Governance in Decentralized IoT Marketplaces

The central question to be elaborated in this article is which governance requirements must be met for the implementation of blockchain solutions in a consortium, especially emphasizing a decentralized IoT marketplace. For this, a short analysis based on the three pillars of governance (decision rights, accountability and incentives) will be presented. Also, a brief comment on several stakeholders will be given, showing that a decentralized IoT marketplace is feasible for all parties if designed properly. — Authors: Philipp Sandner and Marcel Kaiser

What is governance?

To examine which importance governance has for this topic, it needs to be clarified what governance is. Governance can be defined as the legal and factual regulatory framework for the management and supervision of a project. In general, incomplete contracts and differing interests offer stakeholders both opportunities and motives for opportunistic behavior. Governance regulations have the task of restricting the scope and motives of stakeholders for opportunistic behavior through appropriate legal and factual arrangements. In this particular case, it refers to the framework, which is required to be set up in the given use case. Since this use case refers to governance in a blockchain-based use case, the focus should be on governance in the blockchain.

We know that governance is one of the fundamental aspects of blockchain design. Blockchain governance is the mechanism by which design changes are enacted and regulated on a blockchain (ListedReserve, 2018). Blockchain-based systems are initially set up to succeed in the long term. To ensure long-term success, it is important to not only incorporate the necessary technical framework, but also a governance structure. This should ensure that people are able to coordinate the further development of the blockchain ecosystem implemented. While the theoretical perspective of IT governance has been a topic of interest for several decades (Brown and Grant, 2005), Weill presented an IT-governance framework (Weill et al., 2004). This framework is based on three dimensions: decision rights, accountability, and incentives. An overview of the concepts is given below in Figure 1.

Decision rights

Firstly, the dimension of decision rights should be elaborated further. In a traditional company, the decision-making process often is not transparent enough, due to the lack of transparency-providing structures. With regards to SMEs, decision-making rights often are only inherent to a small circle of people, which may or may not be governed by an additional board. Furthermore, if such companies are not listed on a stock exchange, they do not have to publish any relevant information to the public, which furthermore strengthens the lack of transparency. In a DLT-based environment, it first needs to be elaborated about how decision-making works. Compared to traditional structures, decision-making moved from an authoritative process to a collaborative effort over the past years. As van Rijmenam, Schweitzer and Williams noted (2018), with the introduction of a multitude of blockchain companies, the concept of decision-making will again change. In the area of blockchain, decision rights switch from the concept of “who can decide on a company’s activities”, to “who has the responsibility and authority to provide doings on a platform”. This includes two more steps as well, first how earlier made decisions and a future decision will be executed, and how the interoperability of a particular system can be decided by those equipped with the decision-rights, ultimately possessing control over inter-organizational boundaries (Constantinides, Henfridsson and Parker, 2018). A well-known problem towards decision making is still, that not all participants in one framework have perfectly aligned interests. Therefore, conflicts could arise, which need to be resolved to guarantee optimal usage of a blockchain platform.

Accountability

An additional important topic is the accountability of such systems. Accountability is of importance since it is necessary to get citizen trust back (Jameson, Richter and Taylor, 2019). In this case, it should be referred to citizens, but more to participants. A participant only then would join a blockchain-based platform, if accountability is given. Under normal circumstances, a publicly distributed DLT-framework would provide a relevant amount of accountability, since this is one of the main pillars, the idea of blockchain is constructed on. Through the decentralized approach, blockchain-based platforms provide a high amount of fraud-proof working environment, since traditional problems such as fraudulent transactions or bookkeeping, double transactions, or making up numbers, are usually impossible due to the framework construction. Nonetheless, the decision-making authority of any blockchain platform should be able to provide a relevant overview of accountability of the given system to ensure that participants would like to work on this platform, within the given framework.
The final criterion which will be elaborated on is the topic of incentives. The incentive of potential participants of a blockchain platform can be carried out in several ways. On the one hand, participation in such a consortium could break up existing, possibly monopolistic, structures. On the other hand, further incentives can be distributed in the course of participation. With regards to the earlier described use case, a break-up of highly concentrated market power could be achieved, which would, in combination with a proper governance framework, provide incentives for possible participants to join and maintain the framework, and accept the given rules. Within such a framework, potential incentives towards participants could be provided by linking the achievement of certain targets to a payout, which could be triggered by a smart contract. The design of such incentives would be relatively easy to implement.

Incentive compatibility

Incentive compatibility is a concept from mechanism design, closely related to game theory. It determines implementability which is also what this section is attempting to do. Incentive compatibility is achieved once each participant in a system/game/project has no incentive to deviate from acting honestly, independent from the action of others. Acting honestly in terms of a Bayesian-Nash incentive-compatibility means revealing true preferences to others. A popular example of neglecting incentive compatibility is a Lindahl tax. This example is a tax for a public good depending on the utility derived from using the public good. It incentivizes those using the public good to lie about their usage to minimize costs. This is called a preference revelation problem and creates informational problems. In an incentive-compatible system, individuals would be better off or equally well off if they reported their usage of a public good honestly.

The research of Rey and Tirole (2007) shows that incumbent members have an incentive to exploit their market power or restrict entry by new players. Regarding blockchain, this is a significant centralization issue within proof-of-work systems due to the concentration of mining power within groups of initial members (Smit et al. 2020).

In conclusion, it can be stated that governance is an important topic regarding blockchain consortia. As Bosankic (2018) stated, governance refers to all actions such as decision-making processes that are involved in creating, updating, and abandoning formal and informal rules of a system. These rules can be code (e.g., smart contracts), laws (e.g., fees for malign actors), processes (what must be done when X happens), or responsibilities (who must do what). It can be further summarized, that governance with regards to DLT-frameworks describes how responsibilities and powers are aligned within the participants.

Governance on decentralized IoT marketplaces

Incentives for suppliers

In the context of the proposed IoT marketplace, governance has to balance suppliers, buyers, and neutral parties interacting with the marketplace. In a fully transparent market, supplying companies run the risk of revealing business secrets to competitors without actually gaining new insights themselves. This can ultimately hurt them and make them worse off in comparison to non-participants in the market. Since suppliers are one of the core components of the marketplace, this scenario is undesirable since suppliers would be incentivized to not participate in the marketplace and only to observe. Thus, governance has to make sure that participants are not worse off by operations in the marketplace. Maintaining a high degree of transparency is challenging to implement in this marketplace. In the scenario of each supplier revealing their information to each other active supplier, highly successful companies would be incentivized to stay away from the market again, which would, in turn, motivate remaining suppliers to do so as well, rendering the marketplace useless. A good proxy for success in the marketplace can be supplier activity. The higher the supply on the marketplace, the more attractive it is for buyers due to high competition. Assigning a special value to suppliers in terms of governance design is therefore highly reasonable.

Decision rights of buyers and suppliers

When changes detrimental to the continuation of marketplace activity are to be decided, it makes sense to give active suppliers the opportunity to forge decisions with voting rights. Suppliers will have an interest in enabling their buyers to continue using their services on the marketplace and will therefore likely not deviate from the best interests of the buyers. Vice-versa, this argument can not easily be made. Buyers might insist on cutting rights or imposing conditions on their suppliers when it suits their preferences as long as an outside option exists. However, supplier-dominated governance where profit generation influences decision power too much can lead to a platform oligopoly. If firms with a majority of voting power protect their rights by increasing obstacles for market entry of smaller competitors, market concentration could arise. This is of course only true in an environment where democratic decisions concerning the structure of the marketplace can be made. As a consequence, those have to be avoided for the sake of the structural integrity of an open IoT marketplace. In contrast, the governance of this marketplace should concentrate on avoiding situations of any type of lock-in.

Stakeholders’ angles: regulators

Regulators play a major role in how the implementation will have to take place. However, since many consortia are international players, also the interplay between regulators can play a major role. The EU and the US have a favorable relation and by themselves, have a sufficiently large industry to enable cross-continental cooperation as well as intercontinental action. Especially the EU as a conglomerate of many sovereign nations can effectively mediate legal groundwork for intra-EU implementations of all types of use cases. Large players like China already established their regulatory frameworks which is an advantage in terms of implementation but larger international cooperation can be negatively affected if other regulatory frameworks deviate in other directions. This is not likely but possible.

However, not only do regulators form the fate of companies and consortia, but this is also valid vice-versa. Companies with working implementations, major research results, and who are actively involved in research cooperations have not made any assumptions about the legal situation but certainly, they assume their respective regulatory frameworks to reflect their interests at least partially. Policymakers, therefore, shall not harm their local industries by harsh regulation on blockchain technology in general. Regulatory recommendations were provided in this policy paper.

Stakeholders’ angles: consortia

Multiple consortia not directly involved in the creation of a decentralized IoT marketplace can benefit from its creation. The already named example of LISSI would benefit from application in a broadly-used network. This can generate further knowledge and legitimizes the project further.

Stakeholders’ angles: investors

Investors are not yet considered in the use case of a decentralized IoT marketplace structure based on several system components. However, setup and operations require capital that can not be fully covered by fees. However, investor dependence may not be too high. Depending on implementation and design parameters, IoT marketplaces can be decentrally financed with a token model. A possible model for this could be, for example, a token that draws value from each transaction (a very small fraction) committed and is saved in a basket that represents the steadily growing counter value. The number of tokens could remain static and could be traded. The financial burden of setup would be covered by token sale, operational costs of nodes would be covered by transaction fees. Consequently, a coin would result whose value is a combination of demand for it and expected use of the network. This way, investors can help in the implementation and possibly popularization of the marketplace while profiting from steady returns whose cost should remain negligible for participants.

Conclusion

It is of utmost importance to coordinate the interests and rights of all concerned parties when a sustaining marketplace solution is to be found for the future of industrial production. Thus, governance and all of its components have been defined, put into context and applied to the stakeholder groups. As a result, the currently planned development is on its way to take into account the perspectives of many parties. Challenges were found concerning a lack of clarity in terms of regulation and in the degree to which investors play a role in the ecosystem.

Remarks

This research and development project was funded by the German Federal Ministry of Education and Research (BMBF) within the funding number 16KIS090. The authors are responsible for the content of this publication.

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Prof. Dr. Philipp Sandner is head of the Frankfurt School Blockchain Center (FSBC) at the Frankfurt School of Finance & Management. In 2018, he was ranked as one of the “Top 30” economists by the Frankfurter Allgemeine Zeitung (FAZ), a major newspaper in Germany. Further, he belongs to the “Top 40 under 40” — a ranking by the German business magazine Capital. The expertise of Prof. Sandner, in particular, includes blockchain technology, crypto assets, distributed ledger technology (DLT), Euro-on-Ledger, initial coin offerings (ICOs), security tokens (STOs), digital transformation and entrepreneurship. You can contact him via mail (email@philipp-sandner.de) via LinkedIn (https://www.linkedin.com/in/philippsandner/) or follow him on Twitter (@philippsandner).

Marcel Kaiser is a project owner and research assistant at the Frankfurt School Blockchain Center (FSBC). His expertise is decentralized finance (DeFi) and industrial blockchain applications. He analyzes the impact of blockchain technology on the economy. He speaks at public events about topics like DeFi, Diem and blockchain in general. Feel free to contact him via mail (marcel.kaiser@fs-blockchain.de), LinkedIn, or Xing.

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