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Can Blockchain and Token-Economics Prevent Failed Privatizations? Featured

October 18, 2018 by Andrea Bianconi
Morandi Bridge on the A10 motorway in Genoa, Italy partially collapsed on August 14, 2018 killing 43 people. Davide Papalini
The Morandi Bridge on the A10 motorway in Genoa, Italy, partially collapsed on August 14, 2018, killing 43 people. Photo: Davide Papalini

When I wrote this article about the dramatic collapse of the Morandi Highway Bridge in Genoa, I did it out of anger. Though it was clear to me that the roots of this tragic event were to be found in the wrong privatization model and its misguided incentives, I did not yet realize how globally relevant this issue was.

Widespread discontent with the failures of privatization is a worldwide phenomenon that is largely unacknowledged and rarely debated. Indeed a quick web search under the keywords “failed privatizations” turns out a litany of global failures from Europe to Africa, the US to South America and across Asia.

Privatizing state-owned assets or state-run services is an easy out for governments seeking to raise money for their expenditure budgets. For every privatization that improves the efficiency in which an asset or service is managed (more often the case when subject to free market forces) there are privatizations which simply replace a state monopoly with a private monopoly and remain shielded from market competition.

In practice, the state transfers its privilege of extracting rents through a public asset or a service, into the hands of a wealthy private investor. This is the downside of privatization, especially in so-called “natural monopolies” where the public is compelled to use a key asset or service as there is no alternative. This is typically the case with, for instance, toll roads, water, health services, electricity grids and prisons.

Dissatisfaction for this model of privatization has fuelled calls for them to be reversed in many countries, for example, in the UK with its dysfunctional railway system or its water and gas sectors.

In her interesting research paper on the subject, author Mildred E. Warner emphasizes how “the privatization experiments of the 80s and 90s has failed to deliver… This has led to reversals. But this reverse privatization process is not a return to the old model… Instead, it heralds the emergence of a new balanced position which combines the use of markets, deliberation and planning to reach decisions which may be both efficient and more socially optimal.”

Reading this, it suddenly occurred to me that that’s exactly what we need: A more “balanced position”. So I went to work again on that initial proposal and the result is this article, which expands on the use of the blockchain and token-economics as a viable model to reverse wrong and dysfunctional privatizations in strategic public sectors.

Using token-economics

Although the origins of token-economics can be traced back to the early 19th century – in the field of psychiatric studies – the term is now commonly borrowed by the crypto-world to refer broadly to a system of economic incentives used to influence stakeholders´ behavior towards a predefined “virtuous” model which benefits the whole system.

Token-economics is a branch of the social studies and it does not differ from traditional economics, except that it looks closely at behavioral economics and game theory in order to provide the right economic incentives to drive individual behavior.

Creating a blockchain-based system to manage strategic public assets

The template below can be applied to public assets or services which are vital to society as a whole and would be better not left solely in private hands. Ideally, the state should always retain a measure of control over such assets and services in order to shield the society from the consequences of abuse by private operators.

Such assets include, for example, vital water sources and their supply infrastructure, energy plants and grids, public roads, basic healthcare services and infrastructure and prisons.

Tokenization: Equity or security token?

The term “tokenization” is mainly associated with securities, equities and tangible assets, and it indicates the creation of a digital token which represents different types of rights.  Such as ownership, right to payments, voting, etc., connected with the underlying asset. Such digital tokens are issued by and recorded on a blockchain.

In the proposed model, tokenization is necessary to “translate” economic rights connected with a public asset in a digital format that can be easily distributed to stakeholders. And to which smart contract provisions can be attached in order to guarantee the automatic execution of certain provisions which are key to creating incentives.

The strategic public asset (“A”) will be transferred into a Special Purpose Vehicle (SPV). Here the two likely options:

Option 1 is to tokenize the shares of the SPV by issuing equity tokens which incorporate ownership rights, voting and profit distribution rights, via smart contracts.

Option 2 is to issue security tokens, not representing equity participation in the SPV, but simply an economic right to share the profits of the SPV.

The differences between the two options are: (i) in Option 1 equity tokens are issued and therefore also the corresponding ownership portion of the SPV and A are transferred; (ii) applicable corporate law will dictate the voting rights belonging to shareholders and – as a consequence – to all equity token-holders.

This will likely reduce the flexibility of governance. Moreover, because applicable corporate law also dictates the formalities for the transfer of the shares (such as companies registries and public notaries), those “real world” procedures enormously complicate the reconciliation between the equity tokens issued digitally and the underlying share certificates, thereby impacting on the flexibility and the automated execution of smart contract provisions.

I, therefore, came to the conclusion that the second option is better because:

a) A and the SPV remain 100% in public hands;

b) The security token issued does not represent equity in the SPV but simply the right to a monetary payment;

c) Even if this is still a security for the purpose of applying securities laws and compliance, the issuer will have very little constraints in designing the monetary rights attached to it, as well as their role in the governance (i.e voting rights);

d) The issuance is not limited by physical ownership like in Option 1 (i.e 1 share-1 token) or by the value of the shares, but only by the profitability of the SPV-A or, if insufficient, by the willingness of the state to guarantee that it will cover the shortfalls;

e) Such security tokens can also be airdropped to key stakeholders and/or auctioned to investors, should the state need to raise money to either buy-back the asset or pay penalties to private investors in the case of reverse-privatizations. Or, if necessary, to revoke previously granted private concessions over public assets.

In conclusion, Option 2 seems simply far more flexible.

Main stakeholders and financial flows

The main stakeholders will be then:
– The state which owns the asset;
– The citizens who use public services/assets;
– The maintenance and service contractors;
– Token holders.

Financial flows will be:
– Fees generated by the A and collected by the SPV, such as tolls for public roads or utility bills;
– SPV´s payments for maintenance services and repairs.

Blockchain and distributed ledgers

In my first proposal, I have advocated for the use of a public blockchain with open access. Some commentators have disputed the need for a blockchain in that model. Some confusion surrounds the term “blockchain”. This term is now widely used to refer to substantially any type of Distributed Ledger (DL), and certainly not only to the first and the purest form of blockchain – the bitcoin protocol.

Therefore the use of a blockchain/DL in this model essentially means creating an asset accounting system of the records stored. Since the way DLs can be built is both modular and optional, there is no need here to build a 100% permissionless and decentralized blockchain like bitcoin.

Some functions can be decentralized, while others can be centralized. Also, centralization can still be positively influenced by governance provisions in order to guarantee more distributed supervision and control.

Moreover, whatever type of blockchain/DL and consensus protocol are adopted to make this model work, this remains a technical issue which is outside the purpose of this article and which will hopefully be solved by technically proficient people other than myself.

What is here important to note is that it should guarantee mainly (i) transparency and (ii) immutability of the records stored. This means that stakeholders should be able to access all documentation regarding, for instance, the financials of the SPV, maintenance bills, safety reports, engineering reports, public tender procedures, bills from contractors ans so on.

Everything should be open to public and government scrutiny and data could not be changed or corrupted by any stakeholder. This is a well-known problem: When dramatic events like those in Genoa happen, key evidence and documents tent to suddenly disappear from servers.

Token-economics and the right incentives for stakeholders

A balanced system of economic incentives and governance tools is essential in order to influence positively the behavior of key stakeholders, such as the contractors, the auditors and the state itself. The contractors are an essential part of it.

Too frequently, especially in public procurement jobs such as public roads, the poor conditions of the work done, and of their subsequent maintenance, are of great concern to all citizens. In the best case, this is both a sign of the state’s incapability of managing its resources and of holding the contractors accountable for shoddy work. In the worst case, this is a sign of corruption.

To hold the contractors accountable, they must have an economic interest in the proper functioning and proper maintenance of the asset which generates revenue. This can be done by ensuring that contractors “have skin in the game”.
In addition to being paid in installments as milestones are reached, contractors will also be paid-in-kind with the tokens issued by the SPV.

This ensures that the contractor holds an interest in the continual function of an asset or service. In case of disputes, the public administration will have an additional recourse – tokens can be automatically repossessed or burned via smart contract provisions. Clearly, dispute resolution mechanisms and so-called “oracles” must be in place as well.

More “skin in the game” can also be added by requiring contractors to subscribe to an interest-bearing government bond corresponding to a percentage of the contract’s value. This bond can be also tokenized, thereby ensuring an additional recourse against the contractor should it be in breach of contract obligations or of its guarantees/warranties or maintenance periods. This bond will be held as a collateral in a smart-escrow.

While its function is similar to that of a traditional performance-bond – where a bank guarantees performance on behalf of the contractor. The difference here is that the state bond does not have a cost for the contractor and it benefits – in a virtuous cycle – both the government and the contractor which receives the interest payments. Simply put, it is a way to contribute internally to finance the governments´ debt, thereby reducing reliance on institutional investors. The flexibility that can be achieved by programming different features into such a digital bond is another key advantage.

Governance tools

Aligning private contractors´ incentives is only part of the game while influencing the state’s behavior is much more difficult. To do so, we have to create the right set of governance tools. The main concern here is to avoid the state wasting money and to make sure it efficiently allocates the revenues generated by the asset.

Therefore a proper set of governance rules for the SPV and all the Stakeholders are essential in this model. The first step shall be to earmark the revenues generated by the SPV to be either (i) spent in maintenance or (ii) reinvested in new infrastructure or (iii) distributed to the token-holders. The percentage of redistribution of the residual profits can also be programmed differently in the smart contracts in order to maximize incentives. For example by rewarding, with higher percentages, the most diligent contractors.

The second step shall be the creation of governance bodies. In this model, I have conceived three governing bodies, the Treasury, the Asset Committee and the General Assembly.

– The Treasury receives the revenues from the SPV and, in compliance with its mandate to earmark the revenues as indicated above, it allocates the funds as indicated by the Asset Committee.

– The Asset Committee shall be constituted by representatives of the State, of token-holders and of technically qualified professionals in the specific sector of activity. The Asset Committee decides how to spend the revenues of the SPV, based on a set of priorities and reports received from third-party controllers, auditors and technical experts on the conditions of the asset (i.e maintenance and/or new investments).

– The General Assembly is composed of all stakeholders and it will vote the composition of the Asset Committee and perform an ex-post supervision of the allocation of the funds done by the Asset Committee.

Interestingly, my colleague at Untitled-INC, Karl Michael Henneking, has introduced the concept of Proof of Quality Management (PQM), which is basically a rating mechanism to evaluate how efficient the Asset Committee has been in allocating the funds.

Essentially, a rating index – reflecting the status of the asset – can be created by comparing the sums invested with the levels of satisfaction expressed by its users and with the reports from the auditors and technical experts.

Simply, the more the funds invested and the poorer the feedback received from stakeholders, then the poorer the rating and therefore the performance of the Asset Committee will be judged. Vice versa, the lower the sums invested and the better the feedback reports received, then the better the rating and the performance of the Asset Committee will be judged.

Conclusions

With the limitations and dysfunctions of past privatizations now apparent, and ever more publicly criticized, a new model for managing key public strategic assets is needed now more than ever.

The interest which my first proposal received was a pleasant surprise. The inquiries I received from a number of public administrations, including that of Nigeria, regarding the possible use of this model to reverse the privatization of its electricity grid, brings me hope that change is coming and that new technology, such as blockchain, DLs and smart contracts, will be instrumental.

My hope is to see this model applied everywhere strategic public assets need to be managed with economy and efficiency and prevented from being abused in private hands, or for that matter, wasteful public hands.

A new and more balanced management model for strategic public assets and services is now at hand.

 

I wish to thank my fellows Thomas Euler and Karl Michael Henneking at Untitled-INC who provided me with valuable feedback and ideas on the governance of this new model. Since the crypto space is moving at a rapid pace, I expect to see frequently new developments and innovative approaches to this topic. Thus, I regard this model as being very “fluid” and subject to future modifications and improvements.

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Andrea Bianconi

Andrea Bianconi, Untitled INC

Andrea Bianconi is an international business Lawyer with over two decades experience, a scholar of Austrian Economics, monetary history and geopolitics, a believer in the future of Bitcoin and Blockchain... view profile


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