Solving Adverse Selection In Capital Markets

According to traditional economic theory, the managers of a capitalist firm should, when considering a new project, act as if the capital to acquire the project is guaranteed to be found. The reason is straightforward: in a transparent world, all that managers must do is publicly announce the project, risks, and future returns and investors who seek to allocate their capital will immediately invest the capital into the firm.

Reality could not be more different. Firms are constantly worried about cash flow and raising capital. Many times, highly profitable projects are forgone simply due to an inability to raise capital for said project. Recently for blockchain companies, the situation has become dire. After the collapse of market prices for cryptocurrencies, even clearly valuable investments are skipped over by investors. When asked, investors consistently state their fear is due to the high rates of failure of blockchain companies and the associated risk of capital loss. But as long as offered rewards outweigh the risks, investors should still be willing to allocate capital. What gives?

Part of the answer lies in a 1984 paper by the MIT economist Steward Myers and fellow financial expert Nicholas Majluf. Titled “Corporate financing and investment decisions when firms have information that investors do not have,” the paper goes deeply into detail on the consequences of adverse selection in capital markets. Specifically, the authors built an equilibrium model of firms looking to raise capital and investors looking to fund firms. The model allowed the authors to study details of how capital allocation functions in markets with asymmetric information between managers and investors.

The results of Myer’s and Majluf’s research have far reaching consequences on our understanding of firm’s ability to efficiently raise capital. Because a firm’s managers have deeper insight into the risks and rewards of a particular project than investors do, investors demand a higher return for their investment to compensate for information asymmetry. In everyday terms, the managers are constantly hyping their projects while investors discount the value of the project because they know the managers may not have anything real to back the hype. No big insight there, but the real shocker comes next. From the paper:

“Firms whose investment opportunities outstrip operating cash flows, and which have used up their ability to issue low-risk debt, may forego good investments rather than issue risky securities to finance them. This is done in the existing stockholders’ interest. However, stockholders are better off ex ante - i.e., on average - when the firm carries sufficient financial slack to undertake good investment opportunities as they arise.”

Since investors struggle to tell the difference between good investments and ones that are just big on hype, they discount all projects including good ones. Good managers, faced with the choice between hyping easy but bad projects and developing difficult but good ones, skip over the good projects and focus on the bad. Myer and Majluf’s equilibrium model showed that this passing over of good projects severely distorts capital markets, forcing firms to focus on internal sources of capital (whether through bootstrapping or raising “slack”) instead of efficiently selecting the best investments for growth. Thus, even managers upholding shareholder’s interests tend to over raise capital when they can, so that good opportunities can be taken when they arise. More usually, self-interested managers raise capital for fraudulent projects that increase their own power, wealth, and prestige.

Taken to the extreme, adverse selection in capital markets should make almost all investment proposals fraudulent. So in traditional stock markets, why is this not the case? The reason is regulation, in the US specifically the SEC. The US SEC was created by the “Securities Exchange Act of 1934” to prevent the sorts of fraud that created the stock market boom of the 1920’s and the resulting crash that triggered the Great Depression. Specifically, the purpose of the act was “To provide for the regulation of securities exchanges and of over-the-counter markets operating in interstate and foreign commerce and through the mails, to prevent inequitable and unfair practices on such exchanges and markets, and for other purposes.” At the time, adverse selection in capital markets was not well understood. Of course, regulation may have reduced investment as first. However, as increased transparency forced fraud out of capital markets, investors were able to more accurately price the value of investments, increasing the efficiency of capital allocation.

To anyone following blockchain closely, the pattern may sound highly familiar, and some details of the commonly accepted story of the cryptocurrency market crash fall apart. For those unfamiliar, the standard reason is that the SEC started regulating ICOs and big investment banks used derivatives as the tail that wags the dog to crush an existential threat. But a closer inspection makes the standard story fall apart. The report from the SEC on "The DAO” tokens, for instance, was incredibly low key especially considering the large numbers of small investors who lost huge sums of money. The SEC took no action against the people behind The DAO even though they clearly and flagrantly violated securities regulations, and the result was many investors trusting their money to an organization without understanding the substantial risks, one of which was smart contract hacking which indeed happened. Even at its most aggressive, the SEC has focused primarily on the worst offenders who were clearly acting in bad faith.

But the previous paragraph’s purpose is not to paint the SEC in a good light. Let us not mince words: The SEC is a centralized organization that violates individual freedom, causes innovation to ice over, and imposes draconic costs on organizations that are ultimately passed on as higher prices for consumers, lower profits for investors, and fewer raises for employees. However, the SEC’s actions make sense given the degree to which fraud has taken over the space.

Many blockchain advocates have given up and surrendered to the dark side, even going so far as to welcome the centralized lords of security regulation with open arms. These “advocates” would do well to revisit the core tenants of the cypherpunk manifesto, the 1980s great-granddaddy of the cryptocurrency movement. Centralized regulation is not the answer. The answer is privacy protecting decentralized collaboration and software-defined rules of engagement that prevent bad actors from ruining our freedoms.

That’s why the SwiftDao standard is needed at this particular moment at time. The cryptocurrency space is in a moment of crisis, where its initial values of freedom and decentralization are under threat from the realities of liars, cheats, frauds, and charlatans. The world of individual freedom from centralized finance capitalism we were all initially promised by Satoshi has gradually faded in the dust of greed and blockchain abandonware. The future is not guaranteed. Progress lies in our hands; us who build, develop, design, and use. We decide what future we want to build for ourselves.

The SwiftDao solution to the problem of adverse selection in capital markets is astonishingly simple. Make investors into managers. Collapse the traditional hierarchy of the firm with Daos following simple rules allowing investors to directly and transparently see the finances of their Dao and make managerial decisions. Traditionally, centralized technology forced organizations to have charismatic leaders to build trust. Instead, SwiftDaos use decentralized smart contracts to build trust between Dao members to allow optimal decisions towards capital allocation.

The future impact, should SwiftDaos become the standard for most capital allocation, will be immense. Without the drawbacks of capital misallocation through adverse selection, investment growth could possibly reach several multiples of its current rate. At the same time, individuals will be more free than ever before to pursue their own interests and make the ethical, financial, and personal decisions they wish to make. Do not surrender to the cynicism of centralized regulation. Work together instead to build a better decentralized world.