Studia i Materiaïy, 2/2018 (28), cz. 1: 126– 139
ISSN 1733-9758, © Wydziaï ZarzÈdzania UW
DOI 10.7172/1733-9758.2018.28.11
Token-based blockchain financing
and governance:
A transaction cost economics approach
Lesïaw Pietrewicz*
The paper presents a conceptual analysis of token-based blockchain financing and governance. Its aim is to explore governance attributes of tokens – a new financial instrument issued
by blockchain startups – with a view to understanding deployment of tokens by blockchains
and their design. Transaction cost economics (TCE) has been chosen as a theoretical perspective for the analysis. The paper extends the scope of TCE theory by applying it to the
blockchain context, and to the study of the role and nature of tokens in particular. It is argued
that blockchains aggregate and coordinate the contributions of a distributed network of peers
using a set of rules encoded in the blockchain protocol, thus eliminating the need for a hierarchy and day-to-day management, and promising to reduce typical coordination problems
plaguing hierarchical organizations. Tokens, and particularly utility tokens, are found to differ
fundamentally from equity and debt in their financial and governance attributes as they aim
to combine the low cost of the rule-based governance with added adaptability characteristic
of equity-based governance. The analysis offers insights for both strategy and entrepreneurship
research and practice as it helps identify industries most vulnerable to disruption by blockchains and inform promising blockchain-based business model designs.
Keywords: blockchain, corporate finance, corporate governance, token, transaction cost
economics.
Submitted: 11.09.18 | Accepted: 10.12.18
Tokeny w finansowaniu i zarzÈdzaniu blockchainem:
Perspektywa ekonomii kosztów transakcyjnych
Artykuï przedstawia koncepcyjnÈ analizÚ finansowania i zarzÈdzania (governance) blockchainem z wykorzystaniem tokenów. Celem opracowania jest zbadanie cech tokenów wbzakresie governance, co ma sïuĝyÊ lepszemu zrozumieniu konstrukcji tokenów i ich wykorzystaniu
wbblockchainach. Jako teoretycznÈ podstawÚ do analizy wybrano ekonomiÚ kosztów transakcyjnych. Przeprowadzone badania wprowadzajÈ tÚ teoriÚ na nowy obszar – blockchaina
ib nowego instrumentu finansowego token. Badania te pozwalajÈ lepiej zrozumieÊ funkcjonowanie blockchaina – agregowanie i koordynowanie wkïadów podmiotów tworzÈcych
spoïecznoĂÊ blockchaina przy pomocy zasad zapisanych na protokole blockchaina, co eliminuje potrzebÚ utrzymywania biurokracji (jednostki hierarchicznej) i bieĝÈcego zarzÈdzania,
umoĝliwiajÈc obniĝenie kosztów transakcyjnych. W pracy wykazano takĝe zasadnicze róĝnice
miÚdzy tokenami (i w szczególnoĂci tokenami uĝytkowymi) a tradycyjnymi instrumentami
*
Lesïaw Pietrewicz – PhD, Institute of Economics, Polish Academy of Sciences.
Correspondence address: Institute of Economics, Polish Academy of Sciences, Staszic Palace, 72 Nowy
¥wiat St., 00-330 Warsaw, e-mail: pietrewi@inepan.waw.pl.
finansowymi – kapitaïem wïasnym i dïugiem. Tokeny majÈ ïÈczyÊ w sobie niski koszt governance opartego na zasadach z wysokimi zdolnoĂciami adaptacyjnymi charakterystycznymi dla
bardziej zaangaĝowanych i elastycznych systemów opartych na kapitale wïasnym. Uzyskane
wyniki niosÈ implikacje dla zarzÈdzania strategicznego i przedsiÚbiorczoĂci, pomagajÈc identyfikowaÊ branĝe najbardziej naraĝone na niszczÈcy wpïyw blockchainów i konstruowaÊ oparte
na blockchainie modele biznesowe.
Sïowa kluczowe: blockchain, ekonomia kosztów transakcyjnych, finanse przedsiÚbiorstwa,
ïad korporacyjny, token.
Nadesïany: 11.09.18 | Zaakceptowany do druku: 10.12.18
JEL: D21, D23, G32, G34
1. Introduction
Corporate finance and corporate governance are closely interrelated (e.g.
Bender, 2013; Bolton and Scharfstein,
1998; Frederikslust, Ang and Sudarsanam,
2007; Gillan, 2006; Grossman and Hart,
1982; Hart, 1995; Jensen, 1986; Jensen
and Meckling, 1976; Margaritis and Psillaki, 2010; Shleifer and Vishny, 1997; Sun,
Ding and Guo, Li, 2016; Williamson, 1988).
Corporate governance deals with the ways
in which suppliers of finance to businesses
assure themselves of getting ab return on
their investment (Shleifer and Vishny,
1997). It is done by linking capital in form
of financial instruments with control rights
given to their owners. As rights attached
to various financial instruments differ,
such instruments can be seen as different
governance structures (Williamson, 1988),
and corporate finance decisions to use one
form of finance or another (e.g. debt or
equity) have a bearing on optimal allocation of power in organizations (Hart, 1995)
and can be used for economizing on transaction costs (Williamson, 1988).
Numerous studies have investigated
the relation between corporate finance
and corporate governance focusing on
the tax, signaling, incentive, and bonding
differences between debt and equity (Williamson, 1988). Typically, they take the
aggregate, composite-capital setup view on
corporate finance to study governance and
performance implications of various ownership and capital structure arrangements.
Transaction cost economics (TCE thereafter) (e.g. Williamson 1975, 1985, 1996)
goes further and regards debt and equity as
governance structures rather than financial
instruments (Williamson, 1988). Thus, it
is most concerned with studying governance attributes of debt and equity taken
separately, rather than in various proportions in capital structure. Similarly, it allows
analyzing other financing arrangements,
like leasing and leveraged buyouts (Ibid.).
Such an approach has been selected for the
present paper as it aims to explore governance attributes of tokens – a new financial
instrument designed specifically for blockchain projects – with a view to understanding deployment of tokens by blockchains
and their design. Such endeavor is instrumental in identifying transaction types and
industries in which blockchains and tokens
can support most disruptive business models.
The study of governance attributes of
tokens seems to be highly relevant and
timely undertaking. In 2017 the blockchain
technology firmly established itself in the
public awareness as a revolutionary new
technology underpinning cryptocurrencies, while more and more startups experimented with other potentially disruptive
applications across a range of functions and
industries (Davidson, De Filippi and Potts,
2018). Blockchain, however, should be
viewed as much more than simply a technological breakthrough. For Davidson, De
Filippi and Potts (2016a, 2016b, 2018) and
Piazza (2017), it provides a new form of
economic coordination and entails a new
form of governance.
We are now at an early stage of blockchain development (e.g. Higgison, Lorenz,
Münstermann and Olesen, 2017; Pilkington, 2016), trying to make sense of its
potential (Tapscott and Tapscott, 2016).
The early stage of development implies
immature governance. Blockchain founders are experimenting with both technology
Wydziaï ZarzÈdzania UW DOI 10.7172/1733-9758.2018.28.11
127
and governance issues. Tokens play a key
role in such efforts as, on the one hand,
selling them secures blockchain projects’
financing, and, on the other, proper design
of tokens, depending on a business model
employed, is decisive for blockchain
projects’ success. Tokens are an integral
part of many blockchain-based business
models, and given their centrality and novelty they merit special attention. Better
understanding of governance attributes of
tokens can help advance their design, align
blockchain governance and support more
viable blockchain-based business models,
as well as inform regulatory efforts.
Blockchain technology offers a new
way of coordinating economic activity
(Davidson et al., 2018; Piazza, 2017) and
supports a new form of organization (e.g.
Buterin, 2013, 2014; Hofer, 2018; Norta,
2016; Teutsch, Buterin and Brown, 2017),
adding to the existing diversity. Therefore,
blockchains should best be analyzed from
the perspective of institutional economics (Davidson et al., 2018), equipped with
concepts, tools and methodology to study
institutions of economic coordination.
The present contribution assumes TCE
(i.e. New Institutional Economics) as its
theoretical perspective for several reasons.
Firstly, the main novelty of blockchain
consists in providing a new way of coordinating economic activities, which is the
subject matter of TCE (e.g. Davidson et
al., 2018; Menard, 2018; Williamson, 2002).
Secondly, blockchains enable a new form
of organization, and explanation of the
phenomenon of diversity of organizational
forms is often viewed as the main aim of
TCE (e.g. Williamson, 1998). Thirdly, the
choice of TCE is strongly supported by
its applicability to corporate finance (Williamson, 1988). Tokens, being a financial
instrument and an integral part of blockchain governance, can thus be studied in
an integrated way. Fourthly, TCE studies
organizations from the perspective of contracts and assumes transaction as the basic
unit of analysis (Williamson, 1996; 2002).
Since blockchain is an exchange (i.e. transaction) technology (as opposed to production technology) (Davidson et al., 2016a,
2016b) and owes its interest primarily to
the potential to reduce transaction costs
and spur competitive advantage (e.g. Catalini and Tucker, 2018; Conley, 2017), and,
again, tokens are central to such endeavors
128
(e.g. Bakos and Halaburda, 2018; Conley,
2017), TCE perspective again seems very
useful. The latter aspect can be placed in
a broader perspective of TCE approach as
central to the fields of strategy and entrepreneurship (Foss, 2003; Gatignon and
Gatignon, 2010; Michael, 2007; Nickerson,
2010). As transaction costs are essential
aspects of creating, capturing and protecting value, TCE insights should be seen as
necessary for adequately understanding
the nature of strategic management (Foss,
2003). What follows is that the transaction
cost approach to the study of blockchains
can be seen as a basis for conducting strategic analyses of blockchains – as competing
with one another and/or with other forms
of governance. This, however, due to the
complexity of the topic and space limits of
the present paper, shall be a subject matter
of another study.
The present paper presents a conceptual analysis of token-based blockchain
financing and governance. It extends the
scope of TCE theory by applying it to the
blockchain context, and to the study of the
role and nature of tokens in particular. It
goes beyond the contributions of Davidson et al. (2016a, 2016b, 2018) and Piazza
(2017) in assuming TCE approach to corporate finance and applying it to the study
of tokens. Blockchain is interpreted here
as a governance structure rather than just
ab technology, similarly, tokens are viewed
as both financial and governance instruments.
The remaining part of the paper is structured as follows. The first section shortly
introduces blockchains, indicating their
main distinctive features and multiple
conceptualizations. The next two sections
develop the relation between corporate
finance and corporate governance, reviewing the relevant TCE literature. Firstly, the
basic tenets of the transaction cost economics are introduced, based on seminal contributions by Williamson, following which
TCE logic is applied to corporate finance.
Two subsequent sections concern blockchain financing and governance. In the
fourth section the concept of blockchain
is explored in relation to TCE extension to
organizational forms beyond market and
hierarchy. The fifth section explores the
attributes and role of tokens in blockchain
financing and governance. Concluding
remarks follow.
Studia i Materiaïy 2/2018 (28), cz. 1
1. What is blockchain
In its most popular understanding,
blockchain is a set of technologies developed around the concept of distributed
ledgers, enabling secure peer-to-peer
online transactions. The term, however, has
been used to denote many aspects or layers
(see Figure 1) of what constitutes blockchain in its widest sense (i.e. a governance
structure), causing a lot of confusion. The
resulting ambiguity implies that any reference to the term should be accompanied by
a short definition (i.e. indication to a given
layer of the meaning).
The term “blockchain”, i.e. a chain
of blocks, refers to a sequence of timestamped blocks of digital information
stored on a decentralized database (the
innermost layer on Figure 1). The decentralized database (ledger) using chains of
blocks and related technologies for recording and storing information on a network
of computers is also called blockchain
(layer 2). Before being recorded in blocks,
data (transactions or states) are verified
using so-called consensus protocols, which
replace centralized clearing settlement systems, making blockchains distributed settlement systems (Caytas, 2016; Kaminska,
2018) (layer 3). Blockchain is also a name
given to blockchain technology-based distributed digital (online) platforms (Waters,
2017) (layer 4), i.e. a mode of organizing
economic activities (Asadullah, Faik and
Kankanhalli, 2015) adding to the existing
variety (Zysman and Kenney, 2018), and
a business model (e.g. Osterwalder and
Pigneur, 2010) competing with central
platforms (Waters, 2017), such as Amazon,
Facebook or Airbnb. In this sense, blockchains enable users to interact directly
with each other rather than through a central hub of the company which owns the
central platform (Waters, 2017). Finally,
blockchains are a new governance structure (Davidson et al., 2016a, 2016b, 2018)
(layer 5), i.e. a new way of coordinating
economic activities. Since blockchains’ socalled consensus protocols offer a new way
of producing consensus about facts, and
such consensus is instrumental to economic
coordination, blockchains can be seen as
a revolutionary new institutional technology for economic coordination, i.e. a social
technology (Nelson and Sampat, 2001).
As such, blockchains compete with more
established institutions of governance, such
as firms, markets, governments, networks
(Davidson et al., 2016a, 2016b,), profiding
governance structure for blockchain-based
applications (Davidson et al., 2018).
Figure 1. Conceptualizations of blockchain
Sequence of blocks
of information
Distributed ledger
Distributed clearing &
settlement system
Distributed digital
platform
Governance structure
Source: own elaboration.
Wydziaï ZarzÈdzania UW DOI 10.7172/1733-9758.2018.28.11
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While it is hard to explain what blockchain is, it is easier to say what blockchains
do. They combine mathematical cryptography, open source software, computer networks and incentive mechanisms
to produce consensus about the state
of the world by verifying authenticity of
transactions in a distributed way, without
the involvement of trusted third parties
(Davidson et al., 2016a). Each computer
node in the network holds a copy of the
ledger, so there is no single point of failure. Every piece of information is mathematically encrypted and added as a new
“block” to the chain of historical records.
Various consensus protocols are used to
validate a new block with other participants
before it can be added to the chain. This
prevents fraud or double spending without requiring a central authority (Carson
et al., 2018). Once created, the block (i.e.
the information contained within) cannot
be changed, giving blockchain the quality
of immutability. Blockchains can be programmed with “smart contracts” – a set
of conditions recorded on the blockchain
protocol, so that transactions automatically trigger when the conditions are met
(Carson et al., 2018). These qualities give
the blockchain technology the business
potential, which consists in streamlining
operations, increasing accuracy of recordkeeping, boosting data security, assuring
transparency of data, improving customer
relationships, cutting costs and improving
relationships (e.g. by reducing transaction
times) (Terekhova, 2018; Yermack, 2017).
2. Transaction cost economics
TCE has its roots in the seminal work of
Coase (1937), with Williamson (1975, 1985,
1996, 1998, and others) being the most
notable contributor. TCE works from the
concept of contract. According to it, any
exchange problem can be interpreted as
a contract, writing and fulfilling of which
entail transaction costs, which are a universal measure of effectiveness of institutions
of governance – markets, hierarchies, networks, governments and others (e.g. Williamson, 1985).
Transaction costs take the form of ex
ante and ex post costs (e.g. Williamson,
1985). The former are related to negotiating and writing contracts, while the latter
include the governance structures’ setup
130
and running costs. Governance needs arise
from and are related to incompleteness of
contracts. If it was possible to draft comprehensive contracts at reasonable cost,
further governance would be redundant.
However, all contracts are by necessity
incomplete, reflecting three factors: (1) in
a complex and highly unpredictable world
it is hard for people to think far ahead and
to plan for all possible contingencies that
may arise; (2) it is hard for the contracting
parties to negotiate about these plans, and
(3) it may be very difficult for the parties to
write their plans down in such a way that,
in case of a dispute, an outside authority
could figure out what these plans actually
mean and enforce them (Hart, 1995, p. 23).
As a result, economic agents write incomplete contracts, i.e. contracts with ambiguities and missing provisions.
Incompleteness of contracts implies
the existence of contractual hazards which
induce transaction costs. TCE is concerned
with identification, explication and mitigation of all forms of contractual hazards
through governance (Williamson, 1996).
Contractual hazards include: (1) bilateral
dependency (resulting from asset specificity); (2) hazards that accrue to weak
property rights; (3) measurement hazards;
(4)bintertemporal hazards (which can take
the form of disequilibrium contracting,
strategic abuse, etc.), and (5) hazards that
accrue to weaknesses of institutional environment (Williamson, 1996).
Economic agents can align transactions with governance structures to lower
transaction costs (e.g. Williamson, 1985;
1996). As achieving alignment requires
understanding dimensions on which transactions and governance structures differ,
TCE addresses the questions of what are
the dimensions of transactions that present
different hazards, and what attributes of
governance structures mitigate hazards and
at what cost? Then attributes of transactions need to be related to the costs and
competencies of alternative modes of governance (Williamson, 1985; 1998).
Contractual hazards accrue to the following attributes of transactions: (1) the
frequency of transactions, (2) the uncertainty to which transactions are subject,
and (3) asset specificity (Williamson, 1985).
The higher the frequency of interaction,
the greater the uncertainty, and the greater
the asset specificity, the greater the transac-
Studia i Materiaïy 2/2018 (28), cz. 1
tion costs. Of these three, asset specificity
is accorded the most explanatory power,
as it gives rise to bilateral dependency,
anticipation of which reduces incentives to
invest in relationship-specific assets out of
the fear of expropriation at the renegotiation stage, strongly encouraging integration
(Hart, 1995). In turn, critical dimensions
of governance structures include: (1) form
of contract law (court ordering or private
ordering), (2) efficacy in autonomous
and cooperative adaptation, (3) incentive
intensity, and (4) administrative controls,
resulting in different cost and competency
profiles of governance structures (Williamson, 1998).
Organizational forms arise to meet
contractual needs of transactions. Market
is a simpler and less costly governance
regime than hierarchy and therefore the
preferred choice. Internal organization of
transactions cannot replicate market procurement in incentive intensity and entails
bureaucratic costs, hence the firm can
be seen as an organizational form of last
resort. Simple transactions can be carried
out effectively in the market while more
complex and thus costly governance structures are needed if contractual hazards
complexify and the hierarchy’s benefit of
added coordination outweighs the cost of
added bureaucracy and impossibility of
selective intervention (Williamson, 1998).
Market mode is the preferred governance
structure if asset specificity is low, transactions less frequent, and uncertainty limited.
The more specialized and less substitutable
products are, the more they are suited for
internal organization of transactions.
3. Transaction cost approach to
corporate finance
Whereas the most typical example to
which TCE is applied is the make or buy
decision, or the problem of vertical integration in intermediate product markets, it can
be applied to any issue that arises as or can
be reformulated as a contracting problem,
including contracts for capital between the
firm and suppliers of finance (Williamson,
1988). In its basic formulation, it takes the
form of a choice between debt and equity.
Regarding debt and equity as different governance structures rather than as financial
instruments, and distinguishing investment
attributes of different projects results in the
view of contractual relation to which standard TCE approach to the study of contracts
can be applied.
While corporate finance scholars typically focus on the tax and bankruptcy, signaling (Ross, 1977), incentive and bonding
(Jensen, 1986) differences between debt
and equity, TCE is concerned primarily
with the governance-structure attributes of
debt and equity, where the former is the
more market-like instrument and latter is
more akin to hierarchy (Williamson, 1988).
The discriminating use of debt and equity is
thus regarded as a variation of the standard
transaction-cost economizing theme of vertical integration (i.e. the make-or-buy decision), neatly fitting in Shleifer and Vishny’s
(1997) widely accepted formulation of the
purpose of corporate governance as assuring the lowest possible cost of external
capital for organizations in the long term.
The governance approach to corporate
finance aims to determine what projects
should be financed with what financial
instruments, like debt and equity. To
this aim, the project finance approach is
adopted and the choice of debt or equity
is seen as determined primarily by asset
specificity (redeployability). Transaction
cost reasoning supports the use of debt to
finance redeployable assets, whereas nonredeployable assets should be financed with
equity (Williamson, 1988).
In this approach, debt is viewed as abgovernance mechanism that works almost
entirely out of rules (making debt “unforgiving”), and in the case of default, debtholders are entitled to pre-emptive claims
to firm’s assets. Equity allows much more
discretion than debt (is more “forgiving”),
equity holders are residual claimants with
a contract for the firm’s lifetime, entitled to
vote for the board of directors in proportion to their share in equity. The board of
directors monitors firm’s managers and has
the powers to decide on their compensation
and to replace them, if judged appropriate.
By giving the board of directors added control over management’s actions (“intrusiveness of equity”) and making equity more
forgiving than debt, equity-based governance structure works to reduce the cost of
capital for projects with low asset redeployability (Williamson, 1988).
For non-specific (i.e. redeployable)
assets, the cost of debt is lower than equity
considering that debt is a comparatively
Wydziaï ZarzÈdzania UW DOI 10.7172/1733-9758.2018.28.11
131
simple governance structure, with low
setup costs and low running costs, as it
is rule-governed. Equity is a much more
complex governance mechanism, as it has
higher setup cost and a greater discretion it
allows comes at a cost of incentive compromising and politicking (Williamson, 1998).
As asset specificity increases, the cost
of debt and equity grows, but the cost of
debt grows more quickly. The reason is
that, firstly, the value of pre-emptive claim
decreases (as it offers limited protection);
secondly, the benefits of closer oversight
grow, and thirdly, debt, being a rule-based
governance regime, can sometimes force
firms to compromise value-creating initiatives or even to liquidate, when a more discretionary, and thus adaptable, governance
regime of equity could be more supportive and value-adding (Williamson, 1988).
Uncertainty, i.e. another aspect of contractual hazards, favors greater use of equity,
as when added uncertainty pushes the firm
into a maladapted state, rule-based governance regime experiences greater stress,
and the more expensive regime of equity,
supplanting rules with discretion, can be
absource of added value (Williamson, 1998).
In short, TCE predicates that for moderately or highly redeployable assets, debt
is a preferred governance regime, whereas
equity is reserved for projects with high
asset specificity and high adaptability needs
(Williamson, 1988). Similarly, low uncertainty environment favors debt, whereas
highly adaptable equity regime offers firms
an edge in highly uncertain conditions.
4. The rise and governance of
blockchains
Transaction cost economics provides
abway of understanding the impact of new
technologies on organizations and organizational forms. According to the theory,
differences in technology give rise to different contractual hazards (Williamson, 1998).
Hence, technological progress changes
transaction cost structures, requiring adaptation in governance structures. Technology also enables changes in costs and competences of governance structures. With
interactions, maladaptation is reduced and
alignment restored. In the process, new
organizational forms can arise.
Numerous scholars went beyond the
original formulation of transacting prob132
lem as the market and firm dichotomy
to address, most notably, networks (e.g.
Baker, Gibbons, Murphy, 2002; Blois, 1990;
Economides, 1996; Jarillo, 1990), including
joint ventures (Hennart, 1988) and entrepreneurial networks (Windsperger, Hendrikse, Cliquet, Ehrmann, 2018). Going
beyond the conventional organizational
forms of hierarchy and markets reflects
the significant changes the scope of the
firm has undergone, including an array of
formal and informal alliances and partnerships. These unconventional organizational
forms have been conceptualized as hybrids
(Williamson, 1991; 1985), clans (Ouchi,
1980), and networks (Miles and Snow,
1986; Powell, 1990).
In recent years much attention has been
given to the impact of digitization on transaction costs and organizational forms (e.g.
Loebbecke and Picot, 2015; Teece, 2010).
Digitization is argued to significantly lower
transaction costs, both within and between
organizations (Butler et al., 1997). The
altered cost structure (substantial initial
investment and negligible or low marginal
costs) and nature of competition (“winnertakes-all” competition (e.g. Parker and
Van Alstyne, 2005; Van Alstyne, Parker
and Choudary, 2016)) put the issue of
scalability (thus, the need to transact at
scale) at the center stage. This, combined
with lowering transaction costs with digital platforms (e.g. Lobel, 2018), has led to
growing concentration in the internet (The
Economist, 2017). The growing criticism
of centralized digital platforms (Facebook,
Google, Amazon, etc.) concerned claims
of lacking transparency, allowing for single points of failure, censorship, abuse of
power and other inefficiencies (e.g. Lange,
2017). Trusted intermediaries, however,
were seen as indispensable to transact for
economic agents who could not trust each
other to transact online. The new blockchain technology promises to eliminate digital systems’ need to have trusted parties
(central intermediaries) who would guarantee transactions.
The transaction cost analysis of blockchains as an alternative to centralized
digital platforms should cover their man
governance components – smart contracts,
transaction verification, and tokens. The
former two will be considered in this section, while the role of tokens will be analyzed in the next one.
Studia i Materiaïy 2/2018 (28), cz. 1
Smart contracts are fragments of computer program encoded on a blockchain.
They detail the conditions which, once met,
trigger an automatic execution of contracts.
Smart contracts can be simple or very complex, but the encoded conditions should be
very precise and specific, leaving no room
for interpretation and contestation (contracts are of binary nature). If the conditions detailed in the smart contract are
not met, the transaction is not executed
and the parties have no obligations to each
other. As smart contracts are programmable, they can cover a variety of contracts
and multiple provisions detailing parties’
obligations in various potential states of
the world. However, for more complex settings, they are not comprehensive, as writing ab complete contract could be prohibitively expensive. If a specific state of the
world is not provided for, the transaction
will not be executed. As parties agree on
using ab given smart contract and, hence,
underlying code, eventual litigations should
be relatively simple (and cheap) as no
human judgment or will was involved in
“deciding” whether to execute the contract
or not. Smart contracts should therefore be
seen as strictly rule-based and not allowing
discretion. The main idea is thus to economize on governance costs, leaving no room
for exceptions and need for intervention.
Not allowing for discretion implies lower
transaction costs. Such benefits, however,
come at the cost of adaptability. It follows
that the governance structure of smart contracts needs to be complemented by other
governance arrangements. When a need to
improve the code is discovered, such proposal is voted on by token holders (more
on this issue in the next section). From the
governance point of view the use of selfexecuting smart contracts is remarkable as
it eliminates the need for day-to-day management, freeing blockchains from possible
human errors and agency problems, and
reducing the risk of disputes between contracting parties.
The public, open code nature of smart
contracts in public blockchains makes them
attractive targets to hackers. The risk of
bugs and attacks are forms of contractual hazards specific to the digital world.
Whereas writing a bug-free smart contract
is difficult, it is possible (although difficult)
to formally verify them, i.e. to use methodology which allows to mathematically
determine whether the program behaves
according to a specification, which provides
a better hazard mitigation than traditional
approaches, like testing and peer reviews
(Kasireddy, 2017).
The self-executable nature of smart contracts limits their viable applications. They
can best be applied to routine transactions, i.e. those susceptible to standardization, and thus automation. By their nature,
smart contracts are not a viable option for
one-off complex contracts nor contracts for
which conditions are hard to operationalize and encode. Since encoding a smart
contract can be relatively expensive, and
executing it should be very cheap (once
technical obstacles are successfully dealt
with), it makes most sense to apply them
to frequent transactions. Uncertainty is
another factor which can affect the legitimacy of smart contracts. Increased uncertainty elicits maladaptation. Once created
(encoded) and marketed, smart contract
cannot be easily changed and may require
costly and time-consuming negotiations by
token holders (tokens typically carry voting
rights). Thus, uncertainty increases transaction costs and reduces the utility of smart
contracts, particularly due to their binary
nature. Finally, weakness of institutional
environment increases the legitimacy of
smart contracts as they can partially substitute for state regulation, thus mitigating
hazards that accrue to weak institutional
environment.
In blockchains, transactions are verified using so-called consensus protocols.
There are two main types of such protocols: proof of work (PoW) (e.g. Nakamoto,
2008; Pilkington, 2016) and proof of stake
(PoS) (e.g. Saleh, 2018). Both are consensus algorithms providing a way to achieve
distributed consensus. In PoW consensus
is achieved using information validation in
open competition. Anybody with proper
software and hardware can become a network node and participate in the competition, and the winning party is rewarded
with tokens. Excessive energy consumption,
however, makes this approach unsustainable. In PoS, those who want to participate
have to commit their tokens, and business
is granted in proportion to committed
tokens. In both consensus regimes other
nodes play the role of confirming calculations of the winning node and storing copies of the ledger (each node stores a copy).
Wydziaï ZarzÈdzania UW DOI 10.7172/1733-9758.2018.28.11
133
Consensus protocols are also relevant
for governance in the context of asset specificity. In the proof of work consensus specialized hardware has a strong advantage.
In 2013, devices called application-specific
integrated circuits (ASICs) were designed
solely for the purpose of mining Bitcoin,
providing a 10–50-fold rise in efficiency and
making mining with a regular computer’s
CPU and GPU unprofitable (Kasireddy,
2017). An alternative PoS consensus eliminates the need for specialized (i.e. nonredeployable) hardware.
5. Financial and governance role of
tokens
Tokens are a digital currency native
to a given blockchain. They play multiple functions in blockchain financing
and governance. Firstly, they are sold in
so-called Initial Coin Offerings (ICOs),
providing finance to blockchain startups.
Secondly, as they act as the internal currency of abblockchain, they can be used to
pay for blockchain’s services and can be
rewarded for work accomplished (succeeding in computations and adding a block of
data). Thirdly, in PoS consensus mechanism they play an additional role of allocating business (orders to verify transactions).
Fourthly, they enable the new organizational form of so-called distributed autonomous organizations (DAOs) (Buterin,
2013; 2014), or “community structures”
(Teutsch et al., 2017), by being instrumental in distributing value to holders. Fifthly,
they give holders voting rights when protocol updates are deemed necessary. Finally,
as token value is related to functionality
(usefulness) of a given blockchain, they
align all participants’ interests to make the
network more valuable. In general terms,
designing tokens requires understanding
where the token can be used (how many
end points the token is meant to hit, how
it travels between them – does it circulate
between participants within the network,
is it exchanged between two or more parties, or is it spent on a service and then
“destroyed”), and for how many use cases
(as protocol tokens can power many use
cases within a single or several protocol layers (Autonomous NEXT, 2018). Designing
blockchain governance involves modeling
participant behavior inside the network and
how tokens mediate in interactions. The
situation is thus much more complex than
in the case of traditional financial instruments and firms. The summary characteristics of token-mediated blockchain financing and governance is given in Figure 2.
Figure 2. Financing and governance roles of tokens
Block-chain
governan-ce
Smart
contracts
Tokens
Transa-ction
verification
mechani-sms
Tokens
Voting
Tokens
Value
distribution
Tokens
Financing
Tokens
Source: own elaboration.
Blockchain project financing and governance design is a major challenge for
blockchains adoption at scale. Great majority of blockchain projects are developed by
startups seeking financing at the proof of
concept stage. Tokens are a dedicated new
form of finance, allowing to raise funds by
previously “unfundable” open source software projects (Srinivasan, 2017). There
134
are various types of tokens (e.g. Pietrewicz,
2018), and relevant taxonomies are in flux,
reflecting the nascent stage of development of this new instrument, indeterminate
legal status in many jurisdictions, changing
market sentiment and directions of blockchain technology evolution. Entrepreneurs
are experimenting with blockchain protocol and applications development, and
Studia i Materiaïy 2/2018 (28), cz. 1
with future network governance rules and
design of tokens.
For simplicity reasons only one type of
token – utility token – is considered in the
present contribution. This choice is motivated by this token type being arguably the
most innovative in terms of both financial
and governance attributes, and, at least till
recently, also the most popular. It can play
the double function of a means of payment
for the network services and a reward for
work rendered, i.e. transaction verification.
Thus, utility tokens are required to access
ab protocol and pay for the service. The
same token is used to incentivize computing power holders to contribute work to
a given blockchain network by using that
power (“hashpower”) to verify transactions.
2017 was a landmark year for blockchain
startups seeking external financing in Initial Coin Offerings (ICOs), that is token
issuances. According to Coinschedule.com
data, blockchain startups raised over $3.7
billion in ICOs in 2017, an almost 40-fold
increase over the previous year, dwarfing
other sources of finance for blockchain
startups. One advantage of token issuances
is democratizing finance. The traditional
model of tech startup financing effectively
keeps small investors from participating
financially in the fortunes of promising new
ventures. ICOs allow individuals to allocate
even small amounts of money to an ICO,
thus dramatically reducing entry barriers
to participate financially in the successes
of the startup sector (Pietrewicz, 2018) and
reducing the cost of finance for blockchain
startups. At the same time, ICOs have
made it possible for these startups to raise
far larger amounts than startups can usually tap (Waters, 2017).
The large scale of initial financing have
both merits and drawbacks. Starting with
the latter, although part of the proceeds
from ICOs is typically intended for further development of software underpinning blockchain project and decentralized
infrastructure, very large sums of money
at developer team disposal can produce
slack and even provoke dishonesty as all
too many cases have shown. One way to go
about this hazard would be to make funds
available to developer team in tranches,
after reaching predetermined milestones.
Large scale of ICOs is, however, primarily
motivated by other governance considerations. Blockchains, to be feasible, need to
reach a critical mass. The major advantage
of blockchains relative to other arrangements is the network effect (Carson et al.,
2018). Tokens are critical to growing the
scale of the network as their key role is to
incentivize the use of a given blockchain’s
services. In simplest terms, prospective
users are more likely to use the service of
abgiven blockchain if they hold its tokens; as
their custom supports the blockchain, the
value of tokens they hold should increase.
Similarly, prospective nodes are more likely
to commit resources to a given network if
they hold its tokens, since their serving as
a node increases the value of the blockchain to users, and that should translate
into increasing the value of their tokens.
Potential benefits of using blockchains for
transacting increase with the size of the
network, as more nodes increase the security of transactions and larger number of
trades should reduce transaction costs,
once the critical technical problem of scalability is resolved. What follows is that token
issuances should be motivated primarily by
effecting network effect, for which purpose
tokens issued in ICOs should find themselves in the hands of future blockchain’s
users and prospective network nodes.
Hence, the strictly financial goal of maximizing the proceeds form ICOs should be
subordinated to corporate governance goal
of incentivizing future customers. Thus,
the offer must be properly structured and
priced, including so-called pre-ICOs in
which tokens can be offered to preselected
entities at steep discounts.
As technology advances, regulations and
competitive pressures change, smart contracts may need to be renegotiated. Such
renegotiation, however, is not carried out
on a case-to-case basis, but concerns the
rules to be encoded in new smart contracts
which are to replace the old ones. Proposed
changes are decided upon democratically,
with votes distributed between token holders in proportion to their possessions. As
the rationale behind developing smart contracts concerns primarily reducing transaction costs (e.g. by speeding up transactions
and ridding of the need to interpret states
of the world not explicitly addressed), the
use of tokens to balance the interests of
parties to a transaction (avoiding expropriation) can streamline the upgrading process. Blockchain networks effectively leave
control in the hands of token holders, and
Wydziaï ZarzÈdzania UW DOI 10.7172/1733-9758.2018.28.11
135
not the central hub of the code developer.
Tokens give users control of the network
and let them profit from its success.
Finally, utility tokens do not hold rights
to cashflow, profits nor liquidation money
of any entity. Rather, token holders gain
product value by being able to spend their
tokens or they can exchange them for other
tokens or fiat money on dedicated platforms (Deloitte, 2017). Giving rights to
product value rather than a company’s cash
flow or profit is a governance experiment
that requires repeated verification.
Conclusions
The present contribution focused on
exploring token-based blockchain financing and governance using the conceptual
apparatus of transaction cost economics. It
portrayed blockchain as a new institution of
governance (a mechanism of governance).
Tokens (utility tokens) were found to differ fundamentally from equity and debt in
their financial and governance attributes.
The goal of embedding incentives into
digital services is to propel the network
effect and give organizations (networks),
deploying them a competitive advantage
over centralized platform networks. Prospective users should prefer to choose to
commit their custom to blockchains rather
than centralized platforms if the former
offer them a share in benefits from their
growth. A well designed utility token
should not only incentivize adoption, but
also work towards aligning interests of all
its holders. Therefore, allocating them to
relevant parties at the ICOs stage should
override the purely financial goal of maximizing proceeds from the issuance.
Blockchains aggregate and coordinate
the contributions of a distributed network
of peers using a set of rules encoded in the
blockchain protocol, thus eliminating the
need for a central authority and day-to-day
management, and promising to reduce typical coordination problems plaguing hierarchical organizations, including large overheads, human error and agency problems,
and thus dramatically reducing transaction
costs. However, thanks to their design,
blockchains can rely on cooperative adaptation and its advantages.
Utility tokens aim to combine the low
cost of the rule-based governance with
added adaptability typical of equity-based
136
governance. Combining their role in smart
contracts execution with the role in consensus mechanism is the chosen approach.
The bigger picture is that traditional stakeholder roles combine, overlap and merge in
blockchains. With tokens, investors can be
expected to assume roles beyond the traditional rights and responsibilities of investors, to include those of nodes, validators,
customers and dispute resolvers. It can be
argued that the fusion of these roles and
the resulting need to reimagine and redefine the relationships and roles of parties
to transactions make blockchain an experiment in governance and organization.
Finally, the analysis implies that blockchain and token potential in various industries should depend on the structure of
contractual hazards and attributes of transaction costs. In a recent study Liu and Tsyvinski (2018) identified potential winners
and losers from the adoption of the blockchain technology and related cryptocurrencies. By regressing each industry’s stock
returns on main cryptocurrencies returns
and the excess stock market returns, they
found positive correlations, for example for
consumer goods, healthcare, and negative
for asset trade (finance) industry. Given
the lack of theory behind, such findings
should be approached with great caution.
Transaction cost economics offer a theoretical background on which to develop
propositions concerning the prospects of
blockchain and tokens in each industry and
to test them in comparative settings.
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