Rebuilding the Governance Premium
Tradfi lessons for a crypto winter.
Earlier this week, Luca Prosperi, fresh out of a depressing governance battle in MakerDAO, proposed a governance trilemma in his most recent blog post, “First Principles of Crypto Governance.” Basically, he argues, crypto protocols today can accomplish at most two of a) being decentralized, b) tackling complex problems, and c) incentivizing benevolent behavior.
He raised several interesting points.
Success breeds complexity. DeFi protocols, in the beginning, are small communities dealing with simple problems. As the community grows, the problems facing it become more and more complex, requiring more and more specialized knowledge in order to address.
Complexity breeds asymmetric incentives. As a community grows rapidly, the wisdom of committed founders quickly dilutes towards the crypto mean, and the complexity of problems they face accelerates rapidly. At the same time, . The complexity-to-average-competence ratio begins to death-spiral.
Asymmetric incentives breed bad behavior. The shrinking minority of specialists face bigger and bigger relative rewards from behaving maliciously, as opposed to benevolently. While many specialists ignore the bad incentives out of long-term reputational interest or altruism, it’s inevitable that a protocol specialist will inevitably engage in “malicious behavior” (engaging in value destruction) if it means that a significant percentage of that value can be pocketed by the malicious actor.
In large crypto communities, ‘bad behavior’ is uniquely catastrophic. The software-ization of money, loss of community confidence, and lack of accountability for bad actors causes large crypto communities to disintegrate at light speed in the face of complex, escalating problems.
Note that this isn’t all gloom and doom.
Simple protocols which do one thing and do it very well (Curve’s stablecoin exchange markets, or the Aave/Compound overcollateralized money markets) have withstood volatility dwarfing anything in the TradFi world.
However, governance tends to break down in the face of complex problems, incentivizing extremely malicious behavior on the part of founders and others with superior asymmetric knowledge. Cases in point: Do Kwon’s extraction of billions of dollars from the Terra Protocol, and Rune Christensen’s attempted funneling of $500 million out of the DAI protocol through Monetalis, a Rune-and-cronies-controlled related party. In the former case, it ended catastrophically (probably much more so than Kwon himself had intended). In the latter case, the “centralized” vigilance of Luca Prosperi and a few other talented individuals saved MKR holders from potentially tens of millions of dollars in debt writedowns, and the fate of 99%+ of protocols: a death-spiral of lost confidence resulting in the liquidation or elimination of the protocol.
Additionally, I think Luca missed a fifth source of bad-behavior-inducing incentive asymmetry: DAOs’ dead weight effect on core contributors.
Addressing the complexity problem: TradFi versus crypto
TradFi equities, at face value, confer governance value far inferior to what a crypto tokenholder gets.
Take Google, for example. Google shareholders own a certificate of stock which is worth … what, exactly?
Owning a share of GOOGL confers no right to any cash flows or dividends from Google. You don’t have any governance power (Larry Page and Sergey Brin have majority control via a special founder class of shares). You don’t have any recourse if Brin and Page spent billions of dollars on overpriced acquisitions or anything else with the most fleeting relationship to the underlying business.
A GOOGL share is essentially an NFT stating that Google management will spend your money responsibly, and maybe divert some income from their cash machine back to you at some point in the future. Even though your rights to any underlying assets or cash flows are tenuous at best, GOOGL shares are worth $1.5 trillion of market cap. Why?
A similar argument could be made for American Depositary Receipts (ADR’s), especially ADR’s in Chinese companies. Chinese ADR’s are American shareholders’ claims on earnings of companies in a hostile country which views American shareholders as suckers, views the US government as a national enemy, and has virtually never ruled in Americans’ favor in any domestic litigation, no matter how egregious the fraud. Nevertheless, sophisticated overseas Chinese investors place enormous value on these ADR’s. Why?
Crypto’s missing incentive alignment
In the case of GOOGL, employees are compensated in GOOGL stock. Brin, Page, and senior management are awarded GOOGL stock options as well. Outside investors know that Page and Brin need to keep their employees happy to run a successful business. They may also think that if Brin and Page do especially outrageous things, the Google Board of Directors might become a hostile entity, severely curtailing their ability to run the company.
In the case of, say, BABA, the employee compensation alignment is the same. BABA shareholders have one major additional problem — the Chinese Communist Party views them as pigs destined for the slaughterhouse. They also have additional perks: ADR’s represent a precious loophole in the Chinese capital control system (allowing BABA employees to sell BABA stock for USD offshore, not subject to the PRC’s strict FX exchange limits), and overseas Chinese investors have created a vocal, highly effective interest group that lobbies the Chinese government to leave ADR’s alone, to the point of creating exceptions in their national security laws so that the SEC and American auditors can examine their Chinese records.
What both of these very different situations share—which is nonexistent in DAOs today—is incentive alignment among all major stakeholders. The stakeholders in GOOGL (shareholders, senior management, and employees) are all aligned via an NFT with only the fig-leaf protection of a Board of Directors that has never stood up to Google management. The stakeholders of BABA include, additionally, the Chinese government and overseas Chinese investors. But all parties are ultimately incentivized to behave in the same direction.
This alignment of incentives doesn’t always produce great outcomes. American investors in Chinese ADR’s haven’t done particularly well historically—although they’ve significantly outperformed Chinese domestic stock listings. But it can persist, even on extremely harsh legal/geopolitical terrain.
Are most DAOs just Soviet socialist republics?
In 99% of DAOs, stakeholder alignment of interest usually evaporates after an initial hypergrowth phase. Protocol growth explodes, tokens are liberally granted to the founding class, and many founders move on to other things. The remainder founder-specialists soon discover that they’re working for a lot of absentee tokenholders. The remaining founder-specialists and producers begin to scatter.
At the point that key producers have left, in one small minority of DAOs, rigorous simplicity saves the day. Curve never submitted different parameters of its famous “xyk” liquidity model to a vote. It just presented a complex idea in a yes/no vote, the model worked under countless edge cases, and the Curve DAO stayed true to its beginnings. Curve thrived as other stablecoin marketplaces came and went, and Curve remains king of the stablecoin bazaar today.
In another tiny minority of DAOs, centralized/individualistic checks and balances save the protocol from centralized flaws leveraged by a central point of failure conspiring with “founder-class” dead weight (Maker). However, white knights are, by definition, too rare to be relied upon.
In the vast majority of DAOs, checks and balances fail, founders dump on bagholders at a certain point, employees either join the dump or are left as bagholders themselves, all the key producers leave, and the protocol dies.
So the urgent question becomes: Are the founders of the 99%-failing DAOs just bad people? Or did something in the incentive structure incentivize them to throw their DAO under the bus?
I strongly suspect it’s the latter. Most DAOs are not proof-of-work organizations, and they very rapidly accumulate dead weight - ‘contributors’ who contribute the bare minimum for token allocation. Remote-work organizations have extreme difficulty policing this kind of dead weight. By the time the dead weight is noticed as a severe problem, it’s too late to do anything about it.
After a period of hypergrowth, key producers look around and realize that their work is being mooched upon by a much greater number of weak contributors. Their altruistic capitalism curdles to contempt. Their incentives are no longer aligned with the community’s. This is where insider sabotage really accelerates.
This problem is mitigated by slower growth, which gives all key stakeholders have more time to re-evaluate the cadence of contribution by other key stakeholders, renew their confidence in the fundamental fairness of the system, and keep on grinding. However, crypto and slow growth never go well together.
Policing the dead weight: DAOs’ greatest challenge
When you compare corporations and DAOs, the corporate hierarchy is fairly effective at enforcing a continuing contribution cadence at all levels of the organization — another key example of stakeholder incentive alignment. DAOs have failed to achieve this.
The next stage of DAOs’ evolution, I’m afraid, will be a path to corporatization: more HR software, more logging of github commits, and more stories of mean management, all in the name of more efficient management. DAOs need more of it. So does crypto’s minority of consistent producers, in order to align stakeholders’ incentives further in the direction of sustainable value creation for all tokenholders.
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