Financial Cryptography

on Governance

Governance seems to be a term that is less familiar to more than a few. So I will try and paint a picture of it. (Caveat: Governance is a huge field, so it won't be possible to give more than a small overview...)

The closest to what we mean in Financial Cryptography is what is called Corporate Governance; other uses of the term suffer from manipulation. In the corporate world, Governance is in essence the need to align the organisation's decision makers with the interests of the organisation itself. (We will come to the non-profit versus for-profit issue later.)

Let's get right back to basics and consider two people, an Owner and an Employee. The owner's interests are aligned with her decisions; if not she loses money.

However her employee has a more perverse situation: his decisions are naturally aligned with his own interests, which might be contrary to the interests of the owner.

(This is called the Principal-Agent problem, where the Principal is the owner, and the employee is an Agent of the Principal. The Agent has a conflict of interest, whereas the Principal does not, in simple terms. It is a widely studied theory.)

The Shop of Humble Things

Pretty dry stuff, so let's try an example. The canonical story is that of a small retail shop. How does the Owner structure things such that the Sales Assistant doesn't simply keep the money handed him by the customer?

Several age-old inventions created revolutions that enabled our humble shop to advance to greater things. Here's two from the Halls of Governance Fame:

1. The cash register (or till or box). These days we think the cash register is about the need to calculate change and store the cash safely from robbers, but its original success was due to something else: the creation of a separate box that created a mental and physical barrier between the Agent's money and the Principal's money.

Think here of the old shop assistant's uniform -- a huge pair of overalls with 2 grand pockets in the front, and you'll see where we are heading. The Agent can put the Customer's payment into his 2 grand pockets ... and simply forget some or all of it!

Who's to say?

Instead, by putting the money into the box clearly labelled as the Principal's cash register, a protocol was established; if any money was taken out, that was theft, and if the Customer's money didn't go in, that was also theft.

2. The receipt. Again, today, we think of the receipt as the "customer's right." No such! At least not primarily; its core purpose in life is not evidence for the customer, but evidence for the Principal. At the end of the day, the money in the cash register is counted up, and if the total of receipts didn't match the amount of money, then we have a problem.

So why does the Customer get a receipt? Because the Customer checks that the Principal gets a receipt!

In order to make both the above inventions work, the customer was signed up as an unwitting but interested participant in the purchase of Humble Things. She is encouraged to participate in the protocol by one means or another, and is encouraged to report infractions to the owner. With the receipt, we want her to make sure that the Shop Assistant fills out a copy for the Owner, so the owner rewards her with a copy as well. When she sees money going into those 2 grand overalls pockets, she is encouraged to think about rising prices due to theft.

These two inventions created a revolution in shops: they and other Governance techniques meant that it was possible to employ Agents and trust them to work unsupervised.

Corporate Governance

So what do we mean by Corporate Governance? Simply the enlarged form of the above: using techniques like the cash register to construct larger, better and more trustworthy enterprises.

Imagine your new job is Financial Controller at Enron! Do you get into the spirit of financial engineering, and shovelling of huge bundles of corporate value into obscure corporate vehicles for later profiting ... by self ... or do you work to clean all this up and make the money work for the shareholder?

Well, it all depends on how the interests are aligned. Do you get to keep the money? We all know that everyone has a price, and it only depends on the *amount* money on offer ... we also know that the equation is fundamentally one of risk and likelihood: A nigerian scam offers you millions, but you know that the chances are ridiculous, so your expectation is negative.

So, for our financial controller at Enron, it is *just* another risk calculation, and <ahem> he's very good at that, because risk is his job!

What stands in his way is: Governance. Enron was nothing but a failure in governance.

Corporate Governance, then, is the mission of establishing the shareholder as the ultimate benficiary and searching for the best way to reward that shareholder for her investment. It *specifically* looks at how we align the interests of all the players -- directors, managers, etc -- so that they all work to reward the shareholder.

And, not themselves. Governance works on the expectation that directors and managers will consider their own interests before that of the shareholders. How we deal with that is the art and science of governance; we don't eliminate it, nor even totally control it, but we search for the profitable balance, the convenient seduction, the ultimate win-win. You pick the terms, but recognise that Governance starts when you understand that the employees are on a pay-packet, and that will always be stronger than their interests in the welfare of the shareholder.

Non-profit Governance

Now, how does this all apply to an organisation without shareholders? Well, obviously, the interests cannot be aligned because there is no benchmark available -- no shareholder. Does this mean that Corporate Governance is null and void in the world of non-profits?

Not at all. It means that we start from an absence of Governance, which is a worse situation than a corporation without governance. With a corporation, the owners can always sack the board and start again, albeit with losses. With a non-profit, we can't even take that drastic step.

How we deal with this is tough. I'm no expert on non-profit governance, but I can offer some tips. First one:

Identify the stakeholders. These people can be impressed into service as proxy shareholders; in that where we would align interests to shareholders before, now we align interests to the stakeholders.

Next, identify the interests of the stakeholders. As we aren't paying them money, it will have to be something else. Money is fantastic for this purpose because each payment ("dividend") is measurable and comparable, and it will be hard to come up with something as good as money to create a feedback loop. But, it is possible.

Then, align the interests of employees to the above interests of the stakeholders. E.g., maybe your stakeholders are interested in "choice in software." If so, we could measure how many choices you offer, and what proportion of the population chooses your choice. Then, we could reward the employees on how the growth in choice pans out over time.

By way of example, consider an option on future market shares of software. Imagine you give me an option on 19% share for our product Fuxbirdie within the overall market for brailers. When Fuxbirdie reaches 19%, I get paid out a buck, and if not, it expires worthless.

Summarising the Governance of Humble Things

Governance isn't exciting. It doesn't seem to get more code written, it doesn't get your picture in Linuxworld, and there are no awards. It literally is the last and most ugly thing to work at.

It is also the thing that fewest honest people understand least well, and most crooked people understand very well. For the crooks, it is their way to their pot of gold, without even the sense of theft; it is the ultimate fraud, one that actually .. didn't happen because the crook changed the rules to make it work in his favour.

Governance is simply about identifying your core stakeholders, their interests and then aligning the business to your stakeholders and interests. Now, your interests. It's easy if you are a Corporate, as the profit motive and shareholder base are easily set up.

It's a bit harder as a non-profit; but there is an avenue in identifying stakeholders, and their interests.

Annex: Things Excluded from FC's meaning of Governance

Political governance, as defined by the World Bank.

Project governance, at least as described in wikipedia. That's what I would call standard project management, dressed up with a new name for the purpose of selling more consultancy time. Call me cynical...

Also, IT governance, as seen here, is not it:

A characteristic theme of IT governance discussions is that the IT capability can no longer be a black box. The traditional handling of IT management by board-level executives is that due to limited technical experience and IT complexity, key decisions are deferred to IT professionals. IT governance implies a system in which all stakeholders, including the board, internal customers and related areas such as finance, have the necessary input into the decision making process. This prevents a single stakeholder, typically IT, being blamed for poor decisions. It also prevents users from later complaining that the system does not behave or perform as expected:

A board needs to understand the overall architecture of its company's IT applications portfolio ... The board must ensure that management knows what information resources are out there, what condition they are in, and what role they play in generating revenue... [1]

Again, this is an old pig called "management." Putting it in a dress and calling it governance doesn't help. I'd speculate that it is done that because telling the board that they don't understand IT isn't helpful, but telling them that it is governance might wake them up.

This is closer, and it might resonate for some people. "Good Governance" as applied in "development literature"

"Simply put "governance" means: the process of decision-making and the process by which decisions are implemented (or not implemented). Governance can be used in several contexts such as corporate governance, international governance, national governance and local governance.

Since governance is the process of decision-making and the process by which decisions are implemented, an analysis of governance focuses on the formal and informal actors involved in decision-making and implementing the decisions made and the formal and informal structures that have been set in place to arrive at and implement the decision."

Posted by iang at February 7, 2007 06:41 PM | TrackBack