The Agency Problem: Aligning Incentives between Corporations and Capital Providers
Finance
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The New Financial Paradigm:

Understanding Blockchains' Impact across the financial system - Report 2

 

This report addresses the challenge of overcoming incentive problems between those within a firm and those outside it. Corporate managers have greater information about the value of a firm than outside creditors and investors do. Unchecked, this information asymmetry can result in incentive mismatches between corporate managers, external creditors, and external investors, reducing firm value by causing:


  • overcapitalization of “bad” firms and undercapitalization of “good” ones
  • suboptimal corporate equity to debt ratios
  • budgetary overreliance on internal capital sources
  • overinvestment in “bad” corporate projects and underinvestment in “good” ones
  • corporate investment that is excessively sensitive to variations in firm liquidity

The financial system presently addresses these challenges through the provision of financial instruments designed to mediate them. These include:

  • securities—such as preferred equity redemption cumulative stocks (PERCS), put warrants, and convertible bonds—that enable corporations to issue new equity without the strong negative signal associated with pure equity issuance
  • derivatives—such as options, futures, and forwards—that enable corporations to source capital internally by shifting cash flow in advance from high payout scenarios to low payout scenarios and from low investment opportunity scenarios to high investment opportunity scenarios

Blockchain is essentially a method by which a decentralized network of actors can render immutable a shared, timestamped record. This report unpacks how blockchain offers external capital providers and corporations new ways to overcome the incentive challenges that arise from their asymmetrical information access. According to Blockmatics’ analysis, the blockchain promises to do so in five ways: 1) by reducing contractual uncertainty, 2) by extending potential collateralized debt financing, 3) by enhancing external transparency, 4) by expanding the firm’s ability to finance projects on the basis of future demand, and 5) by rendering pre-programmable classes of decisions once exclusive to corporate managers.

 

The report is designed to offer useful information to a broad swath of financial professionals.

  • Corporate finance lawyers will be interested to learn how smart contracts could reduce the cost and legal uncertainty associated with invoking contractual enforcement mechanisms.
  • Bond issuers will be keen to understand how smart contracts could combine with the Internet of Things to expand the pool of collateralizable property and speed the repossession process.
  • Corporate accountants and equity analysts will find relevant the ways cryptocurrency transactions recorded on immutable public ledgers could enhance investor information.
  • CFOs and capital budgeting experts will be interested to learn how inbuilt tokens expand our ability to finance enterprise on the basis of future demand for an enterprise’s products or services without the need for debt or equity financing.
  • Institutional investors will want to know how decentralized autonomous organizations (DAOs) could radically reduce existing forms of capital provider uncertainty, while creating new ones.

Companies that understand the disruptive reality of blockchain and wish to bring their staff up to speed are invited to consider hosting a customized Blockmatics training series for your staff. 

If you are interested in learning more download Blockchain-Enabled Aggregation & Division Executive Summary!

Download Report 1


1. In The New Financial Paradigm: Understanding Blockchain’s Impacts across the Financial System, Blockmatics examines the promise and limitations of blockchain’s impacts across the six core financial functions:

  1. pooling resources & subdividing shares 4. providing information

  2. overcoming incentive problems 5. managing risk

  3. transferring resources across time & space 6. clearing & settling payments

Over six concise reports, the series considers how blockchain expands the financial toolbox, describes exemplary early blockchain applications, offers practical limitations that encumber scalability, and shows which types of financial practice are likely to be most immediately impacted. For more on this functional approach, see (Merton and Bodie, A Conceptual Framework for Analyzing the Financial Environment 1995) and (Merton, Crane, et al. 1995).

Merton, Robert C., and Zvi Bodie. 1995. A Conceptual Framework for Analyzing the Financial Environment. Working Paper, Harvard Business School, Boston: HBS.

Merton, Robert C., D. B. Crane, K. A. Froot, Scott P. Mason, Andre Perold, Z. Bodie, E. R. Sirri, and P. Tufano. 1995. The Global Financial System: A Functional Perspective. Boston: Harvard Business School Press .