Impact of Blockchain: Smart Contract Based Incentive Compensation
Most examples of potential blockchain applications focus on making something more efficient. OpenBazaar is like eBay but without fees. Edgeless is an online casino with no edge (duh). That’s all great, but I’m always on the lookout for ways in which blockchain tech can make a more structural impact on the way we do things. Here’s an idea that I’d love to hear some thoughts on:
Problem: incentive plans in finance are hard
Performance based compensation for traders and portfolio managers is, in theory, a great way to align everyone’s incentives and reduce the overall system’s risk. But the problem with bonuses and incentive schemes is that they often look short-term and reduce downside risk to traders but leave the upside unlimited.
Say you’re a trader who has a $100k base salary with an annual performance bonus that increases by some amount for every percentage point that the trader beats the market index. This is a common scheme and it generally works alright.
But unethical and careless traders can game the system by taking on excessive risk. If you invest $25mm in risky assets (like investing in cryptocurrencies, ironically) that have potential for huge upside and huge downside, there are two possible outcomes:
- The investment a huge success. You make $100k salary and a $2mm bonus. The company you work for makes $20mm+.
- The investment a huge failure. You still make $100k salary (still not bad!). The company you work for loses $20mm+.
Say the asset you invest in will plummet in value with 0.9 probability and skyrocket with 0.1 probability. Then the expected value of making the trade is about $300k from your perspective, but about $-20mm from the company’s perspective.
Clearly this is massively unbalanced and will incentivize risky behavior that could have rippling effects in the firm as well as the overall economy.
Potential solution: smart contracts that track true long term performance
The ideal incentive compensation plan would track a trader or portfolio manager across their entire career and between employers and pay based on the true long-term performance of their trades/portfolio. There are a few obstacles to this:
- There’s no mechanism for a firm to effectively compensate people who no longer work for them
- Employees don’t want to wait until the end of employment to get a bonus
- It’s hard to track the performance of a portfolio over long time periods and compare it to an index (there’s too much noise from changing interest rates, inflation rates, economic cycles, etc.)
Making investments through a smart contract or DAO token would enable companies and employees to pay out based on some arbitrary function of investment performance. Instead of just cashing out on an investment’s performance with an annual bonus, the value of a smart contract / DAO token could accurately, easily, and securely be pegged to the investor’s performance across an entire career. This could help solve problems 1 and 3 listed above.
Traders could work knowing that a series of short-term risky plays would absolutely not be in their interest. Incentives of the firm and individual would be aligned much more effectively and this could help mitigate financial crises.
Problem 2 is more tricky to address. One potential solution would to create a market of these bonus contracts/tokens. Users could look at a portfolio, assess it’s risk spread instead of value, and make bets on whether the bonus plan is likely to be stable. Of course this market would be effectively facilitated by a smart contract or DAO! I don’t know if this idea has been explored before by existing financial institutions—please let me know if you’re familiar with it!
What’s next?
I think it’s way too early to begin building something similar to what I’ve described. There’s no way to effectively track the performance of generic assets over time because most trades take place on private/opaque platforms. This would become feasible if DAOs and blockchain marketplaces become far more common. Hopefully that’ll be the case and someone will pursue this concept—it’s important to think more about financial risk and stability as economies and (crypto)currencies become more globalized.
Thoughts? Tweet me at @whrobbins or find my email at willrobbins.org!