From Co-ops to DAOs
Plus: Citadel Securities, JP Morgan, BlackRock
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My bar mitzvah was a loooong time ago. Most of the event has faded from memory, but I still have some abiding recollections: the song that got everyone on the dancefloor, the terrible joke I cracked in my speech and, oddly, the flavour of the ice cream we ate for dessert. Above all, there is one particular gift that I remember to this day.
At the time, it did not seem a particularly special gift. It is customary for bar mitzvah boys to receive gifts of cash from friends and family, to set them on their way for when they’re older. One family friend gave me £20, but rather than simply handing me an envelope, they opened a building society account in my name and deposited it in there.
And there it sat for the next few years. Interest rates were high (I said it was a long time ago) so the money compounded nicely. Not that the wonder of compounding had dawned on me yet; the building society passbook sat at the bottom of my desk drawer, unloved.
Unbeknown to me, along with the money, I had acquired a small ownership interest in the building society. Building societies are structured differently from commercial banks; rather than being owned by outside shareholders, they are owned by their customers as cooperative organisations. The one looking after my money was called Abbey National. It had around nine million members similar to me, and it was the second largest building society in the UK. As a cooperative, it would target sufficient profits to fund its growth and keep its capital position in check, returning the rest to customers via better pricing.
A few years after my bar mitzvah, the law changed. The management of a number of societies felt that they were unable to compete with the banks, and a new Building Societies Act was passed in response to their concerns. This permitted societies to ‘demutualise’. If more than 75% of members voted in favour, the building society would then become a limited company like any other. Members’ mutual rights were exchanged for shares in this new company.
Abbey National became the first building society to take advantage. And so my bar mitzvah gift of £20, which had already compounded a bit due to interest, gave rise to a stock position worth quite a bit more than that. The stock came to the market at £1.30 and went on to rise to £20 (although I had long since sold by then).
It was like magic money from the sky.
Roll forward to 2021 and I was reminded of these events.
Last summer, I bought an Ethereum domain name. I’d been playing around with various decentralised finance protocols, as discussed in My Adventures in CryptoLand, and decided that I needed a crypto wallet with my own name on it – preferable to the string of random characters assigned to me by MetaMask. So I registered the address marcruby.eth and linked it to my wallet.
A few months later, the organisation behind the naming service, ENS, decided to restructure. Since being founded in 2018, it had been run as a non-profit company based in Singapore. But then the founders decided to open up governance of the organisation to a broader constituency. So they minted a load of tokens to convey governance rights and handed a portion to the 137,000 customers who had used their service. Magic money from the sky. The $ENS tokens I’d been airdropped rose in value, from around $30 each to a high of around $80. It was Abbey National all over again.
ENS is one of a new breed of organisations called DAOs – decentralised autonomous organisations. They differ from traditional corporate enterprises in that they push out decision making to stakeholders and use technology to coordinate that process. Some have characteristics of a cooperative, like ENS, which wanted to give customers a stake in its future direction, hence the airdrop. They represent a new iteration in the evolution of organisational structure. What’s interesting is that financial services have been an especially fertile environment for different corporate structures, and DAOs are no exception.
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Back to Cooperatives
Cooperative business models go back a long way. A hundred and forty years before my bar mitzvah, a group of tradesmen in Rochdale, England, got together to set up their own store, selling groceries and other goods at reasonable prices. They pooled £1 per person for a total of £28 of capital under the umbrella of the Rochdale Society of Equitable Pioneers. Each member received an equal vote in decision-making and, as co-owners, they were entitled to a dividend from the store’s profits, proportional to how much they spent.
It wasn’t the first time something like this had been tried, but the set of co-operative principles they laid down helped sustain the business, and their co-operative became a prototype for others around the UK.
A few years later, the model was introduced to financial services, initially in Germany. Friedrich Wilhelm Raiffeisen, a mayor in Western Rhineland, established a credit cooperative for farmers in 1864. He was witness to economic hardship in the agricultural community and developed a scheme for members to pool savings in loan-fund associations, which they could draw on in the form of low-cost loans. Today, Raiffeisen’s name is still associated with banks across Germany, Austria, Switzerland, the Netherlands and Belgium.
Over the years, the model migrated to other countries. Canada’s first financial cooperative was established in 1900 by Alphonse Desjardins. A few years later, Desjardins helped establish the first US credit cooperative in New Hampshire.
While the motivation for forming them was similar, the nature of cooperative organisations differed between countries. In North America, credit unions were more prevalent – not-for-profit organisations, set up to provide services to members. In Europe, cooperative banks tended to be for-profit, providing services to members and non-members, with profits used to bolster capital and fund long term growth.
Relative to other industries, the cooperative model lends itself well to financial services for several reasons. First, financial companies typically have two distinct customer pools – borrowers and savers – and there can be conflicts between them. Savers want a high return on savings, and borrowers a low cost of credit. As owners of the cooperative, both savers and borrowers are inextricably bound to its fortunes, which may help to mitigate this conflict – no surge pricing in the case of a cooperative marketplace. Second, cooperative membership tends to be structured around a common identity like a geographic location or a shared profession. This reduces adverse selection, leading to better loan decisions. Third, as owners, depositors may be more likely to maintain savings in periods of economic uncertainty, ensuring stability of retail funding.
These factors may explain why the cooperative model has been so resilient in the financial sector. In the UK, the Building Societies Association has a market share of 18% in deposits and 23% in mortgages as at September 2021. And that’s with Abbey National (and others) having long since demutualised. By contrast, in groceries, the Co-op Supermarket – the successor to the Rochdale Society of Equitable Pioneers – has a market share of 6%.
In other countries, the cooperative share is higher. Raiffeisen’s bank in Austria has a 32% share of domestic deposits (end 2020); in Germany the cooperative share is 23%; and in the Quebec region of Canada, it is as high as 41%.
Such strong market presence in the hands of entities not seeking to maximise profit can distort underlying markets. It is no coincidence that banking markets in Austria, Germany and Japan rank as some of the least profitable in the world, the flipside being that customers in those markets get a comparatively good deal.
It’s not just in banking that the cooperative model has been deployed within financial services. Some financial services satisfy a public utility role, making user ownership a sensible solution for them. This is the case for the DTCC in US securities clearing and SWIFT in international remittances. In other cases, founders like the ideal:
John Bogle of Vanguard was convinced that the conflicts between the profession of investing and the business of investing could only be reconciled via a mutual structure in which fund holders own the investment management company.
Dee Hock of Visa developed a concept for organisations he called “chaordic”. In contrast to command-and-control organisations, chaordic organisations are decentralised, self-organising and self-governing. He considered Visa – in the cooperative structure it adopted before going public – as the first, albeit flawed, implementation of his new concept.
Cooperative structures do have their drawbacks, of course. In particular, they have limited capacity to raise additional capital over and above what they generate in earnings. In addition, without externally held capital and tradeable ownership rights, cooperative institutions can lack discipline in terms of how they are controlled. Governance can also be compromised in systems where one member has one vote, as members may not have sufficient incentive to exercise control.
These were the arguments that drove Abbey National to demutualise. Sadly, the bank didn’t fare too well in the public markets. With unfettered access to capital and pressure from outside shareholders to generate a return, it rushed into wholesale lending. In the early 2000s, as markets reeled from the collapse of Enron and others, Abbey National suffered large losses. A couple of years later, it was sold to Santander. After 115 years as a cooperative, Abbey National survived just 15 years as a public limited company.
DAOs: The New New Thing
The very first DAO was launched in 2016. It was a scheme to raise funds to invest in Ethereum projects. Unlike a traditional managed fund structure, members would be able to vote on potential investment opportunities. The scheme raised 11.5 million ETH, equivalent to $150 million, from over 11,000 members. But it never got off the ground because within two months, it was hacked, with 3.6 million ETH stolen, equivalent to $50 million at the time.
That wasn’t the end of DAOs, though. Since then, many have been set up to cover a range of different use cases. The organisational features they share are that they are decentralised, i.e. members are responsible for making decisions; and they are autonomous, i.e. they use smart contracts, essentially applications or programmes, to trigger actions automatically on a publicly accessible blockchain.
As well as investment DAOs like that fateful first DAO, decentralised autonomous organisations have been set up to award grants, produce media, create social communities and more. But the biggest DAOs are so-called protocol DAOs: collaborative entities that exist to help build a protocol. And these are especially prevalent in financial services. Of the ten largest DAOs by assets, seven are geared towards finance.
Among them are Maker and Compound, two protocols we discussed in our explorations of decentralised finance. Compound awards governance tokens ($COMP) to its users, so that they have a say in its governance, just like in a cooperative model. The difference with a cooperative structure is that those governance rights can be sold and voting is proportionate to the number of tokens held. Right now, most of the tokens in circulation are owned by third parties. Four venture capital firms (Andreessen Horowitz, Polychain Capital, Bain Capital Ventures and Paradigm) own around a third between them, and the founders own at least another 7%. But as use of the protocol expands, users will build up a higher share of the votes.
The regulatory framework around DAOs is still vague. Outside of Wyoming, they are not considered legal entities. In financial services, this presents a major challenge to them gaining traction. But as legal acceptance grows, DAOs represent an alternative model available to financial services organisations, with some of the benefits of a cooperative and some of the benefits of a shareholder-owned corporation. As the cooperative sector has shown, innovation in finance has always been as much about structure as about product.
For more on DAOs, both Packy McCormick and Mario Gabriele have written very comprehensive pieces – The DAO of DAOs and DAOs: Absorbing the Internet.
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