what is agency problem

What Is the Principal-Agent Problem?

The principal-agent problem refers to a situation where a principal delegates decision-making or execution to an agent, but due to differing objectives and unequal access to information, the outcomes may not align with the principal’s interests. In this context, the principal is the party providing capital or authority, while the agent is the party performing tasks on their behalf.

In investing, this often manifests when assets are entrusted to a fund manager. In Web3, it appears when voting power is delegated to a representative, staking rights are assigned to a validator, or trading strategies are followed by copy trading a trader. Whenever you pay for services that you cannot continuously monitor, the principal-agent problem can arise.

Why Does the Principal-Agent Problem Occur?

The root causes of the principal-agent problem are information asymmetry and misaligned incentives. Information asymmetry means you cannot fully observe or assess the agent’s actions and true risks. Misaligned incentives occur when the agent’s rewards or penalties are not directly tied to your results.

Further contributing mechanisms include moral hazard and adverse selection. Moral hazard arises when agents take greater risks knowing you will bear the losses. Adverse selection happens when you are attracted to agents who appear impressive on paper but may not deliver quality outcomes. High supervision costs and incomplete contracts that cannot cover every possible scenario also exacerbate the principal-agent problem.

How Is the Principal-Agent Problem Different in Web3?

While the principal-agent problem persists in Web3, the tools and environment differ. On-chain transactions and governance are more transparent, and smart contracts can encode rules directly into code, reducing ambiguity from verbal agreements.

However, Web3’s open and global nature introduces a more diverse participant base. Anonymity and rapid innovation improve decision speed but also present new oversight challenges. At the user interface and community layers, information asymmetry can still exist—for example, newcomers may find it difficult to understand smart contracts or proposal details, leading to underestimation of risk.

How Does the Principal-Agent Problem Manifest on Exchanges?

On exchanges, principal-agent issues commonly arise in asset custody, wealth management products, copy trading, and custodial staking. After you delegate funds or trading authority, whether actions align with your objectives depends on product rules and agent incentives.

For example, on Gate: wealth management and earning products typically specify yield structures, fund usage, and redemption terms, but you should also review fee schedules and liquidity arrangements. In copy trading, you act as the principal while the trader you follow is the agent—monitor their historical drawdowns, risk limits, and profit-sharing terms. For custodial staking, evaluate validators based on commission rates, past slashing incidents, and uptime records.

How Does the Principal-Agent Problem Appear in DAO Governance?

In DAOs, the principal-agent problem often arises when token holders delegate voting rights to representatives or when core teams manage treasury expenditures. With many participants and complex proposals, voter apathy and concentrated decision-making among a minority can occur.

As of 2024, public treasury data platforms show that most major DAOs manage treasuries ranging from hundreds of millions to several billion USD (source: DeepDAO, 2024), yet proposal participation rates are often low—giving more discretion to representatives and execution teams. To mitigate risk, DAOs implement multi-signature treasuries (requiring multiple approvals for disbursements), transparent budgeting, and regular audits—decentralizing power and enhancing accountability.

How Can Smart Contracts Mitigate the Principal-Agent Problem?

Smart contracts can encode critical rules directly into code: when payments occur, under what conditions settlements are made, and how violations trigger automatic penalties. This reduces human deviation and improves predictability.

For example, staking penalties embed validator misbehavior costs into protocols: if a validator double-signs or remains offline too long, the contract automatically slashes their stake. Multi-signature treasuries require a minimum number of signatures before funds are released. Linear or streaming payments can release budgets over time—halting payments if milestones are missed. These mechanisms better align agent incentives with principal goals.

What Are Common Risks and Examples of the Principal-Agent Problem?

Common risks include: liquidity mismatches in wealth products making rapid withdrawals difficult; copy trading resulting in drawdowns that exceed your risk tolerance during high volatility; validators being penalized by protocols and impacting your staking returns; DAO budgets being inefficiently spent without milestone controls.

In public blockchain staking between 2023–2024, industry reports indicate that a small number of validators were penalized for protocol violations—reminding delegators to select reputable nodes and diversify risk. Governance disputes also highlight the importance of on-chain transparency and post-event accountability. When dealing with funds, caution is essential—any promised return may involve principal risk.

How Can Individual Investors Reduce Principal-Agent Problems?

Step 1: Clarify your objectives and constraints. Document your maximum acceptable drawdown, liquidity needs, and holding period to prevent agents from using incompatible strategies.

Step 2: Align incentives. Favor arrangements where agent compensation is linked to your long-term results—such as performance fees above high-water marks, milestone-based budget releases, or multi-signature approvals.

Step 3: Use transparent tools. Review on-chain data, audit reports, and product whitepapers; on Gate’s product pages, read fee disclosures, exit rules, and risk notices—test with small amounts if needed.

Step 4: Set hard limits. In copy trading, implement stop-losses and per-trade loss caps; for wealth products, diversify across maturities and product types to avoid single-point failures.

Step 5: Choose mechanisms with penalties and accountability. When staking, select validators with low historical penalties and high uptime; in DAOs, support multi-signature treasuries, transparent budgets, and performance reviews.

Step 6: Maintain ongoing oversight with revocable delegation. Regularly check net asset value and proposal execution progress—adjust or revoke authorization as necessary.

Key Takeaways on the Principal-Agent Problem

The principal-agent problem arises from information asymmetry and misaligned incentives—it is common in exchanges, DAOs, staking, and other Web3 contexts. Tools like smart contracts, penalty mechanisms, and multi-signature treasuries can predefine rules; aligning incentives, transparent disclosure, and ongoing supervision help minimize divergence. For individuals: clearly define your objectives, diversify and limit exposure, scrutinize fees and exit terms, and prioritize arrangements with accountability and revocability to practically address principal-agent risks.

FAQ

What are the consequences of the principal-agent problem?

The principal-agent problem leads agents to prioritize their own interests over those of principals—resulting in decisions that may harm principals. Typical outcomes include misappropriation of funds, concealment of negative information, excessive risk-taking, or negligent behavior. On exchanges this may cause unclear fund flows; in DAO governance it can result in abuse of voting power.

Does holding crypto personally involve principal-agent problems?

Self-custody accounts generally do not face principal-agent problems because you control your own private keys and assets directly. However, if you store crypto on an exchange, lending platform, or through a delegated wallet service—a principal-agent relationship is created. In such cases you should assess platform security certifications, insurance mechanisms, and disclosure standards to ensure your assets are not misused by agents.

Why is information asymmetry at the root of principal-agent problems?

Principals usually cannot monitor all agent actions or motivations in real time. Agents may hide or distort information to cover up misconduct. This informational gap makes it hard for principals to accurately evaluate whether agents act as agreed—forcing principals to pay high monitoring costs or bear additional risks.

Can smart contracts fully solve the principal-agent problem?

Smart contracts can significantly reduce risk through automation and transparency but cannot eliminate it entirely. Smart contracts themselves may have vulnerabilities; oracle data can be manipulated; agents may legally circumvent contract provisions in harmful ways. Thus, smart contracts are a tool that should be combined with multi-signature audits and well-designed incentive mechanisms for comprehensive mitigation.

How can you identify principal-agent risks when choosing an exchange or platform?

Key indicators include: third-party audit acceptance; proof-of-reserves (PoR) disclosure; existence of user asset protection (such as insurance funds); transparency of executive background and corporate governance. Avoid concentrating all assets on a single platform—diversify delegation to reduce single-point risk. Leading platforms like Gate usually provide more standardized disclosures and are preferable choices.