Programmable instruments are a measure of value.
By: Martin Worner
Tags: Smart Contracts, Innovation, Stakeholder Capitalism, Value Investing, Dso

Photo by Joel Fulgencio on Unsplash

A Decentralised Social Organisation (DSO) was introduced as a variant of a Decentralised Autonomous Organisation (DAO) with the key difference, that unlike in a DAO where there is an instinct for “code is law”, the DSO embraces human interpretation and decision making which are then captured through a governance process on a blockchain. This was further developed in the discussion around what a Public, Permissioned Blockchain would look like, describing self-sovereign groups, and the possibility of setting permissions on financial instruments that are only tradeable within the permissioned groups.

We then explored what multiple-dimension programmable instruments might look like when we combine a traditional fixed income product with provable events which generate Environmental, Social and Governance (ESG) credits. The ESG credits generated open up interesting opportunities on how they are used, such as contributing to an ESG score of an instrument or making them fungible thus creating a market.

We can extend this idea to other areas in finance, let’s imagine that mortgages are tokenised as smart contracts in their own right, we then apply the concepts of ESG where the more energy efficient houses generate environmental credits, or occupancy rates are tied to social credits. The mortgage holders are incentivised to provide the information, and there may be verification of the data done to prove it is correct. If we were to package mortgages into mortgage backed securities, we combine the credit rating with the ESG ratings which, again becomes interesting how the effect of a higher ESG rating would effect the demand and thus the price of the bond.

The power of the programmable instrument is in the verifiable outcomes which result in the issuance of credits. There are two approaches to the verification process, either the issuer specifies which independent auditor or authority verifies the data or alternatively, the DSO framework is used, where self-sovereign groups are formed to verify the data. The groups have incentives to verify and there are punishment mechanisms in place, should the verifiers behave maliciously.

In an ideal world all debt is repaid, and while there are mechanisms such as pledging collateral to cover defaults, over-collateralisation would make the borrowing unviable. We recognise that loan defaults happen and that is built into the credit scoring and thus the rate of interest the issuer needs to pay. What happens to the ESG credits in the event of a default? If the ESG credits are issued throughout the lifecycle of the instrument then the ones created before the default event are still valid. There may need some intervention, for example, if the electric car manufacturer issued a social credit for every 5,000 cars sold to a car sharing club. The last issuance was at 15,000 units and the default occurred when he manufacturer had reached 18,250 units, should there be a partial credit issued or are they only issued every 5,000 no matter what?

Debt instruments have a use for governments and corporations to borrow money for a fixed time period and use the money for specific projects or activities. So far we have looked at a sub-set of finance, specifically debt instruments, and how we can add further dimensions such as ESG credits.

Photo by Ildefonso Polo on Unsplash

Multi-dimensional programmable instruments and stakeholders

Equity as an asset class is a challenge for creating programmable instruments, unlike most debt instruments where there is a fixed schedule, equities have no end date, the distribution of profits through dividends is variable and as an asset class it already has two dimensions, capital value and ownership rights.

The ownership rights, vary from company to company and on the share class, however, in principal there is the right to vote at meetings such as the Annual General Meeting (AGM) which will have motions to approve board appointments, remuneration of the executives, and the dividend payments.

The lifecycle of an equity can be more complex than a debt instrument as equities can be subject to rights issues, mergers and acquisitions and stock splits. To program all these event types and outcomes is possible, but complex.

There has been much debate in the last few about Milton Friedman’s famous article in the New York Times where he exhorted business leaders should ensure “The social responsibility of business is to increase its profits.” The notion of maximising shareholder returns is being challenged and there are calls for companies to be run for the benefit of all stakeholders, namely customers, employees, suppliers, communities and shareholders.

In theory all that would need to happen is for the executive team to consider all the stakeholders, and for the shareholders to support it, they would publish the annual report with sections covering the various stakeholders and how they benefitted each group. The downside to this is that is buried in a report and not a standard set of benchmarks and verified measurements which can be used to rate the company and compare them with their peers.

It would be possible to construct a programmable stakeholder instrument which would contain the necessary elements for each stakeholder. The shareholders have an equity element which is the vehicle that has the voting rights, pays the dividends, and is subject to the corporate actions. The community element will have information around social schemes such as mentoring disadvantage school children, volunteer working, or financial support to community projects, which have benchmarks set and whether they were achieved, thus issuing social or stakeholder credits. The suppliers element is a set of metrics around prompt payment according to the target payment dates, number of disputes which feed into a stakeholder credit. The customers element, based on targeted and verified satisfaction ratings which when achieved generate stakeholder credits.

As we saw with the programmable debt instruments there are external activities which prompt the issuance of credit tokens (ESG). The importance of the external data in issuing the credits means that it needs verifying, as suggested this is a self-sovereign group based on a DSO model which has the right incentives and degrees of punishments for transgression of the rules.

It could be an interesting incentive for organisations if the stakeholder credits had a “half-life” and decayed in value overtime, this would provide a strong incentive for companies to work hard in achieving or exceeding their set stakeholder objectives.

The accumulation of stakeholder credits along with the financial returns in a programable instrument creates a statement of value which considers a range of dimensions rather than purely on the maximisation of profit.

Conclusion

There are accusations of “green wash” around ESG and that the stakeholder focus is nothing but a PR stunt. The mechanisms of a DSO, and programmable instruments provide the framework for verifiable outputs that are compared to the objectives set and thus form a stronger foundation for creating real value beyond the simple outputs of traditional financial instruments.