlight on a much more recent trend: the rise of cryptoeconomics. I use that term rather than say, ‘Web3.0’ or ‘blockchain’, because those terms tend to place a focus on the technology itself rather than the organizational forms it enables. Rather, I follow Nathan Schneider of the University of Colorado Boulder who in a recent blog available here defines cryptoeconomics as “an area of applied cryptography that takes economic incentives and economic theory into account.” It is exactly because my interest here is in exploring how applied cryptography is shaping human incentives and therefore the governance of entities old and new that I also don’t use here the more generic terms distributed or decentralized governance.  I have used those terms before in a previous article contrasting modern corporate governance (‘mGov’) with the rise of decentralized governance (‘dGov’). Of course, decentralized governance long predates the advent of cryptoeconomics, but the widespread application of cryptoeconomic tools has enabled and empowered new thinking about applications beyond the world of Web3.0 only.

Over the past ten years, the cyptoeconomic applications of blockchain technology and smart contracts have increasingly broken out well beyond their initial domain, namely software development, to define the governance of increasingly large pools of capital in the DeFi (decentralized finance) world. Even at this relatively early stage, legal scholars are already hailing the potentially wider significance for governance. Nathan Schneider calls for more admiration of what cryptoeconomics has already accomplished in a short while, while also cautioning about a blindness to its limitations. Professor Aaron Wright of Cardozo School of Law wrote in a 2021 Stanford law journal article: “..there is early-stage indication that blockchain-based governance will have a significant impact on the way firms are governed—both by digitizing traditional governance mechanisms and by offering fundamentally new ways of organizing business enterprises.” 

My interest in this article is to assess what cryptoeconomics has to teach us about governance for innovation, as a specific instance of governance by design.

Governance by design vs design-based governance

First, a quick excursion is necessary to distinguish what I have called ‘governance by design’ from the narrower technical concept of ‘design-based governance.’ In a 2020 paper, researchers Gritsenko and Wood present their schema for distinguishing classic modes of governance such as self-governance and hierarchical governance based on two main dimensions: 



(i) whether the rules are developed and imposed ex-ante or emerge ex-post; and 

(ii) the degree of commitment to the arrangement. 

For them, design-based governance is a distinct mode in which the rules are imposed ex-ante, like in hierarchical governance; but with relatively low commitment, more similar to self-governance. Through considering three examples in which algorithms are increasingly used to make decisions, they propose that the rise of algorithmic governance through blockchain and smart contracts is becoming an important form of design-based governance. 

Why does all this context matter for our discussion here? For one thing, we need greater definitional clarity: in a new and fast-emerging field, we are all groping towards more precision with which to describe these emerging phenomena. However, even terms like algorithmic governance don’t quite fit all the proliferating types of decentralized autonomous entities (DAOs): for example, some entities are indeed fully algorithmically governed, without the ability of any party to upgrade protocols but only to ‘fork’ or ‘exit’; while others do allow for contracts to be upgraded by following governance processes. At this early stage, the wider world of cryptoeconomic governance remains sprawling and increasingly diverse. But one could say the same about the wider open-source movement itself from which many cryptoeconomic pioneers originate: open-source has become a major force in the world of software development but the modes of open-source governance differ widely–as shown in the nine different archetypes set out in Mozilla’s useful report, A Framework For Purposeful Open Source.

Against this background, I have chosen here rather to use Schneider’s term cryptoeconomic governance since, to me, it signals better that the human element in all these new schemes is not forgotten or underplayed. Indeed, Schneider and others like Primavera De Filippi have called out the ‘invisible politics’ at work in many decentralized schemes like bitcoin, leading even to the emergence of ‘crypto-politicians.’ Crypto pioneers like Vitalik Buterin have decried the emergence of ‘crypto plutocracies’ in which a few large token holders exercise effective control over apparently decentralized schemes. 

But that choice of language simply reflects my preference. More importantly, however, the concept of ‘governance by design’ is not one specific mode of governance, as design-based governance is. It is rather the meta-set of intentional choices made to shape the decision making architecture within which organizations function best. Hence, governance by design would include the consideration of whether, and if so, when, design-based governance is appropriate in a particular setting; but also of when hierarchical forms of governance are needed to achieve organizational purpose. Because I have framed the purpose here as sustaining innovation, and because design-based governance has been such a fertile source of innovation in recent years, my inquiry here is therefore to ask what principles we may see at work in cryptoeconomics which may inform the wider principles of how to optimize governance for innovation. 

Three distinctive features for innovating governance

There are three main features through which cryptoeconomic governance will shape the wider landscape of governance for innovation over the next decade. 

• First, the greater transparency and security of decision-making in cryptoeconomic schemes may help to build trust across diverse parties who need to collaborate to support an innovation process or system. Cryptoeconomics places an intentional focus on defining the decision-making rules from the outset of a project or organization. This focus may be more likely to create initial conditions for collaboration for innovation across diverse groups of parties–whether that innovation is embodied in a startup firm with diverse owners and workers or in a project.   

• Second, the leading organizational form of cryptoeconomics, the Decentralized Autonomous Organization (DAO), offers a way of reducing the transaction costs of organizing new forms of economic activity, especially across borders.  I have for example been approached by promoters who operate conventional services (meaning outside of Web3.0 world) who now want to explore whether the establishment of a DAO would help them scale their business offering by collaborating with others in new ways. DAOs fit the lean startup frame quite well as organizing vehicles. However, until quite recently, DAOs have lacked one crucial feature provided by the traditional corporate legal form, namely the concept of limited liability. In many jurisdictions, they may be deemed to be forms of general partnership for liability and tax purposes. However, jurisdictions from Wyoming in the US to Malta in the EU are now making provision for DAOs to achieve legal shielding through amending company laws to accommodate them. 

• Third, the concept of secure token issuance at the heart of cryptoeconomic schemes allows for a more differentiated way of allocating rights within an organization or innovation ecosystem. Tokens can allow for the separation of economic rights (the right to future revenue flow) from governance rights (the right to indicate choice around certain types of decisions) and from participation rights (the ability to contribute and be recognized for a contribution). Token systems make the concept of shares in a company seem like a primitive evolutionary way of staking claims, bundling a limited set of active governance and passive economic rights in ways which most small shareholders don’t understand and fewer still actually exercise in practice. 

To call out these powerful positive features is not to deny the darker side of cryptoeconomic governance. Even pioneering enthusiasts like Buterin or sympathetic observers like Schneider acknowledge these: for example, the lack of proofs of personhood or of integrity in Web3.0 environments act as limitations on the robustness and value of ‘pure’ cryptoeconomic design; and suggest the need to pay more attention to the incentives involved to reveal, authenticate and monitor these.

Proposing further candidate principles of governance by design

What lessons might we draw from this burgeoning cryptoeconomic world to add to our understanding of governance by design, even outside of that world alone?  I would propose they may be summarized at least in these three principles which I propose to add to the ‘canon’.

1) The design of decision-making mechanisms should be intentional from the start, and then allow for forms of evolution

Cryptoeconomic schemes are remarkable for their explicit designs of voting mechanisms for dynamic decision-making–this clarity is needed in order to code them. Reaching clarity on how different types of decisions are made is a useful feature for any governance process but is often vague in traditional companies where certain powers are usually reserved to shareholders but the rest are left vague, sometimes causing friction between boards and managers especially in early stage firms. Of course, not all decision categories can be foreseen in advance, but even to define a process by which a new type of decision would be handled may be a sign of progress in governance over vague and confusing norms or protocols. Intentionality from the start does not need to imply lock-in as it is in rigid algorithmic schemes; rather, it may provide a better basis for evolution over time.

2) Clarify the boundaries between rules and discretion as they shift over time

This is in many ways a corollary of #1: judgment-based schemes may clog up by overloading their decision-making with issues which can be decided more efficiently using other automated approaches: these could include voting schemes which can be much more sophisticated than majority voting alone. Not all decisions require the same amount of judgment, and distinguishing more clearly where there is value-add from the application of human discretion would be helpful. This can only happen through intentional learning around governance processes which again is rare in early stage entities. 

3) Identify wider stakeholder voices and consider new ways to engage them 

The hierarchical form of modern corporate governance is under pressure to include new classes of stakeholders as equals with providers of capital who were previously privileged in their status. This is not easy to do, especially if stakeholder groups are diverse and widespread. The emerging world of cryptoeconomic governance provides some interesting examples of how the assigning of differential rights–for example, to be heard–can be made to work more effectively. Corporate token schemes could be a way to incorporate more voices, assigning rewards and recognizing voice in new ways, which go beyond surveys only.

Conclusions



It was observing the key governance features of the world of venture capital which led to my previous suggestion that the principles of proportionality and risk alignment were foundational for governance for innovation, regardless of the organizational form: that is, they would apply in the world of DAOs as well as in early stage companies. This article’s brief excursion into the burgeoning world of cryptoeconomics has now added some further principles to the growing governance by design playbook: intentional design from the start; reset rules-discretion boundaries and harness stakeholder voice. 

Some commentators have queried whether the rise of cryptoeconomics may not create something new in organizational form, as much as turbocharge older forms of organizational governance: for example, cooperatives, the history of which goes back at least as long as limited liability companies. Jesse Walden of venture capital firm a16z has proposed here that the application of cryptoeconomic tools could enable the re-emergence of new generation cooperatives by balancing better the efficiency considerations which have long favored the emergence of companies with the greater participation benefits offered by cooperatives to their members. I think that cryptoeconomic tools may well enable that re-emergence; and more beside. Seeing them as tools, rather than as artefacts from a parallel universe, may better equip innovative organizations which pursue governance by design.