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.
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
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.
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.
Wulf Kaal 