POTENTIAL OF SMART CONTRACTS TO OVERCOME CONFLICTS AND REDUCE AGENCY COSTS

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Author: Mohamed Hamza Ghaouri

Any organization is made up of a set of contracts that define the relationships between the actors. A principal-agent relationship exists when one party (the agent) agrees to act on behalf of another party (the principal). The agency theory is a principle that is used to explain and resolve issues in the relationship between business principals and their agents. An agency, in general terms, is any relationship between two parties in which the agent, represents the principal, in day-to-day transactions. The principal (s) have hired the agent to perform a service on their behalf. Most commonly, that relationship is the one between shareholders, as principals, and company executives, as agents.

By definition, the agent uses the resources of the principal. The principal entrust money but has little or no day-to-day input. The agent is the decision maker but incurring little or no risk because the losses will be borne by the principal. Financial planners and portfolio managers are agents on behalf of their principals and are responsible for the assets of the principals. A tenant may be responsible for protecting and safeguarding assets that do not belong to them. Even though the lessee is responsible for taking care of the assets, the lessee has less of an interest in protecting the property than the actual owners.

The main point of dispute is when a fund manager, for the sake of short-term profitability and high remuneration, may desire to expand a business in new high-risk markets. However, this could present an unjustified risk to shareholders, who are most concerned about long-term growth and share price appreciation. Another central issue often addressed by agency theory involves inconsistent levels of risk tolerance between a principal and an agent. For example, shareholders of a bank may object that management has set the bar too low on loan approvals, thereby taking too great a risk of default.

A company is “nothing more than a series of contracts and relationships” that ensures trust between the parties. Governance therefore consists of designing contracts with mechanisms that allow optimal allocation of property rights, create ownership structures and define mechanisms so that interests are aligned between the principal and the agent. However, the opportunistic behaviour and the asymmetry in the distribution of information between the agent and the principal entail agency costs since the principal must set up incentive systems and control mechanisms (monitoring and supervision) in order to ensure that the interests of one are aligned with those of the other.

One of the important, but still little-discussed aspects of the blockchain technology is the possible changes in corporate governance. By offering a new way of understanding contracts and bypassing the traditional dilemmas of agency theory, namely the agent-principal dilemma and agency costs, blockchain could well sign the end of traditional centralized and hierarchical structures with the emergence of new forms of organizations.

A blockchain offers a new technological way of designing a governance model based on IT management of trust through smart contracts. Smart contracts and smart property are blockchain-enabled computer protocols that facilitate, verify, monitor, and enforce the negotiation, execution and performance of a contract between principal and agent. Agency relationships in smart contracts run exactly as coded without any possibility of opportunistic behavior of the agent. All contractual terms are public and fully transparent.  Accordingly, a company’s finances, for instance, are visible on the blockchain to anyone, not just to the company’s accounting department. Smart agency contracts run on a customized blockchain that enables principals and agents to store registries of debts or promises and create entire markets, among many other aspects that have not yet been considered.

Blockchain compromises the economic efficiency of hierarchies (which exploit incomplete contracts) and relational contracts (which require trust between parties). It eliminates the opportunism and transaction costs of actors through transparency and automatically executed governance mechanisms in the form of smart contracts. Thanks to blockchain technology and smart contracts, it is possible to guarantee confidence in the entire contractual process, namely:

  • The agreement, which represents the set of rules and defines the links, conditions, rights and obligations, between the principal and the agent is electronically sealed by the smart contract.
  • Formalization is done digitally using a computer code contained in the smart contract.
  • The execution of the contract which is now carried out automatically thanks to the computer code which controls, in almost real time, the agreement between the principal and the agent.

The transparency of the blockchain makes the information held by the agent and the principal fully verifiable. This eliminates the ex-ante or ex-post opportunism of the agent since all the information is presented to the actors. To continue, the uncertainty and verifiability constraints associated with the transaction that previously weighed on the third-party responsible for executing the contract are no longer relevant because smart contracts certify the transaction process in near real-time.

Agency related governance in the blockchain takes place without intermediaries, counterparty risk, or principal’s control mechanisms.  This technology simply does not require the layers of control and verification that prior financial systems necessitated. Control mechanisms such as regular management meetings with shareholders, financial disclosures, the scrutiny of analysts and pressure on management from stock performance and investors, are no longer part of the blockchain enabled agency relationship in corporate governance.

Aware of the importance of this disruptive technology and its role in overcoming conflicts and reducing Agency costs in the corporate world, Finterra offers the next generation of blockchain technology known as Gallactic Blockchain. The architecture of this internally developed blockchain allows information to be stored and transmitted transparently, securely and without validation from a central control body.

In the Gallactic blockchain trust is not based on the organization, but rather on the security and auditability of the code which is verified by all actors. Forcing or inducing the parties to respect their commitments is no longer relevant since the computer code validates the execution of the contract in real-time. Rather than entrusting a trusted third party with the validation of transactions, they are certified by a peer-to-peer network of computers acting as a server that will execute the blockchain protocol and thus validate the information by consensus. In addition, the potential of our Gallactic blockchain goes way beyond the framework of financial transactions and can be utilised in other areas such as health, education, energy, etc.

Finterra’s Self-validating blockchain transactions can help resolve the agency issues between stakeholders. In addition to addressing the traditional agency problem in corporate governance between shareholder-principal and manager-agent, Gallactic-enabled smart contracts allow for the public a fully transparent, secure, and completely networked exchange between the corporation and customers, owners and investors, other stakeholders, staff, regulators, strategic partners, suppliers, and service providers.

The Gallactic Blockchain increases the efficiency of agency relationships and lowers agency costs. It removes the need for monitoring agents, disclosure regimes, market pressure, executive-agent compensation schemes, and other checks and balances in corporate governance. It also provides a qualitative shift in efficiency in the agency relationship and in corporate governance overall.

Reference

https://www.investopedia.com/terms/a/agencytheory.asp

https://theconversation.com/comment-la-blockchain-va-changer-la-gouvernance-des-entreprises-84079

https://www.frontiersin.org/articles/10.3389/fbloc.2020.00024/full

https://clsbluesky.law.columbia.edu/2019/05/23/blockchain-solutions-for-agency-problems-in-corporate-governance/

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