There’s a lot of excitement surrounding the decentralized Internet and cryptocurrencies. Technological advancements plus tokens are shaking up traditional business models, enabling organizations to emerge outside the form of traditional companies that we know of today. There’s great promise to build large scale platforms to run open source projects among other things.
But how exactly will these platforms be organized? If participants aren’t bound by legal entities and contracts, how will they be managed?
According to transaction cost theory, transaction costs are used to explain the size and structure of organizations. Ronald Coase’s Nature of the Firm states that enterprises exist in order to decrease transaction costs: it can be more cost-efficient to bring partners in house rather than procuring goods and services via contracts and the market.
Additionally, company size will be determined by transaction costs: company growth is initially advantageous (since it lowers transaction costs for procuring resources/services, etc.), but eventually, increasing overhead costs among other things will lead to decreasing returns. And this is what prevents a company from growing indefinitely.
The Internet lowered transaction costs, in some cases to nearly zero. It’s significantly cheaper to find products, services, and suppliers. By the same token, today’s lower overhead and remote collaboration make it possible for teams to organize as a company where the the costs may have been too high to do so before.
Tokens and decentralized platforms take this dynamic to the next level, making it even easier to get many people working towards a common goal.
So what are the elements that decentralized platforms have at their disposal to manage the behavior of participants? There are three: financial incentives, formal governance and leadership. Ultimately all three elements are exactly the same core elements that traditional corporations have available to steer people and the company, but there are two key differences:
- Decentralized organizations involve a way larger network of people
- Joining and leaving a network is practically frictionless, since membership is liquid. On one hand, this is advantageous since people won’t be hanging around for the wrong reasons. But, it has its downside too, since the speculators (people with short-term interests) can end up playing too big of a role.
Financial incentives (Tokens!)
Issuing tokens gives participants a stake in the project. It’s an innovative business model to overcome the chicken and egg problem and it lets value increase accrue to the participants rather than a centralized entity.
However, we still need more experience and experimentation to determine how token sales should be structured. Vitalik Buterin, co-founder of Ethereum, analyzed the pros and cons of the various token sale models. His conclusion? “Nearly every significant sale, including Brave’s Basic Attention Tokens, Gnosis, upcoming sales such as Bancor, and older ones such as Maidsafe and even the Ethereum sale itself, has been met with a substantial amount of criticism, all of which points to a simple fact: so far, we have still not yet discovered a mechanism that has all, or even most, of the properties that we would like.”
There are several considerations when it comes to token sale mechanisms:
- What’s the function of the token? Is it a usage token or equity token? Nick Tomaino explained the difference between the two. A usage token doesn’t give you any specialized rights within the network but it does give you access to the service. Equity or work tokens give you rights to contribute work to the platform (and earn value) to help it function properly.
- What’s the mechanism? Funding against progress over time (several token sales) or an initial token sale that tries to maximize the money raised? I believe that funding against progress over time is optimal since a) too much money too fast is almost never a good thing (a lesson that many start-ups and VC investors have learned over the past decades) and b) the current approach of a large initial token sale results in extremely rapid appreciation of tokens well ahead of their use value.
- Having some kind of built-in inflation (such as the future issuance of tokens) would limit this. In a recent post, Albert Wenger wrote that an optimal token sales model would keep the initial sale small, hold one or more subsequent sales of increasing size and then hold a final sale once the protocol is ready that gets most of the tokens out for use.
The bottom line is we are still not at the point where we can truly grasp all the effects of each token sale mechanism. Experience will help show us what works best.
Governance is the second crucial element to managing blockchains. The first question that arises is who votes and how should voting be structured? One approach is through proof of work (e.g. solving a math quiz or confirming a transaction). The other approach is proof of stake (owning a piece of the currency). Proof of work is a very capital intense process; as such, it can lead to centralization and the potential for a 51% attack.
A decentralized organization also needs to figure out how to manage changes to the blockchain. One approach is a hard fork: if participants cannot agree on changes, the losing minority decides to split off through forking the blockchain (what we just experienced with the recent Bitcoin hard fork). This can be quite risky since a hard fork weakens the base for both projects. We’re seeing a different approach with Tezos which is attempting built-in governance, including a process to discuss and approve/disapprove proposed changes and hence integrate the changes from within the protocol.
Leadership can come from different groups. It can be the founders of the protocol – like Vitalik Buterin who has been the public face and voice for Ethereum for awhile now. It can be the people who run the foundation (like the Ethereum Foundation) that manages the protocol and plays an active role in interpreting the mission and core value of the protocol. Last but not least, we may see the emergence of activist investors that only have a small stake in the protocol but have enough influence or large enough reputation to have their voices heard.
This is an incredibly exciting time: blockchain is a socio-economic experiment at massive scale. It offers new ways for people, schools, companies, organizations, governments and communities to organize, work together, and earn money. During this experimental phase, there will be failures – but it will still be fascinating to see the governance structures that form behind each network. However, I believe that the vision and continued involvement of the founding teams will be critical over the next few years as we learn to use the other mechanisms to manage these projects.