Can the Blockchain and Token Economics Fix Privatizations?

Introduction

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 wrong incentives, I did not yet realize how this was a global issue. In the sense that the discontent and the failures of privatizations are a worldwide phenomenon — little known, mostly unacknowledged and rarely debated.

Indeed, a quick web search under the keywords “failed privatizations” results in a long list of global failures — anywhere from Europe, to Africa, the United States, South America and Asia. This Columbia University paper and the Michael Hudson paper “Let us glory in inequality” are worth reading.

Privatizing state-owned assets or state-run services and functions has been an easy option for governments to raise money to contribute fixing their budgets. If privatizations may effectively improve the efficiency in which some assets or services are managed — whenever such assets or services are subject to free market forces and competition — there are privatizations which rather replace a state monopoly with a privileged rent-extracting private monopoly, which is shielded from free market competition. In practice, the state transfers its privilege of extracting rents — with a public asset or a service — into the hands of a wealthy private investor. This is the downside of privatizations, especially in so-called “natural monopolies” or with key strategic assets or services which the public is compelled to use without any alternative option. Such is the case, for instance, with toll roads, water, general health services, electric grids or prisons.

Dissatisfaction for such a model of privatizations has fuelled many calls to reverse them in many countries such as — for example, in the United Kingdom regarding its dysfunctional railway system or the water and gas sectors.

In another interesting research paper, the author, Mildred E. Warner,  emphasizes:

“The privatizations experiment 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 use of markets, deliberation and planning to reach decisions which may be both efficient and more socially optimal.”

Then suddenly it occurred to me that what I did elaborate — instinctively and out of anger after the events of Genoa — is exactly what is needed globally to achieve this new “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.

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

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 toward a predefined virtuous model that 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/DLT-based system to manage strategic public assets

The template below can be applied to public assets or services that are strategic to the society as a whole and would be better not left solely in private hands but, ideally, the state shall always retain at least the control of such assets/services in order to shield the society from the consequences of abuses by private operators. Such assets are, for example, vital water sources and its supply infrastructures, energy plants and grids, public roads, minimum healthcare services and infrastructures, and prisons.

The Tokenization: Equity or security token?

The term “tokenization” is mainly associated with securities, equities and real assets, and it indicates the creation of a digital token that represents different types of rights — such as ownership, right to some economical payment, voting, etc. — connected with the underlying asset.  The token is normally issued on a blockchain.

In the proposed model, the tokenization is necessary to “translate” economical rights connected with the 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 enforcement of certain provisions key to the incentives.

The strategic public asset (‘A’) will be transferred into a special-purpose vehicle (“SPV”). Here there are substantially two options:

Option one 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 two 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 difference between the two options are: (i) in option one, equity tokens are issued, and therefore the corresponding ownership portion of the SPV and ‘A’ are also 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 the 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.

Therefore, I came to the conclusion that the second option is better because: a) ‘A’ and the SPV remain always 100 percent 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 securities laws application and compliance, the issuer will have very few 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 one (i.e., one share-one 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 step up to guarantee for the shortfalls; e) such security tokens can also be airdropped to key stakeholders and/or properly 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 two seems simply far more flexible.

Main stakeholders and financial flows

The main stakeholders will then be:

• The state which owns the asset.
• The citizens who use the 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 DL

In my first proposal, I advocated for the use of a public blockchain with open access.

Some commentators have also disputed the need for a blockchain in that model. Some confusion is generated around the term ‘blockchain.’ This term is now widely used to refer to pretty much any type of distributed ledger (DL) and certainly not only to the first and purest form of blockchain, which is 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 percent 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 be solved by technically proficient people other than myself. What is important to note here is that it should guarantee mainly (i) transparency and (ii) immutability of the records stored. This means that the 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, etc.  Everything should be under the light and open to public and governmental scrutiny, and data should 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 suddenly disappear from the servers.

Token-economics and the right incentives for stakeholders

A balanced system of economic incentives and governance tools is essential in order to positively influence 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, for instance — the poor conditions of the work done and of their subsequent maintenance status are of great concern to all the 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 the bad jobs done. 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 the revenues. This can be done by ensuring that contractors “have skin in the game.”

In addition to being paid in installments at the reaching of milestones, as is normal, contractors will also be paid-in-kind with the tokens issued by the SPV. This ensures that the contractor holds an interest in the continued functionality of the assets. In case of disputes, the public administration will have an additional recourse against the tokens allocated to the contractor, which 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 given by requiring the contractors to subscribe to an interest-bearing government bond in percentage of the contract value. This government 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. The flexibility that can be achieved by programming different features in that 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 that the state wastes money and to make sure that 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 the most diligent contractors with higher percentages.

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 by 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 Karl Michael Henneking at Untitled-INC 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 lower the feedback received from stakeholders, then the lower the rating and therefore the performance of the Asset Committee will be. Vice versa, the lower the sums invested and the higher the feedback reports received, then the higher the rating and the performance of the Asset Committee will be.

Conclusions

While the limitations and dysfunctions of past privatizations are now apparent and ever more publicly questioned, the need for a new approach and a new model for managing key public strategic assets becomes ever more pressing. The interest with which my first proposal has been received was, for me, a pleasant surprise and the enquiries received from a number of public administrations — including from Nigeria regarding the possibility of using this model to reverse the privatization of its electricity grid — brings me hope that something will change in the future and that new technologies, such as blockchain/DLs and smart contracts, will be instrumental to the creation of this new model.

My hope is to see this model applied anywhere there is need to economically and effectively manage public strategic assets without blindly leaving them in private hands nor in wasteful public hands. A new and more balanced model of management for strategic public assets and services is now at hand.

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