Ethereum’s true killer app: Endogenous Political Reform
I do not believe that the solution to our problem is simply to elect the right people. The important thing is to establish a political climate of opinion which will make it politically profitable for the wrong people to do the right thing. Unless it is politically profitable for the wrong people to do the right thing, the right people will not do the right thing either, or it they try, they will shortly be out of office.
— Milton Friedman
With the rise of decentralized finance (DeFi) in 2019, the candidate for Ethereum’s killer app appears for now to be money. This is no modest claim, by the way: with the ongoing decentralization of money, massive societal problems such as inequality, the business cycle, and even price inflation are being addressed not by concerned politicians but by tenacious buidlers. Permissionless composability of dapps is the evolutionary elixir that traditional finance has no hope of replicating. As amazing as DeFi is turning out to be, I don’t believe it really is Ethereum’s endgame. DeFi is still somewhat stifled by the ever-present threat of overzealous regulators whose looming shadows coax DeFi founders into carefully tiptoeing around SEC announcements. Until honest, well-meaning, transparent Ethereum buidlers are free to experiment with wildly new concepts without the threat of being lumped with the likes of Carlos Matos, innovation will mostly be refinements of what has already proven to be legally safe. It often feels as though lawmakers are stumbling around in the dark swinging clubs at “bad” crypto people with little understanding of the nuances of this rapidly exploding space. If regulators and lawmakers could have their incentives properly aligned with the honest actors in the space, the need for jurisdictional shopping and constant protective legal advice would diminish. More importantly, this needs to happen in a way that keeps Ethereum open and permissionless. That is, honest actors shouldn’t have to identify themselves, form lobby groups or obtain licenses. This brings me to Ethereum’s true killer app.
Endogenous political reform.
Cryptoeconomics holds the promise of making it politically profitable for politicians to do the right thing and unprofitable for them to act corruptly. The foundations of using game theory to guarantee desirable behavior were first demonstrated by Bitcoin’s proof of work mining and with the help of DAOs and a decentralized dispute resolution mechanism such as Kleros, Ethereum provides the infrastructure needed to encourage politicians to mine ‘good laws’ and reject bad laws. The term “endogenous reform” captures the idea that in this new era, laws won’t be handed down to us from distant capitals but instead will be crowdsourced from within the economy as a service that citizens can consume. When the era of endogenous reform takes off the world will begin to spontaneously decentralize politically, setting the stage for humanity to become a truly planetary civilization. This article will explain the economics of endogenous reform, why it should be bootstrapped with the reform of laws surrounding Ethereum development and ends with a simple example of this in practice.
The classical divide between business and state
Under the traditional conception of a market economy, firms operate through markets that are bounded by institutions created by the state. Institutions such as the protection of private property, international trade treaties, the provisional of a stable legal system and even the production of money are traditionally treated as exogenous constants by the market and economists alike because market forces have no direct impact on them. Instead, these institutions were born out of the political machinations of the democratic system of government.
Meetings in the Lobby
People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. — Adam Smith, Wealth of Nations
The idea that the market and state evolve in orthogonal realities is dismantled by Public Choice theory which explores the incentives of public (aka government) actors and how their individual preferences translate into public policy. Public Choice theory also investigates the economics of narrow economic interest groups lobbying for influence in lawmaking bodies such as Parliaments and Congress. Lobbying is the financial bridge between the market and political actors. In fact, the term lobbying originates from the practice of agents representing business interests waiting in the lobbies of Capitol Hill in order to have a chance to ‘talk’ to Congressmen on their way to and from voting on issues.
The Economics of Lobbying
Suppose a vote on raising tariffs on the import of socks is due in a few days. Analysts suspect the vote will be split down the middle with only 3 senators on the fence. If the bill passes, the price of socks will rise by 20 cents per pair which will translate into $45 million of extra profit for the local sock industry. Big Sock sends lobbyists to Capitol Hill in the hope of swaying the undecided senators. If the 3 undecided senators can be swayed for less than $45 million then the effort is considered profitable. After making pledges to donate $5 million to each Senator’s re-election campaign, they secure all 3 votes and the bill passes. The total cost of lobbying is $15 million, meaning that the lobbying effort generates a profit to the industry of $30 million.
Why do the Senators buckle so easily? Precisely because most consumers don’t really notice the 20 cents extra per pair. Politically, the senators face very little blow-back from voting for protectionism but the personal payoff is huge.
The fundamental problem with lobbying is that special interests benefit enormously, giving them a strong incentive to coordinate a sophisticated lobbying effort while the cost of protectionism is spread over so many people that, individually, consumers have very little incentive to coordinate and offer counter proposals to politicians.
Explanation of Public Goods (skip if you know what a public good is)
For most goods, consumption by one person prevents others from consuming it. If I eat the apple, you can no longer eat it. To prevent conflict arising, civilized societies develop rules over who has the right to consume things, usually codified in private property rights. If I own the apple, I have the exclusive right to consume it until I voluntarily forfeit the right by either giving it away or trading it away. Conversely, the only way I can consume an apple is by either growing one myself or by trading for it with something else I own or have produced. As long as the property rights of apples are strongly enforced, a market will naturally emerge to meet the needs of apple consumers. Apples are considered private goods because the management, production, and ownership of them can be handled sufficiently well by private individuals.
There is another class of goods for which assigning consumption rights is far murkier. For example, a street lamp provides a sense of safety to all passersby at night. My benefiting from a street lamp doesn’t prevent you from benefiting from the same light. Because access to light can’t be controlled, it can’t be sold. Suppose the street lamp costs $1200 to construct. In any given year, 30 people would pass under it and each person values the light they receive over the year at $150. This means that collectively, society values the lamp at $4500. If everyone chipped in $40 into a pool to fund the construction of the lamp, the net benefit per person would be $110. On the other hand, funding this lamp individually, would be a big net loss (150–1200=-$1050). Markets for these types of goods don’t always emerge spontaneously because the process of coordinating is more complex and fraught with trust issues. This can often mean that things such as street lights are underproduced. For this reason, societies tend to expect goods of this nature to be funded by large established collectives such as the state which is why they’re referred to as public goods.
Good Law framed as a Public Good
We can think of good legal systems as public ‘goods’. To do so, we just need to massage the terminology a bit. Suppose that when I benefit from a good law, I’m consuming it. For instance, a same-sex couple marrying under newly legalized same-sex marriage can be said to be consuming the new legislation. Similarly, effective criminal justice reforms that radically reduce the crime rate in my area are being consumed by me when I walk the streets at night, secure in my person and property. In both these examples, my consumption doesn’t prevent others from consuming the good law. For this reason, we fall into the intellectually comfortable belief that law can and should only be produced by the state since it exhibits the properties of a public good.
The problem of course, as identified in the sock tariff example, is that the humans responsible for crafting good law (or equivalently repealing bad law) are disproportionately swayed by narrow economic interests in the form of lobbyists. The only counterweight to lobbying is that sufficiently outrageous lawmaking can be punished at the ballot box once every few years. However, this isn’t enough to curtail the constant production of seemingly benign regulatory capture such as in the sock tariffs example above. What we need is a funding mechanism sufficiently large to tempt lawmakers into resisting the offers by special interests. The funding only needs to be large enough to force the lobbyists into an unprofitable position which, fortunately for society, is still very far below the benefits society receives from convincing lawmakers to shy away from protectionism.
Lobbying vs Ethereum: enter the DAO
After recovering from the DAO hack and coming down from the highs of the simplistic 2017 ICO model, innovation into DAO research is once again blossoming in Ethereum. The first entrant into DAO innovation is the exciting MolochDAO, a simple game theoretically balanced contract that has the express purpose of funding the development of the Ethereum ecosystem. Public blockchains in general and Ethereum, in particular, are demonstrating how communities can endogenously bootstrap public goods financing by using innovative ways of capturing value for the contributors. From scarce utility tokens to reputation to non-fungible badges to future voting rights, DAO governance rewards are still in their infancy but promise to revolutionize the way public goods financing is conducted. Since DAOs facilitate the crowdsourcing of public goods, we should be able to apply the concept to the provision of “good laws”, envisioning a DAO designed to reward lawmakers for resisting the temptations of lobbyists. Instead of targeting the top of the leadership pyramid who might not garner support from their henchmen, the DAO could be designed to be politically profitable for the entire lawmaking body. For instance, the forgiveness of public debt or the funding of a popular public project in return for the repeal of a protectionist law.
From MolochDAO to MoDAO
The Mo Ibrahim prize was created by the Sudanese Billionaire Mo Ibrahim to reward African leaders with a multimillion-dollar bounty for voluntarily stepping down after their term limits have been reached. The prize is a noble effort to curb corruption and we can only hope that the net effect is better governance but the prize itself is still fairly small compared to what a corrupt leader can hope to acquire from looting the treasury or accepting bribes. In the age of DAOs, we now have the technology to take the Mo Ibrahim prize to the next level. Imagine a MoDAO intended to raise enough money to reward meaningful reforms toward better laws.
Bootstrapping MoDAO: the case for less DeFI regulation
To get the ball rolling on a MoDAO, we should identify an area of reform that would lead to rapid societal innovation. I believe that the best place to start is by reforming and shaping the regulations surrounding DeFi. If traditional finance is unable to thwart DeFi with regulatory capture, endogenous reform will have a powerful funding engine going forward.
Regulations and regulatory compliance come at the cost of raising the barrier to entry for newcomers in all industries. In Ethereum and DeFi in particular, it often feels as though a net of compliance is slowly being tightened to choke the vibrancy of the industry. These restrictions are presented as a form of consumer protection from Bitconnect style scam artists. However, there’s very little point in having an open, transparent, permissionless mechanism of smart contract deployment if deployment first requires consulting a legal team. This isn’t a simple argument for freer markets. In fact, I’d argue that the motives for regulating traditional financial industries simply do not imply the regulation of decentralized finance. Since the industry is open by nature (smart contracts can be inspected on the blockchain), there are many ways for the industry to self-regulate. This is very different to traditional “offchain” brick and mortar businesses.
Kleros and the birth of endogenous regulation of Ethereum dapps
The regulations are programmed into the trading algorithm
Kleros is a decentralized dispute resolution mechanism on the Ethereum blockchain which can be used to establish the truth about real-world events and record those truths on-chain for smart contracts to consume and integrate. The killer app for Kleros so far hasn’t been to settle disputes between parties but to facilitate the decentralized curation of lists. As bizarre as it sounds, these lists are the foundation of financial regulation and consumer protection in the Ethereum ecosystem. To understand why consider the case of unsavory ERC20 tokens. The ERC20 standard does not guard consumers against centralized scam coins. It simply specifies the interface that these tokens use to operate on the blockchain. To combat scam coins, Kleros has established a system of badges that tokens can earn by adhering to a strict set of requirements. For instance, the DutchX badge requires the token cannot be arbitrarily deleted from the supply by some centralized source. The badge exists on the Ethereum blockchain for anyone or any contract to inspect so that if a token has been awarded the badge, other smart contracts can immediately choose to admit or deny the token based on this information. Decentralized exchanges that wish to only permit the trade of legit tokens can automatically bar tokens that have not been awarded the badge. This inspection happens at trade time and has no need for human oversight. The regulations are programmed into the trading algorithm. If a token loses its badge status for some reason, it will automatically vanish from the decentralized exchanges without any human action required. As more such lists of legitimacy are created on Kleros, a new ecosystem of ethical dapps will emerge which automatically comply with the ideals espoused by those lists. This type of regulation isn’t external oversight but made intrinsic to the operation of the blockchain which is why I refer to it as endogenous regulation.
Ideally we don’t want honest actors to bear any compliance costs and this is exactly what endogenous regulation achieves.
Contrast the endogenous regulation provided by Kleros with traditional financial regulation: not only is it not heavy-handed, it selectively adds a barrier to adoption for scam coins while clearing the path for honest coins without the creators of honest coins requiring a legal compliance team. Ideally, we don’t want honest actors to bear any compliance costs and this is exactly what endogenous regulation achieves. Traditional oversight regulation burdens both the honest and dishonest alike and is often subject to regulatory capture by the larger incumbents at the expense of potentially innovative newcomers. While immoral dapps can still exist in a climate of endogenous regulation because Ethereum is permissionless, unlike brick and mortar businesses, they can’t pretend to be legit and they can’t hide the degree to which they are centralized. Any form of centralization which isn’t carefully justified is a signal that they’re probably trying to hide something.
In behavioral economics, there’s a concept known as the full disclosure principle which states that if a person can signal something to set themself apart from their competitors then even the competitors will be forced to disclose their own disadvantaged position. For instance, suppose the law forbids potential employers asking for proof of tertiary education during job interviews. The purpose of the law is to give those without degrees a fair shot at skilled employment. However, since interviewees know that having a degree sets them apart, those that have will volunteer the information. The interviewer can then surmise that those who do not volunteer their qualifications do not have any.
If we apply the full disclosure principle to Kleros lists, tokens that do not have the badge of approval and which therefore cannot be listed on decentralized exchanges that require such badges are signaling to the world that they probably cannot qualify for the badge.
Analogue markets also have standards bodies but these are characterized by the requirement for trust, a condition from which Kleros doesn’t suffer. For instance, suppose I wish to consume vegan produce. There are a number of organizations that put their stamp of veganism and “not tested on animals” on various products but unless I personally audit these organizations, I have to simply trust them. Collusion and corruption are serious issues that do not have obvious solutions but cryptoeconomics can eliminate with certain mathematical guarantees. Free markets in analogue markets are weakly self-regulating because firms are subject to the Darwinism of consumer selection but there can sometimes be a very big lag effect between unethical operation and consumers discovering this information. This lag creates a reasonable justification for regulatory oversight.
Ethereum ecosystems, on the other hand, become safer, cleaner and less corrupt over time not by coincidence but by design. In the presence of endogenous regulation such as Kleros lists and under the principle of full disclosure, the lag between unethical operation and consumer detection is eliminated entirely and with it, the need for regulatory oversight is similarly eliminated.
MoDAO’s prime directive
Not only are traditional regulations such as KYC compliance or classifying tokens as securities completely inappropriate for decentralized finance but they are positively toxic for innovation by killing one of the cornerstones of dapps development: permissionless innovation. For this reason, the MoDAO’s primary mission should be to reward jurisdictions which actively leave Ethereum dapps alone. Perhaps they can pass exemption laws such as “So long as a dapp adequately warns consumers of the risks involved and does not make numeric promises for profit, and so long as the dapp isn’t simply a front for a traditional financial company, the operation of the dapp shall not be subject to compliance with existing financial regulations or be required to register with any bodies. Dapps are expected to have decentralized governance in order to be considered dapps and not simply apps. However, new dapps have a 2 year leniency period.”
The MoDAO in practice
The primary funding mechanism of the MoDAO could be to sell tickets for 1 Dai each. The proceeds of tickets are added to a central reserve which is deposited into some DeFi product to gain interest and beat inflation. Perhaps for safety, the funds are simply deposited into the DSR either directly or through an intermediary token such as Chai, cDai or WeiDai . Tickets entitle the holder to nominate governments or jurisdictions which have recently or are in the process of enacting Ethereum friendly reforms. In order to nominate a jurisdiction, a ticket deposit is required. The larger the deposit, the sooner the proposal will be reviewed. The nomination is submitted alongside a list of reasons for the nomination. The proposal is evaluated by the Kleros court system. First the list is evaluated to see if the reasons comply with the ideals of the MoDAO. If they do, the reasons themselves are evaluated for their truthiness. If either of these steps fail, the tickets are destroyed (after rewarding the Kleros jury). If the nomination passes, ticket holders can sponsor the nominee with staked tickets and some sort of percolating prediction market mechanism such as holographic consensus can be used to bubble the winner to the top. Once a clear winner exists and that winner has secured a quorum, the prize can be allotted to the winner. At this point, an agent has to claim the prize on behalf of the winning nation. Perhaps a third party auditing firm such as PWC can act as a broker between the DAO and the state. Here, Kleros will need to be invoked again to assure the DAO that the agent is legitimate.
Reform all the things
Once the MoDAO has made it politically profitable to enact reform in the arena of Ethereum regulation, it can turn its sights to other areas that require reform such as fiscally unsustainable states, complicated trade barriers, criminal justice reform etc. Imagine creating the incentive for states to move their prison systems to be more like Norway’s or their education systems to be more like Finland’s. However, if the only thing MoDAO did was to create the space for Ethereum to flourish, I’m fairly confident dapp developers will find creative ways to improve the world and decentralize our future.