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How the Blockchain Could Fix Asset Management
A DAO is like the crypto version of an investment club — and it could be the solution to one of the industry’s most nettlesome problems, writes columnist Angelo Calvello.
It’s time asset owners embraced the blockchain.
I’m not talking about allocating to a venture-capital fund focused on blockchain projects, cryptocurrencies, and nonfungible tokens (NFTs).
I’m talking about asset owners using the blockchain to create their own investment DAO (decentralized autonomous organization).
A DAO is created by a group of people or entities seeking to achieve a specific objective or perform a specific function. It’s reminiscent of a traditional investment club — but in this case, it is built on a blockchain.
While most investors might not be familiar with DAOs, they have been around since about 2016 (and the idea seems to have its origins in a 1997 paper by German computer scientist Werner Dilger). To give you a sense of the DAO ecosystem, DeepDAO, a dedicated DAO analytics firm, is currently tracking more than 4,800 DAOs with a total of $9.3 billion in their treasuries.
Many of these might seem a bit frivolous. After all, who wouldn’t like to be a member of BeerDAO (whose mission is to “collaborate with fellow beer lovers and beer makers to create an environment that helps all parties while providing membership benefits”) or BurgerDAO (“a community of food and Web3 enthusiasts creating the first decentralized burger franchise”)?
But there are also commercially focused DAOs. BitDAO, which aims to support builders of the decentralized economy, raised $230 million from investors such as Peter Thiel, Pantera Capital, and Dragonfly Capital and has over $2 billion in its treasury.
I believe DAOs could serve not only as a mechanism for asset owners to invest in digital innovations, but also as a solution to one of the most nettlesome problems in the asset management business.
My suggestion: Asset owners with a keen interest in Web3 (a decentralized internet built on the blockchain) and decentralized-finance (DeFi) projects form a DAO whose purpose is to invest capital in such projects to generate a return and gain firsthand knowledge of the blockchain. In a word, I’m suggesting asset owners create their own digital VC fund — we could call it VCDAO.
Let’s assume that five U.S. endowments agreed to start our VCDAO. They would collectively outline VCDAO’s mission and purpose. This statement of intent would be used to solicit interest from other parties.
Our endowments and other interested parties would then pool their assets and fund VCDAO’s treasury by exchanging cryptocurrency (usually Ether) for VCDAO’s governance token, $VCDAO.
Governance tokens are digital units created by the DAO that not only grant holders membership in the DAO, but also give holders the ability to participate in the management of the DAO. It’s the members, not intermediaries, who govern DAOs.
As token holders, members, through a consensus process, can create the rules that dictate how our VCDAO will be run — for example, how funds will be allocated, what employees might be hired, and how profits will be distributed among the DAO’s token holders.
These rules are written — or, more properly, coded — into a set of smart contracts that are placed on a blockchain, typically the Ethereum blockchain, making them, as well as VCDAO’s membership records and financial transactions, immutable and public.
Importantly, these smart contracts are self-executing: Whenever the encoded conditions are met, collective decisions are made autonomously. And once encoded and placed on a blockchain, these rules can only be changed through a vote by the DAO members.
With rules in place and the treasury funded, VCDAO would fulfill its purpose by sourcing, vetting, and making investments in Web3, DeFi projects, and NFTs that meet the criteria encoded in VCDAO’s smart contracts.
VCDAO would invest in these opportunities by exchanging a certain amount of the cryptocurrency held in its treasury for these projects’ own governance tokens and/or NFTs. The expectation is that these projects and/or their respective tokens would appreciate, resulting in a profit for VCDAO — that is, its members.
Profits in the form of more $VCDAO could be distributed as dividends or retained in VCDAO’s treasury for future use, depending on the rules set by the members. The success of the DAO would also increase the market value of its tokens.
While the creation and management of a DAO might sound a bit complicated, there are companies that can provide turnkey DAOs.
My intention is not to offer a tutorial on DAOs, but to show how a DAO could be used to fix a bug in the asset-management business model, which consistently disadvantages asset owners — the principal-agent problem. This problem is the result of misaligned interests between allocators and managers, as well as incentive and informational asymmetry.
Because a DAO is a decentralized organization, no central agent is acting on behalf of clients.
With membership based on the ownership of governance tokens, each member is both principal and agent — in our use case, both client and manager.
The members’ interests are naturally aligned because all members have skin in the game and are thus incentivized — individually and collectively — to create and support the DAO and its projects in some way.
So it is no longer the case that clients may win or lose, but managers always win. If the DAO wins, the members win. Any success the DAO experiences flows directly to the members, according to its rules, without an intermediary taking a piece.
Additionally, because the DAO’s rules are encoded as self-executing smart contracts, there is no need to trust that an agent or general partner will always act in the investors’ best interests. These smart contracts codify trust between all members.
Trust is further established because these contracts — along with the DAO’s membership, financial transactions, and treasury — are all maintained on a digital, time-stamped, immutable, and public blockchain. All members and even the public can audit the DAO (now this is radical transparency).
This governance structure and the transparency offered by the blockchain also remove the informational asymmetry that exists in the allocator-manager relationship, where asset owners underwrite a manager’s research and development but typically do not share in the knowledge gained in this process. Any knowledge gained through the activity of the DAO is available to its members.
It’s critical to add that, despite their proliferation, DAOs are still in their infancy and come with significant risks regarding their security, legality, and governance structure. (No introductory discussion of DAOs is complete without a mention of the 2016 hack of The DAO, where because of vulnerabilities in its underlying code, hackers were able to siphon off about $50 million of Ether.)
However, this idealized use case of our VCDAO as a digitally based VC fund reveals the possibility of disrupting our industry by making it possible to do asset management without asset managers — something all asset owners should embrace.
Angelo Calvello, Ph.D., is co-founder of Rosetta Analytics, an investment manager that uses deep reinforcement learning to build and manage investment strategies for institutional investors. He would like to thank Michal Lyskawinski for his technical assistance.