Authored by Jason Potts
What are the basic economics of a foundation that supports this new class of decentralized, distributed computing technologies and the economies that are built upon them?
Blockchains are both technological institutions (the tech stack) and an ‘institutional technology’ (the econ stack). Blockchains produce common knowledge (a.k.a. ‘state’) that coordinates people who do not necessarily know or trust each other, thus enabling decentralized cooperation. The challenge for a foundation such as DCF is to provide ‘services’ to what is both a computational system and economic system at once. This post seeks to explore what a foundation is and does in these new computational market systems.
What foundations do
Foundations are a type of corporate legal institution that have long served important and useful roles in industrial economies and societies. Foundations funded by donors do beneficial things for a community. They provide services or financial support that private corporations and governments in modern industrial economies are poorly suited to provide, due to limited capabilities, incentive alignment, or time horizons. Foundations, both public and private, have long been instrumental to the development of some of the most important technology projects of our age, such as open source software (e.g. Linux Foundation).
A foundation is a solution to the problem of how to launch and support a project to grow into an open economy or ecosystem. Four conditions generally hold:
- The founding team lack specialist skills and/or attention and/or strong incentives to build support infrastructure and services.
- Infrastructure and services has the character of a public good, so other independent parties may benefit from accessing it.
- Open access to that support infrastructure and services powers development of the overall economy or ecosystem.
- Vertical integration or an industry association are non-viable solutions.
Foundations tend to spin-off from ambitious projects that seek to build a quasi-public infrastructure for an open economy. They provide support to the growth or bootstrapping of the project, often before it is clear who other users will be and what they will do. Foundations also support ongoing maintenance of the project’s upstream needs, from technical infrastructure to research and education. These support and maintenance services could of course potentially be provided through volunteer resources or public resources. However, the complexity and sensitivity of such provision often requires focused and well-resourced attention that a dedicated and independently chartered foundation can provide.
Economic theory of foundations
The most obvious reason that a tech project would seek to support an independent foundation to do this work is that a foundation can have a very specific charter to target the provision of this sort of work, and to maintain that target even when short run or specific interests of the project offer competing incentives. Other corporate organizational forms lack the ability to tightly define a specific mission and the principles by which that will be undertaken.
The tech project itself might also benefit from not being vertically integrated with the support and development of infrastructure and quasi-public goods due to concerns with specialization and incentive alignment. A separate organization with different longer-term incentives, and the ability to allocate resources toward those goals, will furnish a better outcome and avoid the problem of underinvestment.
Another reason for unbundling a project from project-supporting infrastructure is signaling. A foundation with separate governance and resources under its own control, is a credible (and costly) signal that it is safe to build on the infrastructure by a new party, irrespective of whether that new project is complementary to or in competition with the original project. In the absence of an independent foundation, there remains a hazard of capture or becoming a client of the original project. This risk is harmful to the development of the ecosystem.
A key hazard of building on top of any software project, or of investing in developing skills or capital that is complementary to a particular specific project, is forking. A large treasury is a costly signal that creates a moat that raises the opportunity costs of exit. This stabilizes expectations about future existence and development of the chain, which de-risks current investment in complementary assets to the project
For a foundation to be effective, the mere existence of a large, transparent and well-managed treasury in effect leverages existing private investment in complementary assets by assuring future public goods. In other words, with a credible war-chest of future spending, the foundation does not need to do all the work in providing early public goods.
A further implication of the ‘costly signaling/exit moat’ theory of foundations is that it provides support for a larger allocation of funding to maintenance, over pure research and development, which is usually favored for growth maximization. The clear identification of this problem of the value of funding maintenance support for OSS was made in a very good book by Nadia Eghbal.
The DCF has another important role in its ability to delegate its own treasury funds across the validator set in order to build resilience and promote equity, and to directly support high-quality validator governance (e.g. training and standards), which is also a clear ecosystem public good. This ‘staking power’ builds capabilities and robustness in the POS system.
A central task of any foundation is funding community-specific public goods. The hard part of this is figuring out what to fund, and how.
This is an information problem that involves choosing what particular goods or services to support, how to support them, who to fund to deliver what, at what quantity and quality, using what methods and approaches. This is an entrepreneurial discovery problem that is aided by the experience, expertise and judgment of a foundation’s board and subcommittees.
It is also essential that a foundation develop mechanisms to surface high-quality local information from the community about the sorts of public goods and services needed, but also of the capabilities to provide those and at what cost. This information, often tacit, must be elicited by some discovery mechanism. This is why mechanisms that capture intensity of preferences, such as quadratic voting (e.g. gitcoin quadratic funding), are useful and why a mix of prizes and grants is desirable.
Prizes, which reward outputs, are often effective when a particular outcome is desired. Or when it is easy to recognize when a challenge-problem is solved, yet the foundation has no good idea of specifically how that challenge or problem will actually be solved. Prizes also work best over a horizon of about 2-4 years, else they tend to support outcomes already in the pipeline. Effective prizes motivate talented people to shift their activities in the direction of the target.
Grants target inputs and work well when the foundation knows what inputs it needs to deliver specific infrastructure goods or ecosystem services, and can effectively recognise and evaluate them. A grant creates a high-powered incentive for those with those capabilities and resources to self-identify to the foundation and to signal the sorts of contributions that could be made. Grants move risk to the foundation and away from inputs themselves.
By inviting a pitch, grants also elicit information about the sorts of entrepreneurial possibilities and priorities that might be supported by a foundation. The foundation’s role is simply to indicate some broad directions or themes, and the resources available. Tenders and contracts are a mix of both, with partially specified inputs and partially specified outputs.
As such, a high-performing foundation will need to draw upon a repertoire of different mechanisms – including grants, prizes and tenders (as well as internal decision-making) – and to experiment with the design of these mechanisms, based on:
- the information problem that it is trying to solve;
- its judgment over the trade-offs over whether to carry risk on the input or output side.
The foundation’s board should be regularly discussing and clearly communicating its thinking and decisions about these factors to stakeholders.
Foundations also supply governance. Many view blockchain governance through the lens of political governance, but it is actually much closer to corporate governance, which is the problem of how suppliers of finance control managers, i.e. a situation of strong insiders and weak outsiders. It is often argued that blockchain decentralization mitigates the existence of ‘insiders’ and that rules (encoded in smart contracts) can replace governance discretion. Yet the need for governance in permissionless blockchains arises when smart contracts do not execute as intended, or residual control rights need to be bargained over, or due to bugs that need to be repaired or some types of attacks that require manual defense.
The inevitable need to deal with unexpected bargaining or re-contracting situations in a crypto-economy, due to unanticipated events, means that an arms-length foundation provides crucial governance services that protect the interests of outsiders (i.e. token holders). An independent foundation is therefore also a crucial safety feature for investors and other stakeholders.
About the Author
Jason Potts is an academic economist specializing in the economics of new technology and institutional evolution, and inventor of the field of institutional cryptoeconomics. He is one of the world’s leading innovation economists, winner of the Schumpeter Prize, a member of the Academy of Social Sciences Australia, and an editor of the Journal of Institutional Economics. He is founder and co-director of the Blockchain Innovation Hub at RMIT University in Melbourne, Australia, and Chief Investigator in the ARC Centre of Excellence in Automated Decision-Making and Society. Jason also serves on the Board of Directors of the DCF.