Private Fund Fee Structure and Blockchain Applications

 

(Forthcoming: Lowell Milken Institute for Business Law and Policy – UCLA School of Law)

Fully Cited Version:  https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2959730

The traditional 2/20 fee structure of private investment funds has come increasingly under pressure in the last ten years. Several market factors help explain the pressure on the fee structure of the private investment fund industry. Private fund investors withdrew $70.1 billion from the private investment fund industry in 2016. In 2016 a total of 1,057 private investment funds closed down, exceeding the 1,023 liquidations of private investment funds in 2009, and falling just shy of the record 1,471 closures in 2008. According to some observers the market is oversaturated which increases pressure on private investment fund managers’ performance and results in compromise fee arrangements, such as paying fees on invested capital only. Other factors that help explain the pressure on fees in the industry include the inadequate performance of the private investment fund industry, the ability of large investors to negotiate special terms, the withdrawal of private investment fund investments by large institutional clients and public retirement funds, and the consolidation of the industry, among several other market-driven factors.

A factor contributing to the market pressure on the fee structure that has not been examined by commentators pertains to the increasing use of use of blockchain technology, artificial intelligence, and big data by private fund advisers. Anecdotal evidence suggests that the majority of private fund advisers that use blockchain technology, artificial intelligence, and big data in different aspects of their operations or strategy have a substantially lower fee structure than those who do not use them. Prominent examples of lower fee structures driven by the use of blockchain technology include those of Lending Robot’s Lending Robot Series, and platforms for blockchain-enabled fund management, such as those offered by Melonport or Drago, among others.

Using a dataset of 98 private investment fund advisers that utilize blockchain technology in their investment strategy or internal operations, this article shows that the fund advisers who use the new technology are able to charge overall lower fees. The article explores the reasons for lower fees in those funds and examines possible future applications of the technology in the private investment fund industry. While the overall proportion of strategies of private investment funds that apply modern technologies, including blockchain technology, is still small, as the use of blockchain technology grows in the private investment fund industry, the pressure on the fee structure is likely to continue to grow.

I.       Changing Fee Structure

The fee structure of private investment funds has changed substantially in the last ten years. Traditionally, the hedge fund industry has charged fees to investors based on the so-called “2/20” formula. This means that most fund advisers were paid monthly or quarterly an annualized 2% management fee based on assets under management and a 20% annual performance or incentive reallocation based on net fund profits. Similarly managers of private equity funds generally used to charge an annualized 2% management fee based on committed capital and most commonly received a 20% commission on returns over a designated amount (referred to as the carry) as incentive compensation. However, the historical fee of 2% of commitments through the reinvestment period, then 2% on the cost basis for the investments/value of fund has shifted in recent years closer to 1.0% for new managers and 1.5-1.8% for established managers with an adequate track record.

It has become increasingly common in recent years for investors to negotiate fees with fund managers, particularly with newer fund managers who may be more willing to engage in such negotiations to induce seed investors at the time of fund formation. Alternative fee arrangements include but are not limited to modified highwater marks, incentive hurdles, and triggers, as well as clawbacks.

First-time or new managers are particularly affected by the new fee structure. Unlike in the recent past, first-time managers are now often forced to share the business budget (rent, employee salaries,  etc.) to justify the 1.5% management fee. Moreover, the industry is increasingly seeing contested track records for new managers, i.e., the new firm cannot get a consensus from the new manager’s old employer about the manager’s track record with that employer. Another phenomenon that affects first-time managers pertains to early limited partnership investors who increasingly throw their weight around to negotiate tough terms on fees.

II.       Factors Creating Downward Pressure on Fees

For the better part of the last ten years, the inadequate performance of the private investment fund industry created substantial pressure on its traditional 2/20 fee structure. A prominent example, exemplifying the pressure on the fee structure given the performance of the industry, is the wager between Warren Buffet and Ted Seides. In 2007 Warren Buffet entered into a wager with Ted Seides of Protégé Partners, betting $500,000 that a purely passive investment strategy, that is passively tracking the S&P 500 Index, over a ten-year period would beat any hedge fund portfolio over the same time period. Buffet asserted that the fees of the private investment fund industry (2/20) were too high for hedge funds given the returns of the industry and did not justify the fees continuing existence. To show his commitment, Buffet selected a Vanguard S&P Index Fund, passively tracking the S&P 500 Index, while Seides chose five hedge funds of funds. Seides’s hedge funds of funds had collectively invested in over 100 hedge funds. The wager was on the higher of the respective funds’ compounded annual return for ten years (2008-2017) net of fees. Seides entered into the bid despite a huge disadvantage—hedge funds have a much higher fee structure and the wager pertained to compounded annual interest net of fees. A year before the end of the wager, Buffet’s nine-year result is a 7.1 % compounded annual return compared to Seides’s 2.2%. Buffet has opined that the great majority of managers are not skillful enough to outperform the S&P 500, noting that “a good record quickly attracts a torrent of money . . . huge sums invariably act as an anchor on investment performance [and that] most managers will nevertheless seek new money because of their personal equitation – namely, the more funds they have under management, the more their fees.”

The increasing pressure on the traditional fee structure manifests itself in several new fee-related outcomes affecting private investment fund managers. In recent years, private investment fund management fees can deviate from the market rate of 1.5%–2% of the fund’s capital commitments because affiliates or other employees of the investment manager who invest in the fund are not charged management fees, and funds with fewer oversight and monitoring requirements typically charge lower management fees. The new fee structure is also the result of fund managers foregoing market rate management fees, larger investors requiring reduced management fees to induce investment, side-by-side vehicles attracting investors in the co-investment entities by charging less than 2% management fees, real estate funds charging management fees based on the amounts invested in properties, and different investors in the same fund being charged different management fees. Charging different management fees because of the aforementioned pressures on the industry can make it more difficult for fund advisers to market a fund, especially a fund where investors receive “most favored nations” rights.

Several market factors help explain the pressure on the fee structure of the private investment fund industry. Private fund investors withdrew $70.1 billion from the private investment fund industry in 2016. In 2016 a total of 1,057 private investment funds closed down, exceeding the 1,023 liquidations of private investment funds in 2009, and falling just shy of the record 1,471 closures in 2008. According to some observers the market is oversaturated which increases pressure on private investment fund managers’ performance and results in compromise fee arrangements, such as paying fees on invested capital only.

Other important factors for the downward pressure on the incentive fee side include blackened carried interest and changes in the calculation of hurdle rates. Some industry observers are now talking about a movement towards blackened carried interest, meaning a private investment fund manager cannot collect carry until all limited partner investors have had their capital returned within the lifetime of the private equity model. A similar trend is observable in the hedge fund industry. Moreover, hurdle rate calculations have changed substantially. Inflation-indexed hurdle rates are now calculated on a monthly not a quarterly basis. For managers with pension plan limited partners that often means instead of an 8% hurdle rate the manager gets 5% plus inflation.

III.       Blockchain Technology

Blockchain technology has been defined in many different ways, and no truly uniform definition seems to exist. Some refer to it as a giant worldwide, distributed, immutable “google spreadsheet” for transactions. Others define blockchain by focusing on its central elements, e.g., it is a transaction ledger, electronic, decentralized, immutable, and provides cryptographic verification, among several others.

Rather than attempting to agree on a mutually acceptable phraseology for a definition, a description of the core elements of ledger technology can help define the blockchain. As such, a blockchain is a shared digital ledger or database that maintains a continuously growing list of transactions among participating parties regarding digital assets – together described as “blocks.” The linear and chronological order of transactions in a chain will be extended with another transaction link that is added to the block once such additional transaction is validated, verified, and completed. The chain of transactions is distributed to a limitless number of participants, so-called nodes, around the world in a public or private peer-to-peer network.

Blockchain technology removes fraudulent transactions. Compared with existing methods of verifying and validating transactions by third-party intermediaries, blockchain’s security measures make blockchain validation technologies more transparent and less prone to error and corruption. While blockchain’s use of digital signatures helps establish the identity and authenticity of the parties involved in the transaction, it is the completely decentralized network connectivity via the Internet that allows the most protection against fraud. Network connectivity allows multiple copies of the blockchain to be available to all participants across the distributed network.

The decentralized, fully-distributed nature of the blockchain makes it practically impossible to reverse, alter, or erase information in the blockchain. Blockchain’s distributed consensus model, e.g., the network nodes verify and validate chain transactions before execution of the transactions, makes it extremely rare for a fraudulent transaction to be recorded in the blockchain. That model also allows node verification of transactions without compromising the privacy of the parties and is therefore arguably safer than a traditional model that requires third-party intermediary validation of transactions.

Cryptographic hashes further increase blockchain security. Cryptographic hashes are complex algorithms that use the details of all previous transactions in the existing blockchain before adding the next block to generate a unique hash value. That hash value ensures the authenticity of each transaction before it is added to the block. The smallest change to the blockchain, even a single digit/value, results in a different hash value. A different hash value makes any form of manipulation immediately detectable.

Smart contracts and smart property are blockchain-enabled computer protocols that verify, facilitate, monitor, and enforce the negotiation and performance of a contract. The term “smart contract” was first introduced by Nick Szabo, a computer scientist and legal theorist, in 1994. An often-cited example for smart contracts is the purchase of music through Apple’s iTunes platform. A computer code ensures that the “purchaser” can only listen to the music file on a limited number of Apple devices. More complex smart contract arrangements in which several parties are involved require a verifiable and unhackable system provided by blockchain technology. Through blockchain technology, smart contracting often makes legal contracting unnecessary as smart contracts often emulate the logic of legal contract clauses.

IV.       Private Investment Funds’ Use of Blockchain Technology

A recent trend in the private investment fund industry pertains to the increasing use of blockchain technology to facilitate investment and process optimization. Several private investment funds have spearheaded the implementation of blockchain technology and smart contracting in their business model. While some funds simply focus on trading bitcoin and other cryptocurrencies to avoid market fluctuations, others invest in and/or acquire companies that use blockchain technology to provide synergies to their other portfolio companies. Yet others go much further by fully automating a hedge fund secured by blockchain technology, using blockchain technology to improve administrative procedures of private equity deal making, or using cryptocurrencies as incentives for data scientists’ competitive models that facilitate investment analysis efficiencies. Examples include private investment funds such as Polychain Capital, the Northern Trust in cooperation with IBM, Numerai, LendingRobot, and Intellisys Capital LLC, Melonport, among many others.

Several private investment funds have spearheaded and continue to expand the implementation of blockchain technology and smart contracting in their business models. In February 2017, Northern Trust and IBM entered into a partnership for the commercial use of blockchain in the private fund industry. The partnership provides an enhanced and efficient approach to private equity administration. The implementation of the Northern Trust and IBM blockchain is intended to increase the efficiency, transparency, and speed of private equity transactions, improve security, and bring innovation to the private equity market by simplifying the complex and labor-intensive transactions in the private equity market. While the current legal and administrative processes that support private equity are time-consuming, expensive, lack transparency, and involve lengthy, duplicative, and fragmented investment and administrative processes, the partnership’s solution delivers an enhanced and efficient approach to private equity administration. More specifically, unlike the current deal practice in private equity, which requires parties to reconcile multiples copies of the documents that form the deals to understand the greater picture, the blockchain program announced by Northern Trust and IBM allows all involved parties in an equity deal to look at a single compiled version of the transaction and all other data relating to the deal.

Another example of the use of blockchain technology for private investment funds is Numerai. Numerai is a private investment fund with a global equity strategy that will go live on the blockchain later this year. Numerai operates on the Ethereum blockchain, utilizing a cryptocurrency called “Numeraire.” Numerai uses artificial intelligence to convert financial data into machine learning problems for data scientists. On February 21, 2017, Numerai, announced: “[Today] 12,000 data scientists were issued 1 million crypto-tokens to incentivize the construction of an artificial intelligence hedge fund.” Using data scientists for investment analysis creates efficiency through a synthesis of data. Data scientists working in this model work to solve the same problems in their own unique way with different strategies. Numerai synthesizes these models to create a meta-model out of all the predictions from the data scientists. In the Numerai model, the use of artificial intelligence ultimately helps achieve the goal of efficiency and optimum capital allocation by reducing overhead costs because there is no cost of human capital. In addition, Numerai eliminates barriers to entry because users do not need capital or any special finance or data knowledge.

LendingRobot’s LendingRobot Series is a fully automated hedge fund secured by blockchain technology. Unlike other blockchain-based hedge funds that invest specifically in cryptocurrency, such as Global Advisers and Polychain Capital, the LendingRobot Series invests in lending marketplaces— Lending Club, Prosper, Funding Circle, and Lending Home. Its trading is determined by an algorithm based on the investor’s risk preferences. Once the investor has created a trading profile, LendingRobot selects and executes trades that are recorded in the blockchain public ledger on a weekly basis. Unlike traditional hedge funds that are rather secretive, the LendingRobot ledger shows detailed holdings and provides a “hash code” signature as evidence that the data is tamper-proof in the blockchain.

Established private investment fund managers may consider implementing blockchain technologies in the foreseeable future. Most large fund advisers in the private equity and hedge fund industry have not yet considered implementing blockchain technology in combination with big data applications and artificial intelligence. This, however, may change in the foreseeable future if and when larger managers realize that their smaller competitors who utilize these technologies gain substantial operational efficiencies and cost savings and are able to substantially diversify their portfolio holdings via such technologies. The threshold for change for bigger managers may be dictated by the implementation cost of such new technologies. If and when the long-term benefits of using the technologies exceed the implementation cost, which are much larger for larger managers than for the smaller managers who are currently experimenting with such technologies, larger managers are incentivized to start the innovation process as well.

V.       Blockchain-Enabled Pressure on Fee Structure

Blockchain technology enables managers to charge per-transaction fees which undermines the existing 2/20 fee model. Blockchain technology facilitates a seamless and efficient calculation of management fees per transaction. In contrast to the traditional settlement and calculation of fees in a per-transaction model that created a prohibitive amount of work making such operations very difficult to execute, blockchain technology overcomes all of these restrictions. It enables the fully automated allocation of the appropriate fee to the correct executed trade and associated client account without any manual reconciliation or settlement. While normally the use of this type of fee is prone to human errors that occur during manual calculation or settlement, these errors are removed through the use of blockchain technology which performs the required calculations and settlement procedures automatically and seamlessly. The blockchain enabled per-transaction fee can be pre-determined or modified by the manager in cooperation with clients. It also can be publicly available which allows the private fund adviser to determine the applicable fee in a competitive market. Accordingly, clients who invest in a more transaction-prone strategy will be able to agree upfront to higher fees whereas clients who invest in a less transaction-rich strategy will pay overall lower fees.

While not all blockchain-enabled private investment funds charge per-transaction fees, the majority of private fund advisers that use blockchain technology are able to charge their investors lower fees. Prominent examples of lower fee structures driven by the use of blockchain technology include those of LendingRobot’s LendingRobot Series, the Logos Fund, and platforms for blockchain-enabled fund management, such as those offered by Melonport or Drago, among many others.

Investors in LendingRobot’s Lending Robot Series, the fully automated hedge fund secured by blockchain technology, unlike investors in traditional hedge funds, can withdraw funding on a weekly basis at no additional cost to the investor. Because LendingRobots’ business model removes the investment adviser, overhead costs, and legal fees associated with each investor agreement, LendingRobot is able to charge a mere 1% management fee and a maximum  0.59% fund expense fee per year. Other factors that help keep the fee low include the increased transparency that allows LendingRobot to expense fewer resources on auditing the fund. LendingRobot claims an average performance of from 6.86% to 9.66% depending on the investment strategy selected by the clients. As of March 2017 an analysis of a broad range of traditional hedge funds shows an average of 8.89% annualized return. The increased transparency, reduced costs, and competitive performance enabled by LendingRobot’s use of blockchain technology may give it a competitive advantage in the private fund industry that could continue to exert pressure on fees charged by competitor funds.

The Logos Fund is an alternative investment fund that invests in blockchain and cryptocurrency-related investments. It aims to make blockchain-based currencies accessible to professionals and a broad range of investors by investing in the mining of blockchain-based cryptocurrencies as well as into such currencies directly. To cover base costs and administration, the Logos Fund charges an administrative fee of between 1.2% and 1.92% depending on the size of the investment. The fund management also charges a performance-related fee of from 9% to 21% plus investment surcharges and redemption surcharges in accordance with market practices.

Blockchain-enabled platforms for setting up a private investment fund cause significant pressure on the existing fee structure of the private investment fund industry. Platforms such as Melonport or Drago enable competitive gains for their clients through fewer costs and time barriers to setting up and running a private investment fund. While such competitive gains will benefit the majority of private investment fund managers and investors, the lower operating costs enabled by the platform models will especially enable new and future managers to enter the market because the start-up costs and compliance costs can be significantly reduced. By enabling low set-up requirements and low costs of running a portfolio, platform models may be able to create an unprecedented competitive environment for asset management strategies. The cost of running a private fund adviser portfolio on the blockchain equals the core usage fees, modular commissions, and the infrastructure costs to be paid on the Ethereum platform.  The usage fees are determined by the protocol, and the modular fees are set by the module developers and are a fraction of a cent or a fraction of the trade volume for each usage.

 

 

The graph illustrates that the fee structure of those private investment funds that use blockchain technology deviates from the traditional 2/20 model. While the author was unable to get responses from all managers in the dataset, those who responded suggested that they were able to use an alternative fee structure.

VI.       Conclusion

The meteoric rise of blockchain technology and the abovementioned prominent applications of blockchain technology utilizing artificial intelligence and big data serve as prominent examples of the impending seismic shifts in the private investment fund industry. The paper has illustrated that the rise of blockchain applications in private investment funds has an impact on the already changing fee structure of the industry. Private investment funds that use blockchain technology in combination with other technologies, such as artificial intelligence and big data, among others, are able to lower their fees. As the use of blockchain technologies increases in the industry, the fee structure will be subject to increasing pressure.

 

*Associate Professor, University of St. Thomas School of Law (Minneapolis), United States of America. The author is grateful for out­standing support from librarian Ann Bateson.

Dynamic Regulation Via Contingent Capital

Dynamic Regulation Via Contingent Capital

16 Pages Posted:

Wulf A. Kaal

University of St. Thomas, Minnesota – School of Law

Date Written: April 24, 2017

Abstract

Contingent capital securities are a largely overlooked dynamic regulatory mechanism. This essay evaluates the use of contingent capital securities in a dynamic regulatory context, including the use of feedback effects for optimized timing and information for regulation and anticipatory regulation.

Keywords: Dynamic Regulation, Contingent Capital, CoCos, Feedback Effects, Optimized Information for Regulation, Anticipatory Regulation

JEL Classification: K20, K23, K32, L43, L5, O31, O32

Kaal , Wulf A., Dynamic Regulation Via Contingent Capital (April 24, 2017). Review of Banking and Financial Law, Vol. 36, 2017. Available at SSRN: https://ssrn.com/abstract=

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2957645

Legal Education in the Blockchain Revolution

Mark Fenwick*, Wulf A. Kaal* & Erik P.M. Vermeulen**
Abstract

The legal profession is one of the most disrupted sectors of the consulting industry today. The rise of Legal Tech, artificial intelligence, big data, machine learning, and, most importantly, blockchain technology is changing the practice of law. The sharing economy and platform companies challenge many of the traditional assumptions, doctrines, and concepts of law and governance, requiring litigators, judges, and regulators to adapt. Lawyers need to be equipped with the necessary skillsets to operate effectively in the new world of disruptive innovation in law. A more creative and innovative approach to educating lawyers for the 21st century is needed.

Keywords: Legal Education, Legal Profession, Disruptive Innovation, Artificial Intelligence, Machine Learning, Big Data, Blockchain Technology, Platform Company, Platform Economy, Decentralization, Decentralized Autonomous Organization, Social Media, Technology, Trust.

JEL Classification: D20, D23, F60, G30, K20, K22, L20, L25, L29, O10, O30, O40

New article: #legal #education in #blockchain #Revolution with @erikpmvermeulen & @MarkDFenwick https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2939127

Blockchain Innovation for Private Investment Funds

Forthcoming– Cayman Financial Review (April 2017)

Blockchain technology offers unprecedented innovation opportunities for the private investment fund industry. Several private investment funds have spearheaded the implementation of blockchain technology and smart contracting in their business model. While some funds simply focus on trading bitcoin and other cryptocurrencies to avoid market fluctuations, others invest in and/or acquire companies that use blockchain technology to provide synergies to their other portfolio companies. Yet others go much further by fully automating a hedge fund secured by blockchain technology, using blockchain technology to improve administrative procedures of private equity deal making, or using cryptocurrencies as incentives for data scientists’ competitive models that facilitate investment analysis efficiencies. Examples include private investment funds such as Polychain Capital, the Northern Trust in cooperation with IBM, Numerai, LendingRobot, and Intellisys Capital LLC, among many others.

Naturally, this article cannot encapsulate all recently emerging trends in the private fund industry pertaining to the application of blockchain technology but rather is limited to pointing to prominent examples that illustrate the emerging use of blockchain technology in the private investment fund industry.

Despite these limitations, it is possible to forecast that once blockchain-based hedge funds that trade by algorithm are able to expand beyond peer-to-peer lending investments into the stock market, it is possible that they will monopolize and substantively change the hedge fund industry.

Blockchain Technology

A blockchain is a shared digital ledger or database that maintains a continuously growing list of transactions among participating parties regarding digital assets – together described as “blocks.” The linear and chronological order of transactions in a chain will be extended with another transaction link that is added to the block once such additional transactions is validated, verified and completed. The chain of transactions is distributed to a limitless number of participants, so called nodes, around the world in a public or private peer-to-peer network. The central elements of blockchain technology include: transaction ledger, electronic, decentralized, networked, immutable, cryptographic verification, among several others. Vitalik Buterin, the founder of Ethereum perhaps most prominently defined blockchain as follows:

“Public blockchains: a public blockchain is a blockchain that anyone in the world can read, anyone in the world can send transactions to and expect to see them included if they are valid, and anyone in the world can participate in the consensus process – the process for determining what blocks get added to the chain and what the current state is. As a substitute for centralized or quasi-centralized trust, public blockchains are secured by crypto economics – the combination of economic incentives and cryptographic verification using mechanisms such as proof of work or proof of stake, following a general principle that the degree to which someone can have an influence in the consensus process is proportional to the quantity of economic resources that they can bring to bear. These blockchains are generally considered to be “fully decentralized”.”

Smart contracts and smart property are blockchain enabled computer protocols that verify, facilitate, monitor, and enforce the negotiation and performance of a contract. The term “smart contract” was first introduced by Nick Szabo, a computer scientist and legal theorist, in 1994. An often-cited example for smart contracts is the purchase of music through Apple’s iTunes platform. A computer code ensures that the “purchaser” can only listen to the music file on a limited number of Apple devices.

More complex smart contract arrangements in which several parties are involved require a verifiable and unhackable system provided by blockchain technology. Through blockchain technology, smart contracting often makes contractual legal contracting unnecessary as smart contracts often emulate the logic of legal contract clauses. Ethereum, the leading platform for smart contracting, describes smart contracting in this context as follows:

”Ethereum is a decentralized platform that runs smart contracts: applications that run exactly as programmed without any possibility of downtime, censorship, fraud or third party interference. These apps run on a custom built blockchain, an enormously powerful shared global infrastructure that can move value around and represent the ownership of property. This enables developers to create markets, store registries of debts or promises, move funds in accordance with instructions given long in the past (like a will or a futures contract) and many other things that have not been invented yet, all without a middle man or counterparty risk.”

Private Investment Funds’ Use of Blockchain Technology

Several private investment funds have spearheaded and continue to expand the implementation of blockchain technology and smart contracting in their business models.

In February 2017, Northern Trust and IBM entered into a partnership for the commercial use of blockchain in the private fund industry. The partnership provides an enhanced and efficient approach to private equity administration. The implementation of the Northern Trust and IBM blockchain is intended to increase efficiency, transparency, and the speed of private equity transactions, improve security, and bring innovation to the private equity market by simplifying the complex and labor intensive transactions in the private equity market. While the current legal and administrative processes that support private equity are time consuming, expensive, lack transparency, involving lengthy, duplicative, and fragmented investment and administration processes; the partnership’s solution delivers an enhanced and efficient approach to private equity administration. More specifically, unlike the current deal practice in private equity, which requires parties to reconcile multiples copies of documents that form deals to understand the greater picture, the blockchain program announced by Northern Trust and IBM allows all involved parties in an equity deal to look at one single compiled version of the transaction and all other data relating to the deal.

Another example of the use of blockchain technology for private investment funds is Numerai. Numerai is a private investment fund with a global equity strategy that will go live on the blockchain later this year. Numerai operates on the Ethereum blockchain, utilizing a cryptocurrency called “Numeraire.” Numerai uses artificial intelligence to convert financial data into machine learning problems for data scientists. On February 21, 2017, Numerai, announced: “Today 12,000 data scientists were issued 1 million crypto-tokens to incentivize the construction of an artificial intelligence hedge fund.” Using data scientists for investment analysis creates efficiency through a synthesis of data. Data scientist working in this model work to solve the same problems in their own unique way with different strategies. Numerai synthesizes these models to create a meta-model out of all the predictions from the data scientists. In the Numerai model, the use of artificial intelligence ultimately helps achieve the goal of efficiency and perfect capital allocation by reducing overhead costs because there is no cost of human capital. In addition, Numerai eliminates barriers to entry because users do not need capital or any special finance or data knowledge.

Lending Robot’s Lending Robot Series is a fully automated hedge fund secured by Blockchain technology. Unlike other Blockchain-based hedge funds that invest specifically in crypto currency, such as Global Advisers and Polychain Capital, Lending Robot Series invests in lending marketplaces such as Lending Club, Prosper, Funding Circle, and Lending Home. Its trading is determined by an algorithm based on the investor’s risk preferences. Once the investor has created a trading profile, Lending Robot selects and executes trades that are recorded in the Blockchain public ledger on a weekly basis. Unlike traditional hedge funds that are rather secretive, the Lending Robot ledger shows detained holdings and provides a “hash code” signature as evidence that the data is tamper-proof in the Blockchain. Unlike investors in traditional hedge funds, Lending Robots’ investors can cash out on a weekly basis at no additional cost and Lending Robot only charges a 1% management fee and a maximum of 0.59% fund expense fee per year. Lending Robots’ business model creates superior efficiencies by removing the investment advisers, overhead costs, and legal fees associated with each investor agreement.

Mainstreet Investment, LP incorporates Blockchain technology into its operations. Mainstreet Investment LP operates like a private equity firm by allocating investment capital in American companies, blockchain companies, and real estate. By using blockchain technology the fund intends to provide investors with higher returns in the US compared to low-yielding bonds, high risk equity picks, and profit-erasing fees of mutual funds. Mainstreams’ managers incorporated Blockchain technology into the funds structure by issuing an asset-backed token security on the public Ethereum blockchain using a smart contract that records all assets in the portfolio. Moreover, blockchain is also used by issuing cash flow distributions to token holders through the smart contract. Mainstreet is powered by Ethereum with an organizational framework focused on transparency of the investment portfolio. Blockchain technology will be used to facilitate and administer the decentralized fund, which includes token purchasing, tracking, dividend payouts and dissemination of investor information.

Blockchain Solutions for Agency Problems in Corporate Governance

Abstract

Blockchain technology allows for decentralized networked governance that allows for the removal of internal and external monitoring mechanisms previously necessitated by agency problems in corporate governance. Blockchain technology creates formal immutable guarantees in agency relationships that build the trust needed to overcome the agency problems in corporate governance. It facilitates a substantial increase in efficiency in the agency relationship and lowers agency costs in orders of magnitude.
(An extended and fully cited version of this article is forthcoming)

Introduction

Agency theory (Jensen and Meckling (1976)) is still today the leading theory for governance conflicts between shareholders, corporate managers, and debt holders. A vast literature attempts to explain the nature of the agency conflicts in corporate governance and possible ways to resolve such conflicts. However, the core agency conflicts emanating from the separation of ownership (shareholder principal) and control (manager agent) cannot be fully addressed by the existing theoretical and legal framework. Attempts to monitor agents is inevitably costly and transaction costs abound. The literature has overlooked the unprecedented efficient solutions offered by blockchain technology for agency problems in corporate governance.

Agency Problems

Agency problems originate from the lacking trust between principals and agents. The agency relationship can be defined as a contract between principal and agent whereby the agent acts on principals’ behalf because principal delegated a modicum of decision-making authority to the agent (Jensen and Meckling (1976)). Because of the delegated authority, the agents’ decisions affect both the agents’ welfare and the principals’ welfare. The agency model at its very basic level suggests that information asymmetries between the principal and the agent and agents’ opportunistic behavior resulting from self interest leads to principals’ lacking trust in agents. Because of bounded rationality, incomplete foresight, and information asymmetries between principal and agent, it is impossible for principals to contract for every possible action or inaction of the agent in order to induce the agent to act in the best interests of the principal (Brennan (1995)).

Agency Costs

Agency costs arise because the principal attempts to control, monitor, and supervise the agent. As a result of lacking trust in the integrity of the principal agent relationship, and in an attempt to minimize information asymmetries, principals are forced to put into place costly mechanisms to align their interest with those of the agents. Most prominently, such control mechanism involve periodic reporting, compensation structures for agents, bonding, among others. In the corporate context, agency costs can be seen as the lost value to shareholders (loss in corporation’s share price) that results from diverging interests between shareholders (principal) and corporate managers (agents). As such, agency costs is the sum of monitoring costs, bonding costs, and residual loss (Jensen and Meckling (1976)).

Monitoring costs are costs to the principal resulting from observing, measuring, and controlling an agent’s behavior. Monitoring costs can include the cost of audits, executing executive compensation contracts, and cost of hiring/firing manager agents. While such monitoring costs are generally paid by the principal, agents may be responsible for such costs as well because agents’ compensation is subject to adjustments to cover monitoring costs (Fama and Jensen (1983)).

Bonding costs are the cost of establishing and adhering to system structures that allow agents to act in shareholder principal’s best interests or compensate shareholder principals appropriately if agents do not act in their best interest. While bonding costs are typically paid by the agents, they may in addition to financial costs include the cost of increased disclosures to shareholder principals. If the marginal reduction in monitoring equals the marginal increase in bonding costs, agents no longer incur bonding costs.

first-picture-copy

The agency relationship in modern finance and corporate governance is characterized by attempts to optimize incentives between principals and agents, control costs, minimize information asymmetries, control adverse selection and moral hazard, optimize risk preferences between principals and agents, and engage in monitoring.

Agency Problems in Corporate Governance

second-picture-copy

The lacking trust in the agent’s performance of her duties creates the underlying problems in corporate governance. Despite best efforts at monitoring and bonding, the interest of manager agents and shareholder principals in corporate governance are never fully aligned and agency losses inevitably arise from conflicts of interest between principals and agents, known as residual loss. Residual loss arises because the cost of enforcing suboptimal contracts between principals and agents always exceed the benefits of performing the contractual obligations.

Existing Governance Mechanisms

Existing governance mechanism sub-optimally address the agency problems in corporate governance. To name only a few of many approaches that are beyond this short illustration, a standard approach much touted by the literature for effective corporate governance involved outside independent directors on corporate boards. Another prominent example involves firms’ capital structures with emphasis on higher debt levels. While these and many other attempts at optimizing corporate governance and addressing the agency problems in corporate governance helped optimize the agency problems, many examples suggest that the core underlying agency problems cannot fully be resolved within the existing theoretical and legal infrastructure.

A standard approach for effective corporate governance involved outside independent directors on corporate boards who hold managerial positions in other companies, thus separating the problems of decision management and decision control (Fama and Jensen (1983)). However, CEOs who often dominate the board make the separation of these functions much more difficult, which hurts shareholders. Furthermore, outside directors’ separation of decision management and decision control depends on their concern over reputation as an incentive, which is insufficient in most cases.

Another much touted governance mechanism for firms involved firms’ capital structures with emphasis on higher debt levels. Higher levels of insider ownership by increasing debt and reducing equity (Jensen and Meckling (1976)) in the firm’s capital structure acts as a bonding mechanism for manager agents (Jensen (1986)). Management by issuing debt rather than paying dividends creates contractual obligations to pay out future cash flows in ways unattainable through dividends. Debt financing can also help create external capital market monitoring which incentivizes managers’ avoidance of personal utility maximization and increases value maximizing strategies for shareholders (Easterbrook (1984)).

Despite the unresolved substantive problems associated with the division of ownership (shareholders) and control (agent), the corporate form with the diffused share ownership that leads to such conflicts, and the incomplete and suboptimal rules that govern such conflicts, remains the most popular form of a governance mechanism. The popularity of existing mechanisms to address the agency problems in corporate governance may be related to path dependencies created by the evolution of internal and external monitoring mechanisms in corporate governance and the evolution of governance mechanisms designed to limit the scope of agency problems, instituted to address the agency problems in corporate governance.

Existing universal governance solutions are often ineffective because agency conflicts and the specific scope of agency conflicts differ across firms. Governance mechanisms and the effectiveness of governance mechanisms in reducing agency conflicts in firms differ from firm to firm. Each type of governance mechanism and combinations of governance mechanisms can help reduce aspects of agency costs associated with the separation of ownership (principal shareholder) and control (manager agent). However, existing governance mechanisms work well in some firms but are ineffective in others. The literature today is still lacking a comprehensive understanding of workable governance mechanisms and solutions across a broad spectrum of firms.

Blockchain Solutions for Agency Problems in Corporate Governance

 

Blockchain offers unprecedented solutions for agency problems in corporate governance. Supervisory tasks that were traditionally performed by principals to control their agents can now be delegated to decentralized computer networks that are highly reliable, secure, immutable, and independent of fallible human input and discretionary human goodwill. Blockchain technology provides an alternative governance mechanism that eliminates agency costs – the principal’s cost of supervising agents – by creating trust in the contractual relationship between the principal and the agent.

Blockchain Technology

A blockchain is a shared digital ledger or database that maintains a continuously growing list of transactions among participating parties regarding digital assets – together described as “blocks.” The linear and chronological order of transactions in a chain will be extended with another transaction link that is added to the block once such additional transactions is validated, verified and completed. The chain of transactions is distributed to a limitless number of participants, so called nodes, around the world in a public or private peer-to-peer network. The central elements of blockchain technology include: transaction ledger, electronic, decentralized, networked, immutable, cryptographic verification, among several others. Vitalik Buterin, the founder of Ethereum perhaps most prominently defined blockchain as follows:

“Public blockchains: a public blockchain is a blockchain that anyone in the world can read, anyone in the world can send transactions to and expect to see them included if they are valid, and anyone in the world can participate in the consensus process – the process for determining what blocks get added to the chain and what the current state is. As a substitute for centralized or quasi-centralized trust, public blockchains are secured by cryptoeconomics – the combination of economic incentives and cryptographic verification using mechanisms such as proof of work or proof of stake, following a general principle that the degree to which someone can have an influence in the consensus process is proportional to the quantity of economic resources that they can bring to bear. These blockchains are generally considered to be “fully decentralized”.”

Smart contracts and smart property are blockchain enabled computer protocols that verify, facilitate, monitor, and enforce the negotiation and performance of a contract. The term “smart contract” was first introduced by Nick Szabo, a computer scientist and legal theorist, in 1994. An often-cited example for smart contracts is the purchase of music through Apple’s iTunes platform. A computer code ensures that the “purchaser” can only listen to the music file on a limited number of Apple devices.

More complex smart contract arrangements in which several parties are involved require a verifiable and unhackable system provided by blockchain technology. Through blockchain technology, smart contracting often makes contractual legal contracting unnecessary as smart contracts often emulate the logic of legal contract clauses. Ethereum, the leading platform for smart contracting, describes smart contracting in this context as follows:

”Ethereum is a decentralized platform that runs smart contracts: applications that run exactly as programmed without any possibility of downtime, censorship, fraud or third party interference. These apps run on a custom built blockchain, an enormously powerful shared global infrastructure that can move value around and represent the ownership of property. This enables developers to create markets, store registries of debts or promises, move funds in accordance with instructions given long in the past (like a will or a futures contract) and many other things that have not been invented yet, all without a middle man or counterparty risk.”

Blockchain Guarantees Create Trust in the Agency Relationship

Blockchain technology creates a platform for trust through truth and transparency for parties. Because the blockchain (at the least the public blockchain) is in fact public and immutable, the technology increases transparency, while at the same time significantly reducing transaction costs.

Blockchain technology provides formal guarantees to participating principals and agents that address agency problems in corporate governance comprehensively. Because of the blockchain guarantees, the technology allows a qualitatively different solution for agency problems in corporate governance, especially if compared with the existing finance infrastructure that is riddled with agency problems (see credit rating, executive compensation etc).

The immutability of the blockchain and its cryptographic security systems provide transactional guarantees and create trust between principals and agents in the integrity of their contractual relationship. Such guarantees ensure no participant can circumvent the rules embedded in blockchain code. Blockchain guarantees include contract execution between principal and agent only if and when all contract parameters were fulfilled by both parties and verified by a majority of miners/nodes in the system. Hence, in the blockchain infrastructure, there is no need for the principal to institute oversight and monitoring with the associated agency costs. Because of the governance guarantees embedded in code, blockchain addresses the inherent agency problems in modern finance and corporate governance comprehensively.

Blockchain technology secures the integrity of principal agent relationships by removing fraudulent transactions. Compared with existing methods of verifying and validating transactions by third party intermediaries (banking, lending, clearing etc.), blockchain’s security measures make blockchain validation technologies more transparent, faster, and less prone to error and corruption. While blockchain’s use of digital signatures helps establish the identity and authenticity of the parties involved in the transaction, it is the completely decentralized network connectivity via the Internet that allows the most protection against fraud. Network connectivity allows multiple copies of the blockchain to be available to all participants across the distributed network. The decentralized fully distributed nature of the blockchain makes it practically near impossible to reverse, alter, or erase information in the blockchain. Blockchains’ distributed consensus model, e.g. the network “nodes” verify and validate chain transactions before transaction execution, makes it extremely rare for a fraudulent transaction to be recorded in the blockchain. Blockchain’s distributed consensus model allows node verification of transactions without comprising the privacy of the parties. Blockchain transactions are therefore arguably safer than a traditional transaction model that requires third-party intermediary validation of transactions. Blockchain technology is also substantively faster than traditional third-party intermediary validation of transactions.

Cryptographic hashes used in blockchain technology further increase blockchain security and removes trust barriers in agency relationships that require monitoring of agents and create agency costs. Cryptographic hashes are complex algorithms that use details of the existing entirety of transactions of the existing blockchain before the next block is added to generate a unique hash value. That hash value ensures the authenticity of each transaction before it is added to the block. The smallest change to the blockchain, even a single digit/value, results in a different hash value. A different hash value in turn makes any form of manipulation immediately detectable. As such, hash cryptology provides another level of guarantee in a agency relationship executed through blockchain technology.

Smart contracts enabled by blockchain technology allow for the comprehensive, error free, and zero transaction/agency cost coordination of agency relationships. Smart contracts and smart property are blockchain enabled computer protocols that facilitate, verify, monitor, and enforce the negotiation and performance of a contract between principal and agent. Agency relationships in smart contracts run exactly as coded without any possibility of opportunistic behavior of the agent. Information asymmetries between principal and agent, censorship, opportunism of agents, breaches of fiduciary duties, liability rules for principals and agents, fraud or third party interference are removed entirely. All contractual terms are public and fully transparent. Accordingly, a company’s finances, for instance, are visible on the blockchain to anyone, not just to the company’s accounting department. Smart agency contracts run on a custom built blockchain, that enables principals and agents to store registries of debts or promises, create entire markets, among many other aspects that have not yet been considered.

Agency related governance in the blockchain takes place without intermediaries, counterparty risk, and principal’s control mechanisms. Blockchain technology simply does not require the layers of control and verification that prior financial systems necessitated. Control mechanisms such as regular management (agent) meetings with shareholders (e.g. at the AGM etc.), financial disclosures, management agent scrutiny through analyst reports and financial press, pressure on management from stock market performance, hedge fund investors, and other institutional and private investors, are no longer part of the blockchain enabled agency relationship in corporate governance.

Blockchain technology facilitates a substantial increase in the efficiency of agency relationships in orders of magnitude and lowers agency costs equally substantial in orders of magnitude. The removal of checks and balances in corporate governance, monitoring of agents, audit requirements, disclosure regimes, market pressure, executive agent compensation schemes, among many others, provides a qualitative shift in efficiency in the agency relationship and in corporate governance overall.

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Self-validating blockchain transactions can help resolve the agency issues between most of the stakeholders and constituents of modern corporations. In addition to addressing the traditional agency problem in corporate governance between shareholder principals and manager agents, blockchain enabled smart contracting allows for the public and fully transparent, secure, and completely networked exchange between the corporation and customers, owners and investors, other stakeholders, staff, regulators, strategic partners, suppliers and service providers.

Blockchain Removes Agents

Blockchain technology can facilitate the removal of agents as intermediaries in corporate governance through code, peer-to-peer connectivity, crowds, and collaboration. While it is still difficult to imagine a world without governance structures facilitated by agency constructs, Decentralized Autonomous Organizations (DAOs) have started to challenge the core believe that governance necessitates agency.

The first DAO, launched in May 2016, in the founders’ attempt to set up a corporate-type organization without using a conventional corporate structure, had a governance structure that was entirely built on software, code, and smart contracts that ran on the public decentralized blockchain platform Ethereum. Because if was pure computer code it had no physical address, no jurisdiction that could claim jurisdiction/control over it, and it was not an organization with a traditional hierarchy as we know it from traditional corporate structures. The DAO did not use a traditional corporate structure that necessitated formal authority and empowerment flowing top down from investors/shareholders through a board of directors to management and eventually staff. Indeed, it had no directors, managers or employees. In essence, all the core control mechanisms typically employed by principals in agency relationships were entirely removed in the DAO.

While the first DAO was subject to many limitations and ended in quite some controversy, future DAOs may be less prone to problems. Fundamental flaws in the DAO code enabled hackers to transfer one third of the total funds to a subsidiary account. This hack in combination with additional technological limitations brought down the first DAO initiative. Yet, future DAOs are already created and DAO enthusiasts never stopped testing it. A new DAO is currently being developed that is not set up as a Venture Capital Fund but rather as a donation DAO where participants donate and don’t expect returns. DAO enthusiasts and the DAO community in general are constantly improving the DAO and it seems possible that future DAOs may improve agency problems in corporate governance much more thoroughly than is currently fathomable.

References:

Brennan, M.J. (1995), ‘Corporate Finance Over the Past 25 Years’, Financial Management 24, 9-22.

Fama, E.F. and M.C. Jensen. (1983), ‘Separation of Ownership and Control’, Journal of Law and Economics 88 (2), 301-325.

Easterbrook, F.H. (1984), ‘Two Agency Cost Explanations of Dividends’, American Economic Review 74 (4), 650-659.

Jensen, M.C. and W.H. Meckling. (1976), ‘Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure’, Journal of Financial Economics 3 (4), 305-360.

Jensen, M.C. (1986), ‘Agency Costs of Free Cash Flow, Corporate Finance and Takeovers’, American Economic Review 76 (2), 323-329.

Future of Innovation and Law

A wave of innovation and decentralization is sweeping across the world, challenging the traditional role of law, lawyers and law schools. Central themes from an Incredibly energizing and enabling course co-taught with @erikpmvermeulen at @USTLawMN “Disruptive Innovation – Why Lawyers Matter” include in order of priority: #innovation, #innovators, #platform, #entrepreneur, #bigdata, #blockchain, #smartcontracts, #machinelearning, #ArtificialIntelligence, #InternetOfThings, #sharingeconomy, #legaltech, #regulation, #regulate, #corpgov, #governance, #legal.

Future Companies and Governance

What should companies do to be successful in the future? What kind of structures, practices and processes will best equip a firm to reinvent itself and its products? How can firms transform themselves into 21st century companies? The Answer: Firms should adopt a decentralized and open model of innovation, value creation and growth. Ecosystems and platforms are the new normal. Companies that understand “how to organize now for success tomorrow” (@erikpmvermeulen) will win. Such companies understand the power of the ecosystem and platforms. These companies appreciate that governance is not only about disclosure and achieving sustainable long-term investment and growth but about engaging in an open dialogue, open “personalized” communication with all the stakeholders (not just customers or shareholders).

20th century companies:

  • profit driven
  •  hierarchy
  •  formalistic
  • closed networks
  • job security

21st century companies are better and embrace new values to innovate and stay relevant:

– – mission driven

– – flat hierarchies

– – inclusive

– – fluid

– – open communication

– – millennials

– – best idea wins

– – decentralized

– – crowd-culture

– – platform-enabling

– – create ecosystems for continuous innovation

@wulfkaal & @erikpmvermeulen We use Under Armour as an example of a 21st century company that is embracing the “platform economy”. Its connected fitness platform and open platform of innovation (ideahouse.ua.com) are examples. The Brand House shows that Under Armour lives its values: Act like a global citizen, Think like an entrepreneur, Create like an innovator, Perform like a teammate.

Regulators

When and how should regulators regulate disruptive innovation? Will technology replace regulators, regulations, and lawyers? A possible answer: A need for flexible and inclusive processes exists that involves startups, established companies, regulators, experts and the public. Innovations and regulatory responses must be tested in a “live” environment. To a certain extent, this regulatory approach is recently adopted in the financial industry with the introduction of “regulatory sandboxes”. Dynamic regulatory processes (@wulfkaal) can play a central role in the new world of innovation. Regulators will have to offer more guidance on how to “organize for innovation.”

Lawyers

The lawyers and law firms of the future distinguish themselves by embracing legal tech, join one or more of the emerging legal platforms (e.g. www.digitorney.de) and legal communities and operate as a bridge between the diverse range of actors (accountants, designers, ML engineers etc.) that must now work together in dealing with challenges of the sharing economy. During the course, we show that the development of new platforms and ecosystems, blockchain technology, smart contracts, internet of things, big data, machine learning, and artificial intelligence plays a central role in the future of law and cannot be ignored.

Key Takeaways

Key takeaways of the “Disruptive Innovation – Why Lawyers Matter” course include the recognition that blockchain technology and smart contracts will change the way we live, work and learn. Blockchain-based smart contracts will help scale and accelerate the sharing economy and enable the development of Internet of Things applications. These applications will disrupt the business of law, but will also lead to enormous opportunities for legal professionals. They will have to rethink “legal concepts” in the areas of property law, corporate law, contract law, etc.

Course Description

The purpose of this course is for students to gain an understanding of the exponential rate of disruptive innovation in a broad array of industries, the effect on corporations, the possible approaches for regulating such innovation, and the role of lawyers in this context.

The course examines the exponential rate of disruptive innovation affecting multiple industries. Students will learn about concrete real-life and data-driven examples of disruptive innovation and the short- and long-term effects of this innovation, including the emergence of flat corporate hierarchies to foster innovation and ensure the best ideas prevail in corporations struggling to stay relevant, open communication, and inclusivity. The course will examine innovation driven business cycles and highlight examples pertaining to corporations that failed to institute relevant changes to remain relevant in the face of disruptive innovation (Kodak, Nokia, among others). We will also examine how and why certain corporations (Amazon, Google, Tesla, Under Armour, among others) continue to thrive and what changes they instituted, allowing them to capitalize on disruptive innovation. More specifically, we will examine the emergence of “Dinosaurs” (companies that find themselves in a process of slow and terminal decline); “Unicorns” (large companies that remain private in order to avoid the stifling effects of post-IPO regulation); and “Governance Renegades” (public companies that adopt unconventional corporate structures in order to retain the pre-IPO-start-up-feel).

Given these governance changes and new structures imposed by disruptive innovation, the course examines the role of attorneys in this rapidly evolving environment. Students will learn about the legal relevance of the evolution of business strategy, technology, and the application and evolution of artificial intelligence in businesses. Based on the understanding of challenges and opportunities presented by disruptive innovation, students will develop the ability to discern their own possible value proposition in the disruption of businesses in various industries. The course will evaluate the different skills that allow students to remain relevant including soft skills, psychology, and the ability to understand business cycles and technology. The course emphasizes the importance of student skills at the intersection between law, business, psychology, and technology.

Dynamic Regulation Via Investment Data as a Remedy for Law’s Diminishing Capacity to React to Innovation

First published at: https://www.law.ox.ac.uk/business-law-blog/blog/2016/09/dynamic-regulation-investment-data-remedy-law’s-diminishing-capacity

Key words: Disruptive Innovation, Venture Capital, Venture Investments, Dynamic Regulation, Feedback Effects, Optimized Information for Regulation, Anticipatory Regulation, Big Data

In a series of recent papers – ‘Dynamic Regulation for Innovation’, ‘Regulation Tomorrow: What Happens When Technology Is Faster Than the Law?’, and ‘How to Regulate Disruptive Innovation – From Facts to Data’ – I evaluate the diminishing relationship between regulation and innovation. The so-called ‘pacing problem’ between innovation and regulation suggests that innovation driven by science and technology is accelerating, yet, simultaneously, federal and state agencies’ regulatory processes have slowed down.

Several factors contribute to this pacing problem. Some consensus exists that the legal and evidentiary burdens placed on regulatory authorities have increased substantially over time, precipitating the remarkable slowdown in rulemaking by regulatory agencies. The growing divergence between the time cycles of technological innovation and the time cycles of governments around the world contributes significantly to the pacing problem. Systemic factors such as the political and ideological structures in the rulemaking process, the political gridlock in a two-party system that impedes the passing of legislation, legislators’ disagreement on how outdated statutes should be updated, and the need for crises to precipitate legislative action also help to explain the pacing problem.

 

The existing regulatory infrastructure contributes significantly to this problem. In the existing regulatory framework, the regulatory challenges presented by disruptive innovation are largely associated with facts-based, ex-post, trial-and-error rule-making, with stable and presumptively optimal rules. In essence, some evidence exists that governments mostly regulate to react ex-post, after problems arose in the existing regulatory framework but rules are always assumed to be optimal even though optimality is unattainable in a rapidly innovating and increasingly complex world. Other regulatory challenges are presented by the slow speed of regulation, and ever-increasing unknown future contingencies in rulemaking. Because facts-based, ex-post, trial-and-error rule-making cannot anticipate regulatory issues created by innovation, rule-makers may not – or may much too late – realize what new regulatory demands apply to a given innovation. Rule-makers’ near exclusive reliance on stable and presumptively optimal rules created to attain permanent solutions for perceived regulatory issues ignores the ever-changing environment for rules driven by the exponential growth of technology, and the associated exponential growth of innovation.  The timing of regulation in an environment of exponential innovation is a primary problem for regulators. Formal rulemaking in the existing regulatory infrastructure is almost always too time-consuming because the speed of product innovation often makes regulations pertaining to an innovative product obsolete before such regulations are finalized. Finally, the existing regulatory infrastructure, with stable and presumptively optimal rules, is largely incapable of addressing the ever-increasing unknown future contingencies associated with disruptive innovation. Given the pace of innovation, future contingencies in rulemaking are likely to increase substantially, making the dynamic anticipation of future contingencies more important for rulemaking.

Lawmaking and regulatory design need to become more dynamic and anticipatory in their efforts to address this pacing problem. Increased reliance on different sources of data surrounding new technologies can provide some signals or clues about what, when and, to a certain extent, how to regulate.

Here, I show that data relating to investment in new technology and innovation is of particular importance in this context. A plethora of investment data is readily available to make accurate predictions regarding what the next ‘big thing’ is likely to be.  Such data can be used as an index or proxy for the necessity of regulation. Because start-up companies are the ones that usually challenge existing rules, laws and regulations, private data sources are widely available. The proliferation of the better hand-collected global databases on the market, such as CB Insights, PitchBook and Mattermark, can make an important contribution to a ‘data-driven’ regulatory approach.

Investment data can help to develop a list of technologies and issues that need to be the focus of regulatory attention. From such data, rule-makers can get a better – and earlier – sense of which technologies are developing and which technologies need regulatory attention. This might then allow regulators to be more pro-active and avoid wasting resources on technologies that are unlikely to make it to market. It would also allow regulators to more accurately define the scope of a technology by focusing on the type of firm that is attracting attention.

Wulf A. Kaal is an Associate Professor at the University of Saint Thomas School of Law (Minneapolis).

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