8 Nobel-Prize Winning Rules for Governance Design

…and how protocol markets improve upon existing ones

Illustration by Jac Depczyk

I discussed in our investment thesis that we believe much of the value of the web will migrate from enterprises to protocols. This is because: 1. Protocols can finally govern value transfer based on a set of business rules directly deployable on the open web 2. Digital assets can be scarce and 3. Protocols can be both more efficient and less rent-seeking at coordinating humans and machines.

What we couldn’t define at the time was how exactly the value erosion happens, and where the wedges would be created into the existing web businesses, dominated by giants.

One potential answer to this is where there are digital market failures in our society today.

In economic terms, a market failure is any time the free market fails to allocate resources efficiently, usually requiring government intervention. There are a few types of market failures, but I want to first focus specifically on the tragedy of the commons. The commons refer to a pool of scarce resources, shared by all, but not governable by any, so it’s often exploited and depleted. The only solution proposed by economic theory was privatization — letting an enterprise govern it — or nationalization — letting governments govern it.

This was until Elinor Ostrom proposed a solution which won her the Nobel Prize in Economics in 2009. She observed that many communities have successfully governed the commons provided they adhere to a set of rules. These rules are largely encoded into the fabric of trust built within the small communities she studied and never thought to be socially scalable to our large, modern societies… until crypto protocols came along.

For the first time, the rules for governing a common resource can be encoded and enforced digitally, within crypto protocols, without the need for an enterprise or a government. If we can account for the resource and enforce rules around its consumption digitally, Elinor’s findings can extend beyond the small communities where this already works in practice.

Elinor Ostrom, 1933 — 2012, Nobel Prize Winning Economist for her work in governance

Let’s take a deeper look at these rules and how crypto protocols can enforce them:

Elinor Ostrom’s 8 Principles for Governing the Commons Applied to Protocol Governance Design:
1. Define clear group boundaries: a protocol’s tokens can grant access rights to the resource governed by network in the form of a membership token or a utility currency
2. Match rules governing use of common goods to local needs and conditions: crypto protocols provide a market for matching supply with demand
3. Ensure that those affected by the rules can participate in modifying the rules: tokens can be used to grant governance rights
4. Make sure the rule-making rights of community members are respected by outside authorities: protocol must integrate with existing legal/regulatory systems
5. Develop a system, carried out by community members, for monitoring members’ behavior: protocols require a reputation system which makes market participants’ actions transparent and obvious
6. Use graduated sanctions for rule violators: protocols must provide a way to punish bad actors for bad behavior (loss of staked tokens, price of the token decreasing, exclusion from network, etc.)
7. Provide accessible, low-cost means for dispute resolution: tokens can be used to ensure skin in the game when disputes arise or to incentivize game theoretic proofs, but this has to be simple enough for people to understand
8. Build responsibility for governing the common resource in nested tiers from the lowest level up to the entire interconnected system: protocols must be inter-operable and clearly delineated

Each of these principles probably deserves to be analyzed more in detail, which I will perhaps do in a future post. However, I think we are already seeing a trend of protocol design converge towards these principles, but it’s also clear that we still have a long way to go. Overall, it’s pretty amazing now neatly some of the uses we have for protocol tokens fit into her research.

The Digital Economy

Crypto protocols will have a harder time managing the physical commons because rules like access rights are harder to enforce in meat space without some sort of central party intervention (e.g. clean air, oceans, schools, roads, etc.). However, applied to the digital commons where all the value can now be traced and tracked for the first time, real world adoption begins to look more near term. However, the idea of a valuable digital commons is still somewhat new to us because digital scarcity is new.

What makes this really big is that any scarce resource can be thought of as the commons and managed by crypto protocols if producers and consumers are willing to produce into and consume from the “collective pot”. The problem with this line of thinking has always been the corruption of the incentives of the central party required to manage the allocations back to society.
Again, crypto protocols solve this problem.

They are actually far better at solving this problem than even the most uncorrupt central authority because protocols can deliver services at monopoly efficiency while maintaining perfectly competitive prices. This means that any time a protocol or an enterprise is competing to deliver a service, a protocol can deliver it more cheaply by making it a commodity.

The usefulness of this economic model extends thus beyond the commons and into other types of market failures such as monopolies or oligopolies, which sounds more like where we are today.

Real World Examples

So far, the crypto protocols we know have not been deployed explicitly to manage a common resource, but there is an argument to be made that that is exactly what they do. Take Bitcoin for example, depending on the evolution of the network and the extent of adoption, the Bitcoin network can be said to manage the common resource of value storage or global money supply. Ethereum, depending on scaling efforts, can be said to manage anything from digital token standards to global contracting or computing resources. ZeppelinOS aims to manage a smart contract operating system as a common resource; OScoin aims to manage open source code development; Filecoin cloud storage, and Livepeer verifiable computing / video broadcasting infrastructure.

A Multiplayer World

Time will tell the extent of adoption and how many of our resources we’ll be able to manage as commons. However, as I wrote about in my last post, aligning our incentives with the collective using crypto protocols is powerful because it is how our society works today, but it isn’t how our businesses work. Our incentive structures fail in the face of increasing human connectivity because they fail to capture the growing impact of our actions on our networks and vice versa. In the future, our decisions’ impact on others will be perhaps greater than on ourselves, so continuing to operate in single player mode in a multiplayer world is not only wrong but it is dangerous.

Thanks to many who contributed to this post including the incredible and late Elinor Ostrom; for more on her work, visit here. Thanks to Par Jorgen Parson and Albert Wenger for encourage me to hit publish, OScoin for being the first project I know to explocitly build based on these principles, and Joel Monegro for coining the terms “Single player vs. Multiplayer”.