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Institutional Economics & Governance of DAOs (Part 1)

Read Part 2 here.
This is a chapter from “
Token Economy,” Voshmgir, Shermin. 2019.
It is partially based off a journal article which was published by the author in 2017: Voshmgir, Shermin: “Disrupting governance with blockchains and smart contracts,”, Journal for Strategic Change.

Institutional economics studies the role of formal or informal institutions — such as procedure, convention, arrangement, traditions and customs — in a socio-economic context. Since the emergence of the Internet many distributed Internet tribes have formed, like social media platforms, e-commerce platforms or knowledge platforms. Web3 networks introduce a new type of Internet-based institutional infrastructure that enables distributed Internet tribes to self organize and coordinate in a more autonomous way, steered by purpose-driven tokens, and executed with machine-enforceable protocols. They are commonly referred to as Decentralized Autonomous Organizations (DAOs).

Blockchain networks and similar distributed ledgers can disrupt traditional governance structures and challenge the current forms of how society organizes itself. They can (i) reduce the principal-agent dilemma of organizations by providing transparency; (ii) incentivize network actors with a native token, thereby disintermediating and reducing management costs, and (iii) replace the reactive procedural security of the current legal system, with proactive and automated mechanisms that make a potential breach of contract expensive, and therefore infeasible. Web3 networks generally provide more decentralized and spontaneous coordination over the Internet between people and institutions who might not even know or trust each other. The coordination structures are referred to as Decentralized Autonomous Organizations (DAOs).

DAOs tackle an age-old problem of governance that political scientists and economists refer to as the “principal-agent dilemma,” which occurs when the agent of an organization has the power to make decisions on behalf of, or impacting, the principal — another person or entity in the organization. Examples thereof could be managers that act on behalf of shareholders or politicians that act on behalf of citizens. In such setups, moral hazard occurs when one person takes more risks than they normally would, because others bear the cost of those risks. More generally, it occurs when the agent acts in his own interest rather than the interest of the principal, because the principal cannot fully control the agent’s actions. This dilemma usually increases when there is underlying information asymmetry at play.

“Governance” is political science term that refers to the rules, norms, and actions of how people interact within a community or organization: all processes of governing, whether by a government, market, or network, family, or tribe — formal or informal. This is achieved through laws, norms, force, or language. Governance may take many forms — for-profit, non-profit, public, or private. The governance rules of an organization or group of people hereby regulate the process of decision making among all stakeholders involved.

Institutional economics is a subset of economics that intersects with political science, sociology, or history and studies the role of institutions in a socio-economic context. “Institutions” can be formal or informal and represent a set of rules or contracts that enable social interaction like procedure, convention, arrangement, and traditions and customs. They are often embedded into a setup of different interdependent layers: natural, cultural, and legal rulesets. Institutions can also reflect the entities that channel and incentivize actions of individuals in a group. The institutional economist Gustav von Schmoller said:

The study of the organ and the institution is, for the knowledge of the social body, what anatomy is for the physical body.

The Bitcoin network can be considered to be the first true decentralized and autonomous organization, coordinated by the Bitcoin protocol, and which anybody is free to adopt. The Bitcoin network provides an operating system for money without banks and bank managers, and has stayed attack resistant and fault tolerant since the first block was created in 2009. No central entity controls the network, which means that as long as people keep participating in the network, only a worldwide power outage could shut down Bitcoin. The governance rules are tied to the network token, with the aim to steer the behavior of network nodes with an incentive mechanism that has proven to be an effective motivator for performing network services (read more: Part 1 — Blockchain & Other Distributed Ledgers, Part 4 — Purpose-Driven Tokens).

With the emergence of the Ethereum network, the concept of DAOs moved up the technology stack from blockchain protocol to the smart contract. Whereas before one needed a blockchain network with an attack-resistant consensus protocol to create a DAO, smart contracts made the creation of DAOs easily programmable, often with just a few lines of code, and without the need of setting up your own blockchain infrastructure. Use cases range from simple to complex. The complexity depends on the number of stakeholders, as well as the number and complexity of processes within that organization governed by the smart contract. The token governance rules incentivize and steer a network of actors, replacing the need for top-down organizations with self-enforcing code and enabling distributed “Internet tribes.” Depending on the purpose and governance rules of a DAO, and the level of autonomy of the DAO stakeholders, the use cases can resemble a company or nation state. Organizations that use smart contracts as their operating infrastructure can use the legal system for some protection of physical property, but such usage is secondary to the preemptive security mechanisms that smart contracts can offer.

“TheDAO” in 2016 was a very early example for such a complex smart contract on the Ethereum network. The purpose of TheDAO was to provide an autonomous vehicle for fund management without traditional fund managers. During a four-week token sale, TheDAO issued DAO tokens against ETH, collecting an equivalent of 150 million USD, resulting in the biggest token sale at its time. The idea was that every DAO token holder would be a co-owner of this decentralized investment fund, proportional to the number of tokens held, and could participate in investment decisions with proportional voting rights. Specialized services to TheDAO could be conducted by subcontractors hired by TheDAO token holders by majority consensus. However, due to a programming error in the software, this vision of TheDAO never became reality, as the project was drained of roughly a third of its funds before it became operational. This led to a controversial hard fork of the Ethereum network. One of the major shortcomings was that the governance rules of TheDAO did not account for decision-making processes in the case of unforeseen events (read more in the next chapter: On-Chain vs. Off-Chain Governance).

This early use case of a smart contract-based DAO showed that what the Bitcoin network resolved with a complex consensus protocol, building on decades of applied and theoretical research, cannot be simply replicated with a few lines of code. The purpose of TheDAO was different from the Bitcoin network, and therefore required a new type of attack-resistant steering mechanism, but the governance rules of TheDAO were developed in only a few months, mostly by engineers with no governance expertise at all. TheDAOs token governance rules were based on oversimplified assumptions of how token holders would behave: They did not sufficiently account for psychological phenomena such as “free-rider problem” or “bounded rationality” which are subject to the field of Behavioral Economics (read more: Purpose-Driven Tokens). Instead, they based their token governance design on the assumption that small token holders would mimic the behaviour of big token holders, who were assumed to take the time for sensible decision-making as they had more “skin in the game.” In reality, most small token holders did not participate in any voting processes at all, probably hoping that other token holders would make the right decision on their behalf. Furthermore, the voting process involved personal intervention, with bad wallet usability, excluding many smaller and technically less adept token holders from participating in voting processes. The whole incident showed that “decentralization” is also a question of human behavior, and thus also subject to behavioral economics, and never only a mathematical or technical question.

Newer Web3 applications have focused on providing a plug-and-play end-to-end framework to build DAOs. The tool-set provided include elements such as constitutional frameworks, dispute-resolution frameworks, and many more, so that new DAO projects don’t have to build all organizational and institutional elements necessary from scratch. They reduce the technical costs of setting up a decentralized organization, so you can focus on what you want to build (the purpose of your network) and how you want to build it (the governance rules of your network.) Many of the projects build on top of the Ethereum network and offer a modular smart contract framework, with an easy to use user interface, that allows people without technical knowledge to create their own decentralized organization. The level of decentralization of such organizations can vary according to the needs. Examples of such projects are “Aragon,” “Bitnation,” “Colony,” “Commonstack,” “DAOStack,” or “MolochDAO,” each of which differ in their focus, ideology, or levels of progression and success.

DAOs vs. Traditional Organizations

Large parts of our society are organized in top-down command and control structures. The role of the legal system is to secure and enforce all contractual agreements of all institutions that regulate our socio-economic interactions. The example of such legal frameworks are (i) the constitution of a country, (ii) employment contracts between employee and organization, (iii) supply agreements, purchase agreements, or sales contracts between the organizations, or (iv) bilateral or multilateral agreements between governments of different nations.

The organizational structures of our economic institutions have evolved over time and are a subject of research in institutional economics and management science. Political Institutions governing the members of a geographical area, also referred to as citizens, have also evolved over time and are subject to the study of institutional economics, political science, economics, and sociology.

  • Evolution of Companies and the “Theory of the Firm”: In his book “The Theory of the Firm,” economist Ronald Coase argued that firms arise if they can produce what they need internally more efficiently than through outsourcing — taking into account all costs, such as search, information acquisition, bargaining, and policing of business partnerships or engaging in bilateral trading in the marketplace. His theories explain the concentration of economic production, through vertical integration of production, and the subsequent rise of multinational corporations, from the Industrial Revolution until the late 20th century. In recent decades, these highly structured, centralized, and bureaucratic organizations of the 20th century have given way to looser, flatter organizational forms, such as “Holacracy,” which is an example for a more autonomous organizational structure steered by self-reliant units. The Internet, as an information-sharing technology, has facilitated much of this organizational innovation, and started an outsourcing revolution, and reduced the size of companies (in number of employees). Furthermore, the emergence of the Web2 has facilitated global market-making mechanisms at lower transaction costs, enabling new forms of organizing around, for example, the prosumer. However, there remains one powerful intermediary, a trusted third party — like Amazon, eBay, Zalando, Uber, Airbnb, or similar companies — providing a trusted platform for two people interacting over the Internet. While products and services around those platforms have become more and more unbundled, bringing producers and consumers closer to each other, the terms of service are always dictated by those platform providers, mostly privately held companies which also control all user data. Smart contracts have the power to disintermediate these platforms, introducing new ways of coordinating activities, such as task allocation, coordination, and supervision of a group of people who share common economic interests but are geographically distributed.
  • The Governance of Nation States and Representative Democracy: Democracy is a system of governance where people who share a geographical area and are affected by collective decisions of the group agree to participate in said decision-making process equally. The question of how individuals should participate is and has been the source of many debates and conflicts, and has also greatly evolved over time. Direct democracy is a form of democracy in which people decide upon all policy initiatives directly. However, the bigger the group, the harder it is for members of that group to participate in each and every decision-making process for various reasons, such as the large cost of coordination, and mental transaction costs for each individual involved. Centralized institutions and bureaucratic organizational structures have, as a result, emerged around modern representative democracies. In such a representative setup, elected representatives govern on behalf of all eligible members of a state, the sovereign. Both systems have merits and deficiencies, depending on the size and type of group governed. Recent political history suggests high levels of disenchantment in the general public toward established political governance systems, which political scientists refer to as “Post Democracy.” It is characterized by an increasingly remote governing elite, coupled with increased clamor from the citizenry to reclaim their place in decision making. Globalization effects, such as free trade, cheaper and faster transport, and the Internet, have further undermined the power of a nation state to regulate the life of its citizens. One suggested solution to this disenchantment is “Liquid Democracy,” a type of democratic governance whereby an electorate delegates voting power in a more flexible manner, allowing for differentiation in the powers delegated and the timeframe of the delegation. It is a way of collaborative decision making that does not depend on elected representatives but rather on the partial or temporal delegation of votes. While “Liquid Democracy” may offer a solution to some of the problems of established democratic systems, it is an unfeasible way to govern given our current structures, which are predominantly based on (i) national legal silos that are a relict of a pre-Internet and pre-Globalization era, and (ii) the predominance of paper-based voting systems.
  • Decentralized Autonomous Organizations involve a set of people interacting with each other according to a self-enforcing, open-source software protocol in the absence of bilateral agreements. The blockchain protocol and/or the smart contract code formalize the governance rules of a DAO, regulating the behavior of all network participants. DAOs offer the possibility to establish more fluid decentralized organizations over the Internet and around a specific economic, political, or social purpose. They provide an operating system for people and institutions that do not know nor trust each other, who might live in different geographical areas, speak different languages, and be subject to different jurisdictions. Elements of Liquid Democracy can be applied on a protocol level (delegated Proof-of-Stake, or Proof-of-Work mining pools) and on a smart contract level with lower operational costs than in the “off-chain” world we live in today. Performing network tasks can be rewarded with a network token. Tokens can also be used for exercising voting rights. Once deployed, a fully decentralized autonomous organization is independent of its creator and cannot be controlled by one single entity, only by majority consensus of the organization’s participants. The exact majority rules are defined in the consensus protocol of the smart contract, and vary from use case to use case. DAOs have the potential to resolve global coordination problems such as the intransparency along international supply chains and lack of enforceability of global policy making. This is probably one of the reasons why many organizations of the United Nations are already looking into smart contract applications, such as the World Food Program, UNICEF, UNOPS, and UNDP.

DAOs are open source, thus transparent, and if well designed, incorruptible. All transactions of the organization are recorded and maintained by a blockchain network. Code upgrade proposals can be made by anyone in the network, and are voted for by majority consensus of involved network actors.

As such, DAOs can be seen as distributed organisms, or distributed Internet tribes, that live on the Internet and exist autonomously, but also heavily rely on specialist individuals or smaller organizations to perform certain tasks that cannot be replaced with automation.

However, I would like to argue that there is no such thing as a fully decentralized and autonomous organization. Depending on the governance rules, there are different levels of decentralization. While the network might be geographically decentralized, with many independent but equal network actors, the governance rules written in the smart contract or blockchain protocol will always be a point of centralization and loss of direct autonomy.

DAOs can be architecturally decentralized (independent actors run different nodes), and are geographically decentralized (subject to different jurisdictions), but they are logically centralized around the protocol. The question of how to upgrade the protocol, when and if necessary, is very often delegated to a set of experts who understand the techno-legal intricacies of the code, and therefore represent a point of centralization.

Web3 networks and smart contract based DAOs are complex systems that are composed of three interdependent networks: (i) a network of computers, (ii) a network of people, (iii) a network of flow of tokens. They are adaptive socio-economic networks that are dynamic in time and space. Dynamic refers to the continued state changes of the network as a result of the actions set by their human agents (sending tokens or consuming other network services, contributing with code, or forking into another network.) Adaptive means that DAO participants constantly adapt to the network they are part of because of the feedback-loops between the individual actors and the whole network. Individual actions affect the system and as a result, the system as a whole evolves over time. Complex systems differ from other (less complex) systems, in that the system level behaviour cannot be easily concluded or predicted from the local state changes induced by individual network actors.

System theory is one of many tools associated with “cybernetics,” an interdisciplinary field of science that studies self-governing systems of living organisms, machines, and organizations. The term “cybernetics” has its roots in the Greek language and can be translated with “to steer, navigate or govern the ship.” Steering refers to establishing goals, not telling the system what to do. These goals can be individual (individual wants and needs) and communal (social consensus about collective policies). Self-steering and co-steering systems, in political science, are often referred to as democracy. The Economist Friedrich von Hayek referred to cybernetics as a discipline that could also help economists understand markets as “self-organizing or self-generating systems complex phenomena” using the cybernetic feedback mechanism for economic pattern predictions. He explained Adam Smith’s idea of the “invisible hand” as anticipation of the operation of the feedback mechanism in cybernetics.

Institutional Economics

Different schools of Institutional Economics apply different definitions of what they consider an institution. Early social bodies were communities, such as the tribe, the Sippe, the family. As technological and social evolution made the governance of increasing amounts of people and over larger geographic areas feasible, new social organs emerged, most prominently the nation state and companies.

Since the emergence of the Internet many distributed Internet tribes have formed, such as social media platforms and other platforms. In this historic context, blockchain networks introduce a new type of internet-based institutional infrastructure governed by machine-enforceable protocols. Decentralized autonomous organizations can, therefore, be seen as a new social organism for the Web3.

They represent socio-economic networks that come with real-time data on all network activities, but as opposed to the Web2, that data is public to all and not controlled by one single entity. The Web3 allows us to document and analyze the emergence of new institutions in almost real time and in a publicly verifiable way. Given the advances in data science, this allows for new data-driven coordination mechanisms, and enables new supranational governance forms with almost real-time feedback loops. The coming years will unveil the implications of machine-enforced economic mechanisms, and the implications of smart contracts on the evolution of legal contracts and collective socio-economic steering mechanisms.

In their institutional structure, Web3 networks resemble nation states much more than they resemble companies. The blockchain protocol is comparable to the constitution and the governing laws of a nation state. The autonomous actors in the network are the sovereigns of the network, and are therefore subject to the network constitution, the blockchain protocol or smart contract code. The monetary policy of a Proof-of-Work network, for example, is defined in the protocol, and regulates the circumstances under which a network token is minted. The fiscal policy is also defined in the protocol, and regulates the transaction fees. Stakeholders can opt in and opt out at any time, decide to become active members of the community and participate in the development of the code, or decide over code changes when there is a code upgrade.

Nation states are comparable to permissioned networks, rather than permissionless networks. In most countries, only citizens of said nation states have the privilege to be part of the network, or in other words, to live and work in that country. Non-citizens may receive temporary permission to enter the country or work in the country. While you can opt in and opt out, by way of immigration or emigration, this option usually comes at high personal and economic cost, and takes time. Nation states steer the actions of their citizens mostly by disincentive: when you break the law, you have to pay a fine or go to jail. Taxes can be considered as network transaction costs that citizens pay to receive government services. In some cases, national governments institute tax breaks and subsidies that act as positive incentives to “nudge” their citizens into a specific behavior. Tax policy is part of the fiscal policy of a country that, together with the policies of the central bank, decides over monetary policies, which intend to steer the network actors into certain economic behavior.

Monetary & Fiscal Policy of Blockchain Networks

Monetary policy refers to the governance of the money supply of a national currency, such as inducing interest rates that are strategized and implemented by central banks, currency boards, and other relevant regulatory authorities with the aim to achieve macroeconomic objectives such as inflation, consumption, economic growth, and liquidity. The primary objective of most central banks is to manage inflation while reducing unemployment. In those cases, the goal is usually to achieve economic growth, or at least stability, which is measured in terms of the GDP (gross domestic product), to maintain a low unemployment rate and a stable foreign exchange rate. Most central banks use a combination of following tools to regulate the monetary policy of a country: (i) open-market operations, (ii) reserve requirements, (iii) exchange rate intervention, and (iv) short-term interest rates.

The token supply policy of a blockchain network can be regarded as the “monetary policy” of a blockchain network. This token supply policy is defined in the protocol and establishes the supply and availability of the native network token. Just as the monetary policies of nations might vary from country to country, token supply policies of blockchain networks and other DAOs can differ greatly, introducing a new area of applied research and development. Token supply could be fixed from the beginning, as is the case with the Bitcoin network, or undefined, as in the case of the Ethereum network.

  • Bitcoin’s token supply, for example, is regulated in the protocol and was defined before the protocol was implemented and deployed. Each time a miner discovers a new block, new BTC are created. The first BTC were created in the genesis block in 2009. The number of BTC generated per block decreases by 50 percent every 210,000 blocks, or approximately every four years. The number of Bitcoin tokens is therefore limited to slightly under 21 million BTC. The last BTC is estimated to be mined in 2140, when the block reward would drop below 1 Satoshi, which represents the smallest denomination of BTC. Miners would still be incentivized to maintain the network, in spite of decreasing block rewards, since they could collect fees for securing transactions. Changing the monetary policy of the Bitcoin network would require a majority consensus of network actors, which is possible, but unlikely. Token inflation is determined by the number of newly minted tokens each year, minus the amount of tokens burnt. If a protocol comes with a fixed token supply, this will potentially lead to deflationary price development of the native token, when demand surpasses the supply of new tokens, taking into account sunk tokens.
  • Ethereum’s token supply was not predefined but collectively governed by the stakeholders of the network: (i) developers, (ii) full nodes, (iii) miners, and other network participants. Initial contributors to the Ethereum token sale were allocated 60 million ETH in the genesis block. An additional 12 million ETH were distributed to early contributors and the Ethereum Foundation. Block rewards have decreased over time due to changes in the consensus protocol. An event that impacted the issuance rate was the “Homestead fork” in 2016. Block times were reduced, which temporarily led to an increase in the issuance rate. In 2017, a mechanism was activated that increased the difficulty of mining a block, which slowed down blocks and decreased the issuance of newly minted tokens. It is referred to as the “Difficulty Bomb,” or the “Ethereum Ice Age.” Later that same year, the “Byzantium fork” was released, reducing block rewards from 5 to 3 ETH. The most recent drop was from 3 to 2 ETH in 2019.

Depending on the type of governance rules, token holders with a big stake in the system could influence market demand or affect the price of a token and therefore the exchange rate of that token, acting as a “quasi” central bank. In a network where token holders do not know or trust each other, coordinated action might be hard to implement, as it would require collusion of major token holders to coordinate over buying or selling tokens to manipulate the market and steer the internal token economy. If a large stake in the network token is held by one single token holder, or a limited number of token holders that are known to each other, it will be easier to steer through coordinated action. In the wake of many early token sales, this has been a big issue (read more: Part 2 — Token Sales).

Fiscal policy refers to the use of government spending and tax policies to influence macroeconomic conditions. Taxation is an important fiscal policy tool to steer economic activity while funding government spending, another fiscal policy tool. The government can spend money on subsidies, transfer payments including welfare programs, public works projects, and government salaries. While higher taxes reduce the autonomy of individual actors, government spending can incentivize beneficiaries to spend the funds and can be used for directed economic growth.

In public and permissionless blockchain networks, fiscal policy could be reflected by the level of “transaction costs” that one has to pay for network transactions. This might be comparable with value-added taxes that national governments collect, only that the tax collectors, in the case of a public blockchain, are autonomous nodes validating transactions and getting rewarded for their network services. In a Proof-of-Stake setup, “fiscal policy” mechanisms are reflected in protocol variables such as (i) staking, (ii) vesting periods, and (i) reserve pools that fill or deplete based on bonding curve mechanisms.

References & Further Reading

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All about the Web3, DAOs and Tokenization

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Shermin Voshmgir

Author of ‘Token Economy’ Founder @tokenkitchen @blockchainhub & @crypto3conomics// Artist