Agency Theory & "Skin in the game"
Stephen Whitenstall
Skin in the game
The phrase "Skin in the game" originated in the 1980s and referred to the amount of an investment owned by a companies' management soliciting outside investment.
The more that was owned by management, the equity stake, was seen as an indication of confidence or stability in the investment. A sign that the management were personally invested and therefore had "skin in the game".
The phrase "Skin in the game"
Hence the phrase "skin in the game" has come to be seen as having a stake or personal investment that motivates decision making or participation.
Taleb's "Skin in the game"
Taleb emphasized that "Skin in the game" concerns symmetry
Principal–agent problem
"Skin in the game" can be a problem when there is an excess of interest or investment that prejudices participation and/or decision-making. This tendency is called the "principal-agent problem".
The influence of those who have a large stake may be obscured resulting in a lack of transparency that disadvantages or manipulates those with smaller stakes.
The principal-agent relationship may be between management (agent) and shareholders (principal), or elected officials (agent) and voters (principal), or brokers (agent) and buyers/sellers in a market (principal).
Where there is an asymmetry between agent and principal there will be concerns about moral hazard (exposure to risk) and conflict of interest (corruption).
Relevance to Decentralization
Decentralization has been seen as one way to resolve structural asymmetries.
Blockchain agency theory
In the context of blockchain technologies the question arises of what is the nature of the principal-agent relationship in permissioned and/or permissionless chains.
Where is Agency in a Blockchain environment ?
Where is agency in an environment that is ideally decentralized ? Are there still parties (principal) who delegate work to others (agents) ?
Governance takes the form of consensus algorithms that ideally regulate blockchain transactions. This permissionless state seeks to dispense with the agent-principal dependency.
Participation in a blockchain ecosystem can be characterized as a kind of strategic alliance between software developers, miners, stakepools, coin holders and other stakeholders that build tools and communities on the infrastructure.
Blockchain agency theory, as outlined in a recent paper, seeks to identify shifts in the principal-agent problem caused by disruptive technologies.
Title: Blockchain agency theory
Author: Adah-Kole Emmanuel Onjewu,Nigel Walton,Ioannis Koliousis
Publication: Technological Forecasting and Social Change
Publisher: Elsevier
Date: June 2023
What principal–agent relationships have changed ?
The "Blockchain agency theory" paper identifies 7 assumptions that have informed analysis of the principal-agent problem and pairs these with 7 counter assumptions that may apply to the new blockchain paradigm.
Rather than the principal-agent relationship, the interactions in blockchain alliances take a many-to-many dimension and an ecosystem dynamic to co-evolve and co-create value in a mutual sequence.
1 - Self-interest / Common Interests
The first assumption of Agency theory is that of self-interest. That agents are inclined to opportunistically reward themselves.
Ideally a blockchain will moderate the self-interest of agents seeking to control principal participants. As long as the chain is sufficiently decentralized the common interest of an operational distributed ledger will prevail.
The self-interest of both parties is mitigated by an alignment of incentives and interests.
2 - Conflicting goals / Congruent goals
The second agency theory assumption is that principals and agents have divergent objectives. For example, agents will seek to maximize their income from their specialized capability and principals seek to maximize their return using the agents capability. These divergent objectives can lead to a reduction in effort by the agent seeking to maximize their income and consequently less return for the principals.
Blockchains seek to reconcile these conflicting goals when governance rules are defined in the blockchain design. Members of a blockchain community ideally determine and agree governance of how data and transactions are represented and disputes resolved onchain. This is often framed in terms of common objectives and participation in value creation from stakeholders.
Goals are balanced by an alignment of incentives and interests.
3 - Bounded rationality / Unbounded rationality
The third agency assumption suggests that parties to a contract have limited or bounded rationality. This leads to a conservative approach to decision making where agents and principals fall back on their contingent knowledge and situation. Agents only do what is satisfactory to meet a contract rather than exploiting all economic outcomes.
In contrast, permissionless blockchains are unbounded in the sense of being networks with open data, open source code and accessible information. Ideally this eases bounds on rationality making it possible with AI enhancements to optimize contracts and maximize economic performance.
Individual constraints on rationality are superseded with unbounded access to knowledge thus optimizing contracts and economic performance.
4 - Information asymmetry / Information symmetry
The fourth agency theory assumption is that there is an uneven distribution of intelligence between principals and agents. The agents hold more information than principals which inhibits the ability of the principals to monitor whether their interests are being served. The specialized knowledge of agents can act as a barrier to effective supervision and ambiguity in understanding by the principals.
In contrast, the transparency of blockchain ledgers and their algorithmic governance mitigate concerns of information asymmetry through decentralised consensus mechanisms. Members who use a permissionless blockchains maintain an identical copy of the ledger and information consensus is achieved by continuously synchronising all it's copies to ensure accuracy. All activities are traceable and visible across the entire network and can be reconstructed for audit at any time.
Information symmetry is achieved through transparent access to the ledger and consensus mechanisms.
5 - Pre-eminence of efficiency / Smart contracts
The fifth assumption of agency theory is that ‘principals and agents will choose the most efficient contract’. Consquently any contract is driven by a cost-benefit analysis that seeks the least cost for the highest performance. This pre-eminence of efficiency limits human reflection and choice, reducing contracts to objective but superficial agreements.
Ideally, the use of blockchain smart contracts acts as a countermeasure to the pre-eminence of efficiency in principal-agent relationships. Smart contracts are programs that automatically execute transactions based on predetermined conditions. They eliminate the need for reconciling errors and automate workflows without involving third parties. In complex transactions, such as those in blockchain alliances, smart contracts significantly enhance transaction efficiency, rendering cost/benefit analyses unnecessary.
The tendency to prioritize efficiency in the principal / agent relationship can be reduced by separating out administration and execution with smart contracts.
6 - Risk aversion / Mean risk
The sixth assumption of agency theory is that "agents are more risk averse than principals because they ‘are unable to diversify their employment' while principals 'are capable of diversifying their investments'.
A possible solution is mean-risk sharing where individuals contribute their individual losses to a pool and are responsible for the expected loss based on the total pool loss. Risk is collectively shared among all parties involved.
Permissionless blockchains have the potential to provide a pooling mechanism that offsets principals' risk neutrality and agents' risk aversion.
The blockchain merges the principal / agent relationship into an alliance that spreads infrastructure, data, management and smart contract risks across different areas.
7 - Information as a commodity / Information availability
The final assumption of agency theory is that information can be purchased for a fee so that principals can avoid adverse selection and moral hazard by acquiring information about agents. The assumption that information is an asset that can be purchased introduces intermediaries and the risk of unreliable or incomplete information.
Adverse selection is a problem that occurs when principals have incomplete information about agents. This can lead to principals appointing agents who are not qualified for the job.
Moral hazard is a problem that occurs when agents have an incentive to act in their own interests, even if it is not in the best interests of the principal.
Networks of organizations that participate in blockchain alliances share information on a distributed ledger. Ideally this eliminates the need for intermediaries, which can lead to increased transparency and trust.
Information availability should invalidate information as a commodity in blockchain alliances.
Differences in Blockchain levels and use cases
The "Blockchain Agency Theory" paper does not investigate in detail how different blockchain consensus mechanisms, governance practices and use cases may alter the principal-agent relationship.
Management (agent) and shareholders (principal)
A principal-agent relationship may persist in DAOs with smart contracts ...
Elected officials (agent) and voters (principal)
Elections run on-chain may require agent intermediaries ...
Brokers (agent) and buyers/sellers in a market (principal)
Financial instruments or products such as NFTs may require regulation and reporting ...
References
Blockchain Governance Principles
Appendix
Mitigation of information asymmetry in a principal-agent relationship
Drafted with the assistance of ChatGPT 3
To mitigate the information asymmetry in a principal-agent relationship, the principal can employ various strategies and mechanisms. Here are some common strategies:
Screening: The principal can design screening mechanisms to gather information about the agent's characteristics, abilities, or effort level. This can involve the use of tests, interviews, or other assessments to gain insights into the agent's qualifications or suitability for the task.
Incentive Alignment: The principal can design incentive structures that align the agent's interests with their own. By structuring the contract to link the agent's compensation or rewards to specific performance metrics or outcomes, the principal can encourage the agent to reveal their private information and put forth their best effort.
Monitoring and Reporting: The principal can implement monitoring mechanisms to observe the agent's actions and performance. This can involve regular reporting, progress updates, or periodic evaluations to ensure the agent is accountable and provide feedback on their performance.
Reputation and Repeat Interactions: The principal can consider the agent's reputation and past track record when selecting an agent. Agents with a good reputation or a history of trustworthy behavior are more likely to act in the principal's interest. Repeat interactions with the same agent also create incentives for the agent to maintain a good reputation and maintain a positive relationship with the principal.
Auditing and Verification: In some cases, the principal may need to conduct audits or verification procedures to validate the agent's actions or outputs. This can help ensure that the agent is adhering to the agreed-upon terms and meeting the required standards.
Information Sharing: The principal can provide the agent with relevant information or resources that can improve the agent's decision-making. By sharing information, the principal can reduce the information gap and improve the agent's ability to act in the principal's best interest.
It's worth noting that the strategies employed to mitigate information asymmetry will depend on the specific context and nature of the principal-agent relationship. The principal may need to assess the costs and benefits of each strategy and determine the most appropriate combination based on the level of information asymmetry and the desired outcomes.
How Smart Contracts may manage adverse selection and moral hazard
Drafted with the assistance of Bard
Self-executing smart contracts can be used to manage adverse selection and moral hazard by providing formal guarantees and reducing the transaction cost of coordination of business relationships.
Smart contracts can
Mitigate adverse selection by providing potential members with access to complete and transparent information about the alliance.
Mitigate moral hazard by ensuring that members of the alliance comply with the terms of the contract.
Improve the efficiency of corporate governance by eliminating the need for intermediaries and reducing the need for monitoring.
Improve the transparency of alliances by making it easier for members to access information about the alliance.
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