Information Asymmetry On Public Blockchains

Information asymmetry is one of the problems SwiftDao standards seek to resolve (register at SwiftDao.com if you haven’t already). Often when attempting to agree to a contract one of the parties has better information than the other. For instance, when buying a used car, the seller has more knowledge of the car than the buyer. This information asymmetry makes it hard for the two parties to come to agreement and makes markets less efficient. A litany of well-studied problems in economics find their roots in information asymmetry including adverse selection and the family of moral hazard problems. Information asymmetry even plays a major role in authoritarian social structures, as Harold Innis notes in “The Bias Of Communication” which allow an “in the know” elite to control the deceived masses.

Public blockchains, just from the name, may appear to not suffer from problems of information asymmetry. Since all transactions are public, anyone can view the entire history of transactions by any account. However, this transparency is an illusion. Even in a future digital-identity driven blockchain world where every transaction is tied to a registered entity would still suffer from information asymmetry.

This article goes through a few examples, by no means complete, of information asymmetry on public blockchains. It also discusses ways to manage and reduce information asymmetry with the SwiftDao standard as a primary example.

  1. Technical Knowledge

Most of the public do not have the information to personally audit smart contract code. Frequently, malicious developers have taken advantage of this fact to defraud trusting investors. The most common of these scams is the “Exit Scam.” In the simplest iteration, the developer surreptitiously adds a method to the smart contract that allows the developer to steal all assets deposited into the smart contract by investors. More sophisticated developers obfuscate their ability to exit scam, such as by having a way to make the contract self-destruct and send all assets to an account controlled by the developers.

Hackers also take advantage of improperly designed contracts with their superior technical knowledge. In the infamous “The Dao” hack, over $70 million of Ethereum was heisted due to a lack of technical knowledge by the developers. None of the public investors nor the developers at Slock.it spotted the error before the hacked took advantage of it. Information asymmetry in technical knowledge means that even experienced developers may lack the specific knowledge to make smart contracts behave as intended.

SwiftDao approaches the problem of information asymmetry in technical knowledge with the double prongs of standardization and audits. Standardization means that every SwiftDao runs the exact same copy of the smart contract. Audits can thus be done much cheaper, since they only need to be done once to cover the entire family of SwiftDaos. Audits by multiple trusted smart contract security authorities allow the public to ameliorate its technical knowledge disadvantage by allowing them to place trust in third parties. Decentralization can be maintained by having multiple audits paid for by the SwiftDao community through SwiftPater, the SwiftDao responsible for improving and maintaining the standards.

  1. Project Risks

Often blockchain developers and founders have a clearer understanding of the risks involved in the project than their investors. They are heavily incentivized to develop overhyped business plans that miss key risks involved in the development of the project. This knowledge is completely hidden from the public as it appears nowhere in the transaction history of the blockchain. Blockchain project founders frequently promote projects that sound great to the uninformed but are just a way to part the naïve from their money.  SALT is an excellent example with its 98%+ drop in market cap peaking at over $800 million and, as of November 2019, falling below $7 million due to flaws in the business model. Salt’s whitepaper nowhere mentions any of the risks, except a short generic statement hidden towards the end to say:

“It is entirely possible that the SALT Lending Platform will never be implemented or adopted, or that only a portion of our vision will be realized. We do not guarantee, represent or warrant any of the statements in this paper, because they are based on our current beliefs, expectations and assumptions, about which there can be no assurance due to various anticipated and unanticipated events that may occur.”

No mention of market risks, business model risks, technical risks, or any of the other factors that would have been clear at the time. A direct reading of this short paragraph, likely overlooked by most investors hidden as it was, would lead them to believe that if the developers were able to build what they imagined, which did in fact happen, huge profits were to be had. The vision itself was flawed and unable to handle the ICO crash. Not to be too harsh on SALT: even this token paragraph on risks went far beyond what most projects disclosed.

SwiftDao standards addresses information asymmetry for project risks in several ways. When a SwiftDao is originally formed, the founders must publish publicly a complete business plan clearly outlining the risks involved. Investors can easily compare different SwiftDaos since all must present their business plans in identical formats. After the initial founding, the SwiftDaos members are both investors and managers and thus have no incentive to defraud themselves by ignoring risks.

  1. Obfuscated Finances

Most blockchain project financial statement range from non-existent to atrocious. All the critical metrics to effectively run a business are missing. Without information on cashflow, how can a Dao determine whether it needs to raise capital? Without a balance sheet, how to value the organization’s assets and liabilities? Without an income statement, how can any of the members know what income and expenditures the Dao has and how to vote to more efficiently allocate resources? In blockchain, the blind lead the blind. Basic corporate finance practices developed over millennia are discarded in favor of winging it. ConsenSys is the only major organization taking a practical stab at the problem with Balance3, a barely used tool to bring blockchain-based accounting. Thankfully, the Accounting Blockchain Coalition is working on bringing accounting best practices to blockchain projects.

The solution in the SwiftDao standard comes in several stages. From the beginning, all SwiftDaos are required to produced standardized financial statements that follow an identical format. Standardized, quarterly financial statements allow investors to easily compare SwiftDaos and create their own tools to find what they believe is the correct long-term valuation. Early on, these financial statements will mostly need to be created in the traditional way with accountants. As blockchain accounting technology advances, automated generation of financial statements with little to no human input will greatly reduce accounting costs and thus organizational overhead for SwiftDaos.

Information Asymmetry Is A Serious Problem.

Blockchain governance without transparent information cannot be truly decentralized. Developers, founders, investors, or hackers who have access to better information form an elite within so called decentralized projects as they can make better decisions than the public. Much of the regulation that exists in the US is targeted towards exactly these types of information asymmetry problems. The state of blockchain makes the Enron scandal look honest. Don’t forget the Sarbanes-Oxley Act which came in response, forcing corporations to adopt better accounting standards. The SOX act is now affecting many blockchain projects today with the extensive powers it gave the SEC.

Instead of responding to increased scrutiny by government regulators by solving the underlying problem of fraud, many blockchain projects have turned into centralized, highly regulated, traditional companies with essentially no difference from traditional corporations. Securities regulation just papers over inherent problems with old forms of organizational governance. SwiftDao proposes a brave alternative: A world where well-designed decentralized organizations fix the bad incentives that create fraud in the first place. In such a world, the SEC would find itself swatting the flies that fail to follow best practices while intelligent investors will focus on the companies that follow governance standards that exceed any regulatory requirements.