Corporate Governance and Blockchains

David Yermack is Professor of Finance at the NYU Stern School of Business. This post is based on a recent article authored by Professor Yermack.

In the paper, Corporate Governance and Blockchains, which was recently made publicly available on SSRN, I explore the corporate governance implications of blockchain database technology. Blockchains have captured the attention of the financial world in 2015, and they offer a new way of creating, exchanging, and tracking the ownership of financial assets on a peer-to-peer basis. Major stock exchanges are exploring the use of blockchains to register equity issued by corporations. Blockchains can also hold debt securities and financial derivatives, which can be executed autonomously as “smart contracts.” These innovations have the potential to change corporate governance as much as any event since the 1933 and 1934 securities acts in the United States.

Using blockchains to record stock ownership could solve many longstanding problems related to companies’ inability to keep accurate and timely records of who owns their shares (Kahan and Rock, 2008). Simple extensions could allow blockchains to hold self-executing smart contracts, such as stock options held by employees or warrants owned by outside investors. These smart contracts could extend into areas such as the pre-contracted resolution of financial distress. Perhaps most importantly, blockchains could provide unprecedented transparency to allow investors to identify the ownership positions of debt and equity investors (including the firms’ managers) and overcome corruption on the part of regulators, exchanges, and listed companies. If a firm elected to keep its financial records on a blockchain, opportunities for earnings management and other accounting gimmicks could drop dramatically, and related party transactions would be much more transparent.

For shareholders, blockchains could offer lower costs of trading and more transparent ownership records, while permitting visible real-time observation of transfers of shares from one owner to another. For activists, the technology could allow for quicker, cheaper acquisitions of shares, but with far less secrecy than under the current system. Managerial ownership could become much more transparent, with insider buying and selling detected by the market in real time, and chicanery such as the backdating of stock compensation becoming much more difficult, if not impossible. Corporate voting could become more accurate, and strategies such as “empty voting” that are designed to separate voting rights from other aspects of share ownership could become more difficult to execute secretly. Any and all of these changes could dramatically affect the balance of power between directors, managers, and shareholders.

In this paper, I identify in more detail how the use of blockchains could affect corporate governance from the perspective of corporate managers, institutional investors, debt investors, auditors, and other groups. I also discuss issues related to the internal governance of blockchains themselves, a topic that could become important to corporations in the way that the organization of stock exchanges and other capital market institutions is important today.

Blockchains were introduced by Nakamoto (2008) to track ownership of the virtual currency Bitcoin. After more than six years of successful use with Bitcoin, blockchains have become recognized as an alternative to ownership ledgers based on classical double-entry bookkeeping. Blockchains offer potential advantages in cost, speed, and data integrity compared to classical methods of proving ownership, and the scale of these potential savings has motivated investments by venture capitalists and by established players in the financial services industry. Entrepreneurs are actively investigating blockchains’ suitability for recording ownership of a wide range of assets, from stocks and bonds to real estate, automobile titles, and works of art.

Emerging markets may be among the first to see blockchain technology integrated into their stock exchanges and capital markets. The prediction of early adoption in developing countries rests upon the convergence of three forces: inadequacy of existing record-keeping systems, mistrust of corrupt and ineffective market regulators, and high penetration of information technology such as smartphones. As examples, the rapid growth of mobile payment systems such as mPesa in Nigeria, and the high-profile efforts in 2015 by the government of Honduras to move its land registry onto a blockchain, provide vivid illustrations of the willingness to emerging economies to bypass older technologies and become early users of innovations that integrate economic data with information technology.

To date the most high-profile use of blockchain technology in corporate finance has occurred in the U.S. NASDAQ stock market, which launched a pilot project in May 2015 to evaluate the suitability of blockchains for registering and transferring shares. The Sydney, Frankfurt, and London stock exchanges have also announced research programs to evaluate blockchain technology for their listed companies. Lee (2015) discusses the potential benefits of blockchains to a stock exchange in such areas as cost and speed of execution and settlement. Schroeder (2015) analyzes the legal basis for treating virtual assets on blockchains as “uncertificated securities” under Article 8 of the Uniform Commercial Code.

If blockchains attain a central role in corporate record keeping, the maintenance and upgrading of blockchains themselves would raise interesting governance problems. Governance of a blockchain amounts to having authority to update its code, which might be done either for technical reasons or to change some of the critical constraints or assumptions (such as the rate as which new coins or shares might be issued). As implemented for Bitcoin and other digital currencies, blockchains operate on a decentralized basis, with all participants in a network (such as all owners of Bitcoins) sharing responsibility for updating them in real time. Proposed changes to the Bitcoin blockchain code occur only if they receive “consensus” from the network members via a passive process of adoption or rejection by more than 50%. The passive method of changing a blockchain’s code by consensus might leave it vulnerable to various methods of sabotage and attack, either through brute force strategies resembling denial of service attacks, or more subtle divide-and-conquer strategies based on subterfuge or the exploitation of collective action problems. Overcoming these vulnerabilities appears to be an important, unfinished priority for promoters of blockchain technology. An alternative to the open Bitcoin blockchain is a closed, or “permissioned” blockchain open only to authorized users. While a permissioned blockchain might appear attractive for security reasons, it would lack some of the appealing features of an open blockchain, which does not rely on a controlling middleman to authorize and police transactions.

The full paper is available for download here.

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