DeFi World has a new star called DAO

February 13th, 2022 Louis Lehot and Patrick Daugherty Leave a comment

As financial markets wrap up the year 2021 and launch into 2022 at warp speed, the “DeFi” world has a new star called the “DAO”.

Decentralized finance, short-handed as “DeFi”, refers to peer-to-peer finance enabled by Ethereum, Avalanche, Solana, Cardano and other Layer-1 blockchain protocols, as distinguished from centralized finance (“CeFi”) or traditional finance (“TradFi”), in which buyers and sellers, payment transmitters and receivers, rely upon trusted intermediaries such as banks, brokers, custodians and clearing firms. DeFi app users “self-custody” their assets in their wallets, where they are protected by their private keys. By eliminating the need for trusted intermediaries, DeFi apps dramatically increase the speed and lower the cost of financial transactions. Because open-source blockchain blocks are visible to all, DeFi also enhances the transparency of transactions and resulting asset and liability positions.

Although the proliferation of non-fungible tokens, or NFTs, may have gathered more headlines in 2021, crypto assets have become a legitimate, mainstream and extraordinarily profitable asset class since they were invented a mere 11 years ago. The Ethereum blockchain and its digitally native token, Ether, was the wellspring for DeFi because Ether could be used as “gas” to run Layer-2 apps built to run on top of Ethereum. Since then, Avalanche, Solana and Cardano, among other proof-of-stake protocols, have launched on mainnet, providing the gas and the foundation for breathtaking app development which is limited only by the creativity and industry of development teams.

Avalanche and its digitally native token AVAX exemplify this phenomenon. Launched on mainnet a little more than a year ago, Avalanche already hosts more than 50 fully-launched Layer-2 apps. The AVAX token is secured by more than 1,000 validators. Recently, the Avalanche Foundation raised $230 million in a private sale of AVAX tokens for the purpose of supporting DeFi projects and other enhancements of the fully functional Avalanche ecosystem. Coinbase, which is a CeFi institution offering custodial services to its customers, facilitates purchases and sales of the Avalanche, Solana, Cardano and other Layer-1 blockchain tokens, as well as the native tokens of DeFi exchanges such as Uniswap, Sushiswap, Maker and Curve. So formidable is DeFi in its potential to dominate the industry that Coinbase, when it went public in 2021, cited competition from DeFi as one of the company’s primary risk factors.

If DeFi were “a company,” like Coinbase, the market capitalization of AVAX would be shareholder wealth. But DeFi is code, not a company. Uniswap is a DeFi exchange that processed $52 billion in trading volume in September 2021 without the help of a single employee. Small wonder that CeFi and TradFi exchanges are concerned.

DeFi apps require “DAOs,” or Decentralized Autonomous Organizations, to operate. DAOs manage DeFi apps through the individual decisions made by decentralized validator nodes who own or possess tokens sufficient in amount to approve blocks. Unlike joint stock companies, corporations, limited partnerships and limited liability companies, however, DAOs have no code (although, ironically, they are creatures of code). In other words, there is no “Model DAO Act” the way there is a “Model Business Corporation Act.” DAOs are “teal organizations” within the business organization scheme theorized by Frederic Lalou in his 2014 book, “Reinventing Organizations.” They are fundamentally unprecedented in law.

Just as NFTs have been a game changer for creators, artists and athletes, our legal system will need to evolve to account for the creation of the DAOs that govern NFTs and other crypto assets. (NFTs are a species of crypto asset.) Adapting our legal system to account for DAOs represents the next wave of possibility for more numerous and extensive community efforts.

A DAO is fundamentally communitarian in orientation. The group of individuals is typically bound by a charter or bylaws encoded on the blockchain, subject to amendments if, as and when approved by a majority (or some other portion) of the validator nodes. Some DAOs are governed less formally than that.

The vast majority of Blockchain networks and smart contract-based apps are organized as DAOs. Blockchain networks can use a variety of validation mechanisms. Smart contract apps have governance protocols built into the code. These governance protocols are hard-wired into the smart contracts like the rails for payments to occur, fully automated, and at scale.

In a DAO, there is no centralized authority — no CEO, no CFO, no Board of Directors, nor are there stockholders to obey or serve. Instead, community members submit proposals to the group, and each node can vote on each proposal. Those proposals supported by the majority (or other prescribed portion) of the nodes are adopted and enforced by the rules coded into the smart contract. Smart contracts are therefore the foundation of a DAO, laying out the rules and executing the agreed-upon decisions.

There are numerous benefits to a DAO, including the fact that they are autonomous, do not require leadership, provide objective clarity and predictability, as everything is governed by the smart contract. And again, any changes to this must be voted on by the group, which rarely occurs in practice. DAOs also are very transparent, with everything documented and allowing auditing of voting, proposals and even the code. DAO participants have an incentive to participate in the community so as to exert some influence over decisions that will govern the success of the project. In doing so, however, no node participating as part of a decentralized community would be relying upon the managerial or entrepreneurial efforts of others in the SEC v. Howey sense of that expression. Neither would other nodes be relying upon the subject node. Rather, all would be relying upon each other, with no one and no organized group determining the outcome, assuming (as noted) that the network is decentralized. Voting participants in DAOs do need to own or possess voting nodes, if not tokens.

As with NFTs, there are limitless possibilities for DAOs. We are seeing a rise in DAOs designed to make significant purchases and to collect NFTs and other assets. For example, PleasrDAO, organized over Twitter, recently purchased the only copy of the Wu-Tang Clan’s album “Once Upon a Time in Shaolin” for $4 million. This same group has also amassed a portfolio of rare collectibles and assets such as the original “Doge” meme NFT.

In addition to DAOs that are created as collective investment groups, there are DAOs designed to support social and community groups, as well as those that are established to manage open-source blockchain projects.

As is true with any emerging technology, there is currently not much regulation or oversight surrounding DAOs. This lack of regulation does make a DAO much simpler to start than a more traditional business model. But as they continue to gain in popularity, there will need to be more law written about them.

The State of Wyoming, which was first to codify the rules for limited liability companies, recently codified rules for DAOs domiciled in that state. So a DAO can be organized as such under the laws of the State of Wyoming. No other state enables this yet.

Compare the explosion in digital assets to the creation of securities markets a century ago. After the first world war concluded in 1917, the modern securities markets began to blossom. Investors pooled their money into sophisticated entities called partnerships, trusts and corporations, and Wall Street underwrote offerings of instruments called securities, some representing equity ownership, others representing a principal amount of debt plus interest. Through the “roaring ‘20s,” securities markets exploded in popularity. Exuberance became irrational. When Joe Kennedy’s shoeshine boy told him that he had bought stocks on margin, Kennedy took that as a “sell” signal and sold his vast portfolio of stocks, reinvesting in real estate: he bought the Chicago Merchandise Mart and was later appointed by FDR to chair the SEC. When the stock market crashed, fingers were pointed. Eventually, a comprehensive legislative and regulatory scheme was built, woven between federal and state legislation and regulatory bodies. Almost a hundred years later, securities markets have become the backbone of our financial system, and investors and market participants have built upon the certainty of well-designed architecture to create financial stability and enable growth.

But the legislative paradigm designed in the 1930s was not created with digital assets in mind. The world was all-analog then. The currently disconnected and opaque regulatory environment surrounding digital assets presents a challenge to sustained growth in DeFi markets. Without “crypto legislation,” government agencies have filled the void, making their own determinations, and they are not well suited to do so. Just before Thanksgiving, the federal banking agencies released a report to the effect that they had been “sprinting” to catch up on blockchain developments, that they are concerned by what they see, and that next year they will start writing rules. Plainly, technological development has outpaced Washington again.

Whether crypto assets should be characterized as securities, commodities, money or simply as property is not clear in present day America. Will entrepreneurs continue to create digital assets and will investors buy them if their legal status is in doubt? The SEC mantra is “come talk to us,” but the crypto asset projects actually approved by the SEC are precious few in number, and SEC approvals are not timely. We have clients that have run out of runway while waiting for SEC approvals. In decentralization as in desegregation, justice delayed is justice denied. The recent experience of Coinbase in attempting to clear its “Lend” service through the SEC, only to be threatened with an SEC enforcement action (but no explanation), has caused other industry participants to question the utility of approaching officials whose doors might be open for polite conversation but whose minds seem to be closed.

Similarly, DAOs are a path-breaking form of business “organization” that are not well understood. They are not corporations. Should they nevertheless file and pay taxes, open bank accounts or sign legal agreements? If so, then who would have the power or duty to do that for a decentralized autonomous organization whose very existence decries the need for officers, directors and shareholders? The globally significant Financial Action Task Force, in its recent guidance on “virtual assets and virtual asset service providers,” called on governments to demand accountability from “creators, owners and operators,” as it put it, “who maintain control or sufficient influence” in DeFi arrangements, “even if those arrangements seem decentralized.” Some observers have characterized the FATFs guidance as an attempted “kill shot” targeting the heart of DeFi.

This, too, we know: SEC Chair Gensler has his eye on DeFi. We know that because he has said so, repeatedly. Trading and lending platforms, stablecoins and DeFi are the priorities that he mentions. SEC FinHUB released a “Framework” for crypto analysis that includes more than 30 factors, none of which is controlling. That framework is unworkable because it is too complex and uncertain of application. Chair Gensler, however, apparently applies what he calls the “duck” test: If it looks like a security, it is one. With respect to Mr. Gensler, that simple approach is no more useful than the late Justice Potter Stewart’s definition of obscenity: “I know it when I see it.” Less subjectivity and greater predictability in application are essential so development teams and exchange operators can plan to conduct business within legal boundaries. What we need are a few workable principles or standards (emphasis on “few” and “workable”) that define the decentralization that is at the core of legitimate DeFi and the consumer use of tokens that are not investment contracts. We also need the SEC to adhere to Howey analysis, which it has told us to follow slavishly, and not try to move the goalposts by misapplying the Reves “note” case when it senses that Howey won’t get it the result it craves.

Although futuristic DAOs are a decentralized break from the centralized past and present of business organization, the SEC has seen them before. Indeed it was the “DAO Report” issued in 2017 that began SEC intervention in the crypto asset industry. The DAO criticized in the DAO Report was unlike the DAOs seen today for a variety of reasons, including these: that DAO was a for-profit business that promised a return on investment, similar to a dividend stream, to token holders; and the token holders didn’t control the DAO. “Curators” controlled it, by vetting and whitelisting projects to be developed for profit. DAO participants necessarily relied on the original development team and the “Curators” to build functionality into the network. That sort of reliance on the managerial or entrepreneurial efforts of others is absent in a latter-day DAO whose participants can avail themselves of a fully functional network without reliance on the developers and without delay. It is earnestly to be hoped that the SEC will recognize these critical differences.

* * *

Louis Lehot is an emerging growth company, venture capital, and M&A lawyer at Foley & Lardner in Silicon Valley. Louis spends his time providing entrepreneurs, innovative companies, and investors with practical and commercial legal strategies and solutions at all stages of growth, from the garage to global.

Patrick Daugherty is Louis’ partner in Chicago. A corporate securities lawyer by training, he spent 35 years practicing the law of money (IPOs, ETFs, M&A, SEC reporting and governance). While he still does that, 5 years ago he went down the rabbit hole of crypto assets and he now devotes himself to the law of the future of money.

Archives, Banking, Global Trade Daily

Commerce, Currency, and Credit —and What’s Next

January 29th, 2020 Herk Christie Leave a comment

The notions of commerce, currency, and credit are nothing new. For centuries, we’ve found ways to barter, borrow, and repay one another through the exchange of goods, services, or credit. Exchange aside, every form of currency has an assigned value agreed upon by the individuals or organizations participating in the transaction.

Need a house or a plot of land? Everything had a price. Back then, we offered what we had…like goats, cows, or crops. In modern times and with the development of currency, we have turned to coins, paper, plastic, and other forms of credit to define the values of our exchanges.

If we begin to think about the evolution of commerce in the context of innovation, we simultaneously begin to wonder, ‘What’s next?’

As the COO of a fast-moving fintech company, I look to innovation to answer this fundamental question. It will always be top-of-mind for me, in order to ensure that our business is at the forefront of innovation when it comes to contemplating the many ways Americans — particularly those in the small business community — think about and gain access to commerce, currency, and credit.

Today, small businesses are faced with an unfavorable choice when considering taking on additional capital: curb their instinct to innovate and grow, or encumber themselves with debt. While the growth of small businesses will help our economy thrive, we can’t increase our ability to provide funding to small businesses by maintaining the status quo. So how do we inject businesses with funds, without ultimately harming that growth and innovation? I suggest several ways: decrease our industry’s approval time and simplify the process; provide customized offers and understand the uniqueness of each business through the implementation of artificial intelligence and advanced technology, and restore the innate integrity and trust from the nascent days of commerce.

Here are three topline factors that will drive commerce, currency, and credit — and what’s next:

Convenience

If we look at the transition in the consumer payments industry as a leading indicator, we think about the emergence of fast-pay apps like Zelle, Venmo, or Apple Pay, one thing is clear: convenience is king. Even if it costs the consumer a dollar or two, it beats the basic, but now outdated steps of writing a check, (purchasing and) putting a stamp on the envelope, putting it in the mail, and making sure the mail person gets it on time. Certainly, checks have a role to play in the exchange of money — and perhaps always will — but fast cash apps represent the shift.

If we examine the ways that small businesses have historically gained access to capital, what were once nothing more than hard-copy applications followed up by mountains of paperwork issued by traditional banks that required waiting weeks or even months to hear of an approval, is rapidly evolving into what is now a full-fledged industry dedicated to providing capital in mere days or even hours —with companies in industries ranging from online retailers to credit card processors, and more, working to deliver working capital in the near speed it takes to complete an ATM transaction. Just as odd as dropping a goat off today to pay for a good or service would seem, so too will be the long timeframe to secure small business capital via a long arduous process. We are quickly moving to a couple of button clicks on your cell phone and capital will be delivered into your business account.

Channels

When discussing my philosophy about our business, three words colleagues often hear me use are “channel of choice.” They refer to finding our customers by identifying who they are, where they are, and what is their preferred method of communication; and of course, delivering superior user experience.

Which “channel of choice” will appeal to the busy mom-and-pop shop owner who calls us from her landline in search of new ways to gain access to capital for a new storefront facade; or to the construction company that does most of its business and banking online and prefers to be reached via the web; or, to the 20-something app developer who likes to do his business with a simple click on his phone?

Our success is contingent upon creating an appropriate environment and successful strategy for each of our customers, all of whom have varying degrees of means and preferences to interact with us. While mobile interactions will continue the trend to dominate in preference, there will likely always be a need to handle interactions with just a simple phone call. And delivering an intentional experience with all of those channels in mind will become the new normal

Caution

Over the past few years, the vulnerability of data, privacy, and information security systems has been exposed. As we move into a more digital environment where every piece of data is at your finger times, it’s incumbent upon us in the alternative financial services industry to evaluate the ways we protect the vast information we hold in similar ways customers expected traditional banks to hold and secure their deposits. The phrase “data is the new currency” is quickly becoming reality and expectations of security from those who provide us that information will be just as high as dropping of a deposit to your local bank. As mountains of information continue to become available, it will become a focus for all to consider how we store that information just as a bank locks up its currency in a vault.

_____________________________________________________________________

Herk Christie is the Chief Operating Officer of Expansion Capital Group, a business dedicated to serving American small businesses, by providing access to capital and other resources, so they can grow and achieve their definition of success. Since its inception, ECG has provided approximately $400 million in capital to over 12,000 small businesses nationwide.

Archives, Global Trade Daily, International Banking

8 Ways Your AP Process Leaks Spend – and How AI Can Prevent It

January 28th, 2020 Anant Kale Leave a comment

Today’s companies put huge efforts into negotiating the best terms with their suppliers. Procurement teams regularly spend weeks or months going back and forth on contract terms and volume discounts to get the most bang for their buck.

Too often, these savings aren’t realized. Suppliers may ignore the negotiated terms when invoicing, and AP teams, faced with a deluge of invoices and limited time to get payments out the door, only sample select transactions and only do basic 2 or 3 way matching of volume and price. This inevitably means costly invoice problems fall through the cracks — from mismatched invoice and contract terms, to unapplied discounts, to completely bogus charges, and more.

Optimizing your AP process may seem like a big undertaking, but it’s much easier than it might seem and worth the effort. According to The International Association of Contracts and Commercial Management (IACCM), companies that work to improve controls over invoice payment will see a return of more than 4 percent of invoice value.

Even if you’re ready to improve your AP process, one pesky question remains: How do you actually do it? Once upon a time, it would have been necessary to hire more people to check every transaction. But today, technology can provide a crucial and cost-effective assist for overstretched AP teams.

Artificial intelligence (AI) is becoming more and more common in business contexts. Nearly 90 percent of companies planned to increase AI spend in 2019, according to a Deloitte survey. However, the idea of actually using AI may feel a little unrealistic for some. While more and more corporations are automating AP processes, 30 percent of businesses still rely on manual invoice processing, according to The Institute of Finance and Management.

If you’ve already implemented other technologies in your workflow, AI can fit in seamlessly. AI-powered spend automation software integrates with existing expense management, invoice automation, contract management, and ERP systems to augment rather than disrupt your status quo.

8 common (and costly) invoice problems

Here are just a few of the problems AI-powered solutions can help your team avoid during the spend audit process:

1. Fraudulent invoices: When it comes to invoicing fraud, if you can dream it, chances are fraudsters have tried it: From inflated invoices, to completely made-up charges, to shell companies, to vendor impersonation, and more.

Too often, the calls are coming from inside the house. The Association of Certified Fraud Examiners (ACFE) found that occupational fraud (fraud committed by employees against employers) resulted in more than $7 billion in total losses in 2018. AI systems with a compliance component can spot risk factors commonly associated with fraud so your team has a chance to review these invoices manually before they’re paid out.

2. Duplicate invoices: Up to two percent of the average company’s invoices are duplicates, according to AuditNet. This may seem like a relatively small number, but for businesses doling out millions or billions on business activities, the figure is far from trivial.

Some vendors might double up charges on purpose, but often duplicate invoices are mistakes (after all, your vendors’ finance teams are overworked too). While some invoice automation systems try to catch these double charges, they usually only succeed if the invoices are labeled with the same number or have the exact same total — which isn’t always the case, particularly if there’s someone scheming behind the scenes.

3. Missing discounts: You fought hard for volume discounts, but how often are you checking invoices to make sure they’re applied? AI-based systems can often compare contract and invoice terms automatically to make sure you’re not missing out on an early payment, loyalty, or quantity discounts. You’ll be notified of any missing discounts so you can remedy the situation before you pay. In the case of early payment discounts, this software notifies you that the invoice should be prioritized to get payment out in ample time.

4. Mismatched service levels: You signed up for the standard package, but you’re being charged for the premium offering. This type of mismatch is all too easy to overlook amid your monthly deluge of invoices.

The correct AI solution can compare agreed-upon service levels in your contract with every invoice you receive to make sure that this type of costly problem doesn’t fly under the radar. When it comes to physical items, it can ensure you receive all the items you’re being billed for before you pay, by double-checking shipping documents against inventory systems.

5. Double payments: Double payments can happen as a result of vendors submitting duplicate invoices, but the problem can also originate from your own team. Accounting systems hold up an invoice for all sorts of reasons, e.g., it requires further approval or it failed a match. In many cases, an employee might intervene to get the invoice paid manually (to meet a deadline or because they’re being pestered by a supplier or don’t want to damage a relationship). Meanwhile, the invoice is still in your system and when the hold is later cleared up, it’s processed and paid… again.

This is another one of those sources of spend leakage that most companies never become aware of. AI-powered systems constantly cross-check invoices and payments and flag any duplicate payments before you send them out, so the money never leaves the front door.

6. Exorbitant pricing: It can be difficult and time-consuming to keep track of the market rate for all the various services and products your business requires. AI can regularly compare your current costs to thousands of other sources to determine whether your invoices reflect the market rate for the goods or services provided. It can also flag individual invoices where your price exceeds the market rate.

Knowledge is power, and this information helps your business negotiate more effectively with existing suppliers or look to new ones if there’s an opportunity for cost savings without sacrificing quality.

7. Unsatisfactory work activity: When it comes to hiring contractors, there are situations when it’s particularly difficult to understand and assess whether they’re fulfilling their agreed-upon duties, like professional and IT services. AI-based tools can ingest nearly unlimited data to build a profile of what comprises satisfactory work activity — e.g., regular activity in Slack or over email — and highlight changes in the typical patterns. This helps you verify that you’re paying contractors fairly for the work product they’re providing.

8. Overpaying for software: Are you licensed for seven software seats, but only using three? It’s not uncommon for organizations to overpay for software licenses without even realizing it. AI-based software keeps tabs on your organization’s software usage and compares it to the charges on your monthly invoices to help alert you to savings opportunities.

How AI can help

Implementing a best-in-class AI solution can support a consistent process and add an additional layer of scrutiny. These solutions make it possible to audit 100% of invoice spend prior to payment, automatically and near-instantaneously checking every invoice in your system for risk factors before they’re paid, and flagging the highest risk items for your team to review. This will help your team get ahead of problems and potential leakage, rather than try to recover it afterwards.

Below are the critical requirements for considering an AI solution for AP spend management:

Audit 100%, prepayment. Automatically audit 100% of invoices before reimbursement with AI.

Understand documents. Instantly scan every line of every invoice to understand charges and track the correct spend category.

Enrich with intelligence. Check online sources to identify better prices for similar goods and services.

Assess and refine risk. Flag suspicious addresses or billing changes to avoid fraud. Spot duplicate charges from other invoices, other invoice systems, or expenses.

Streamline process. Integrate into your existing AP automation system to audit every invoice in real-time to spot errors, waste, and fraud.

Conclusion

The best AI software can help your team regain control over your spending by checking every single transaction to identify high-risk invoices in your pipeline — saving time, streamlining processes, and ultimately reducing spend leakage.

If your AP team’s efforts to find problematic spend feels neverending, you’re not alone — but it doesn’t have to be that way. AI has changed the paradigm for modern finance teams, giving them greater visibility into their AP process and the time they need to address the highest risk issues. Not only can AI transform the way finance teams operate, but it also saves the business money by spotting problems consistently and before invoices are paid. By implementing a leading AI solution, your team can audit 100% of spend, make sure that every invoice complies with its contract terms, and ensure you’re receiving every savings opportunity you’re entitled to — all while paying your bills on time.

_______________________________________________________________

Anant Kale founded AppZen in 2012 to bring AI into back offices around the world. As CEO he is responsible for the product vision and execution of the company’s broad mission. Previously he was the VP of Applications at Fujitsu America from 2009-2012, responsible for product management, and delivery of Fujitsu’s applications and infrastructure for enterprise. He has 15+ years of experience in software development. He has an MBA and a BS in Finance and Engineering from Mumbai University.