“We demand rigidly defined areas of doubt and uncertainty!”
Written by 0xOuija
Edited by Danica Swanson; tratium
Introduction
The development of web2 led to the ascent of centralized gatekeepers who now control the majority of access to information and services on the internet. Although centralization has the advantage in terms of efficiency and clarity of decision-making (depending on the governance model), it often comes at the cost of personal freedom, sovereignty of choice, and privacy.
The emergence of blockchains, smart contracts, and virtual assets presents an opportunity to create decentralized infrastructures that can generate and be supported by robust decentralized economies. This new paradigm is known as web3. Web3 offers the potential to deliver self-empowering benefits of decentralization, including more equitable ownership, more censorship resistance, and greater diversity for any who are able to participate. However, the long-term success of web3 depends on our ability to effectively apply the principles of decentralization to complex systems.
This article aims to provide an overview of an emerging web3 decentralized framework, review components of web3 systems (and how they might be used to achieve decentralization), and analyze select models of decentralization and how they might apply in practice. The intention is to provide developers, observers, and potential entrants to web3 with an expansive overview of decentralization, including its challenges and potential.
Decentralization Framework
Decentralization is a key aspect of web3 systems, as it enables decision-making to be distributed away from centralized mechanisms. This typically involves making effective decisions in the least centralized manner. Subsidiarity is a principle that supports a balance between collaboration and integrative decision-making, combined with the efficiency and uniformity of centralized decision-making.
Blockchains and smart contract protocols enable technical decentralization, which in turn enables permissionless and verifiable ecosystems of web3 products and services to be built without central intermediaries.
Economic decentralization enables such systems to develop decentralized economies that encompass trade, services, and wealth dynamics.
Legal decentralization involves an array of considerations such as liability, taxation, intellectual property (IP), ownership, privacy, and reporting. Therefore, it is critical to consider the ever-changing relationship between decentralization and securities laws to comprehend how different decentralized systems might use virtual assets. Due to its relation to other international policy and law, and its position of power in the global attention economy, this article will focus on US law and Securities and Exchange Commission (SEC) policy.
All three elements of decentralization — technical, economic, and legal — are interconnected. Each has limitations that may influence the others. Consequently, they represent a singular design challenge, with technical decentralization providing a foundation for both economic and legal decentralization. Given the nuanced relationship between economic and legal decentralization, it is essential to consider how they relate to one another.
Decentralized Economies
Web3 systems enable the formation of decentralized economies that operate autonomously, or with minimal centralized involvement. These economies include mechanisms for self-regulated value accrual and distribution among stakeholders.
Stakeholders in web3 systems are entrusted with meaningful power, control, and ownership, vested in them through distribution methods such as airdrops. Ideally, balancing incentives among stakeholders of web3 systems drives further contributions of value to the systems for the benefit of participants. However, incentives and participation involve many challenges.
For further insight, review the following article.
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In contrast, the centralized economies of web2 systems rely on concentration of power and hierarchical decision-making to drive value. These systems abide by the conventions and abilities of those that control them, and they typically focus on maximizing returns for controlling parties to the detriment of non-centralized stakeholders.
Decentralized economies do not rely on centralized control. Instead, they encourage stakeholders to contribute meaningful value by providing agency over how their contributions are treated and rewarded. However, less centralized control often results in less efficient organization.
For more on decentralized structure, review this article.
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Ethereum is a decentralized, programmable blockchain with thousands of smart contract protocols and applications built and deployed upon it — with no permissions or rates applied by any central authority. At the beginning of 2022, decentralized finance (DeFi) protocols operating on Ethereum had accrued over $150 billion of deposits. Furthermore, NFT sales (i.e., digital property) reached over $17 billion in 2021 (Axios, 2022).
Decentralized economies offer a compelling alternative to the centrally controlled and captive economies of web2. In web2, platforms apply substantial take rates to developers, creators, businesses, and gig economy workers (among others), making their ecosystems profitable. Often, these captive systems do not enable participants to easily move their contributions, purchases, or data to other systems. Yet they must place significant and undue trust in these platforms if they are to continue to operate without raising their fees or arbitrarily de-platforming stakeholders. Taken out of context, this often resembles a hostage situation or Stockholm syndrome. It is increasingly common to see stakeholders de-platformed for falling afoul of these systems.
Decentralized economies can also help address the erosion of trust created by web2 models maximizing profits at the expense of developers, contributors, and consumers. It is common knowledge that web2 platforms apply enormous take rates from 30% to 100% (Dixon, 2022). Web3 systems can reduce the need for trust, since no central authority can alter the rules by which these systems and protocols operate.
The main value proposition of decentralized economies is the potential for greater autonomy, ownership, and control for stakeholders. These conditions lend themselves to building a more equitable and transparent form of capitalism than we see with the current economies functioning on web2 systems.
Legal Decentralization (US Securities Laws)
US securities laws were designed to protect investors and ensure the efficiency of capital markets. These laws apply to transactions involving investment contracts. Currently, the SEC is applying them to virtual assets. In order to determine whether or not an instrument is an investment contract, the Howey test is applied. The Howey test specifies that securities laws apply when there is an investment of money in a common enterprise with a reasonable expectation of profit that is primarily based on the managerial efforts of others (Wikipedia, 2023). The SEC’s 2019 framework applies securities laws to select transactions in virtual assets, and the SEC continues to push new alterations and agendas on virtual assets.
The SEC’s 2019 framework suggests that decentralized networks with "unaffiliated, dispersed communities of network users" may negate the application of securities laws. Therefore, we may infer that a system might be legally decentralized if it is sufficiently decentralized such that the application of securities laws is unnecessary.
To comply with securities laws, decentralized systems must ensure that their operational information is transparent and publicly available, enabled by transparent blockchain ledgers, and requires no essential managerial efforts. This is critical for networks and protocols navigating the ever-changing legal landscape.
While legal decentralization is achievable for web3 systems, it is also challenging. For example, it is difficult to establish an issuer or registrant for purposes of SEC filings and registration, making the application of securities laws impractical. Furthermore, demonstrating that no essential managerial efforts are necessary is complicated, since there are no clear criteria. However, one progress indicator can be marked when web3 businesses begin to resemble diffuse networks more than traditional businesses.
Economic and Legal Decentralization
As mentioned, the concepts of economic and legal decentralization are closely related. Economic decentralization prioritizes decentralization in three aspects: ownership, value accumulation, and value distribution. On the other hand, legal decentralization requires systems to reduce the risk of significant informational asymmetries and eliminate reliance on essential managerial efforts.
In complex web3 systems, economic decentralization is a prerequisite for legal decentralization. When a web3 system eliminates reliance on a central intermediary and achieves legal decentralization, it may more safely use native virtual assets to effectively manage and stimulate its economy, thus contributing to greater economic decentralization.
For instance, imagine a web3 marketplace that uses a native governance token to incentivize trading activity and feature development. The marketplace's decentralized economy must balance the distribution of the value it accrues to its stakeholders. Any significant and/or sustained imbalance may jeopardize the system's economy.
To function properly, the marketplace needs to design a system that does not rely on a central intermediary, yet can flourish through the efforts of a diverse community of participants. This obviates reliance on essential managerial efforts which could legally jeopardize the system. Furthermore, designing the marketplace to reduce the risk of informational asymmetries would also be beneficial to its economy.
An example of one such web3 protocol is Uniswap, which has a native governance token called UNI. Liquidity providers (LPs) are rewarded with a share of the trading fees collected on the platform. Fees are paid to LPs in the form of UNI tokens, thus incentivizing them to add liquidity to the platform and contribute to its continued growth. Traders benefit from access to a variety of tokens and the ability to trade without interacting with a centralized exchange. Additionally, traders have access to exclusive benefits made possible through the distribution of UNI tokens, such as reduced trading fees.
Together, economic and legal decentralization enable the existence of decentralized economies facilitated by virtual assets. This is a breakthrough in web3, since it positions open source and decentralized systems to compete with closed source centralized web2 systems. Fully decentralized systems must prioritize both economic and legal decentralization to ensure sustainable and equitable economies.
The Building Blocks of Web3 Systems
Numerous components of web3 systems may be used to facilitate decentralization. Of primary importance are blockchain networks, smart contract protocols, virtual assets, and decentralized governance.
Blockchain Networks and Smart Contract Protocols
Blockchain networks and smart contract protocols are fundamental to decentralized systems. These technologies enable technical decentralization by providing a trustless, permissionless, and verifiable ecosystem for value transfer and web3 products.
Blockchain networks are decentralized ledgers that record transactions and other data securely and transparently. They enable multiple parties to verify and update the ledger without central intermediaries. This minimizes the need for trust in centralized authorities and allows for more transparent, distributed, and secure systems.
Smart contract protocols are self-executing contracts with the terms of the agreement expressed in code. They automate the execution of transactions and agreements without the need for intermediaries, enabling decentralized applications (dApps) to operate autonomously without human intervention.
Together, blockchain networks and smart contract protocols support decentralization in several ways.
- First, they enable transparency by providing publicly accessible ledgers, mitigating the risks of potential information asymmetry. Using services like Glassnode and Token Terminal, anyone can view onchain data such as network activity, most-used DeFi protocols, virtual assets deposited, and fees earned. In theory, this transparency ensures that no individual or group has greater access to information than what is already publicly available. Although we know information asymmetry still exists, transparency reduces it.
- Second, provided that the networks and protocols are open source, decentralization is achievable. When the fundamental building blocks are not owned or controlled by any single entity, no individual or group can shut them down. Open source means that anyone is free to use and test functionality that promotes the security of such systems.
- Third, data portability and self-custody are key features of web3 systems. Blockchain ledgers and wallets enable users to retain control of their data, purchases, and assets, and move them between different ecosystems or geographical locations at their discretion. This supports decentralization by making empowerment of users an important component of value flows in web3 systems.
- Finally, smart contract protocols that prioritize composability enable the development of new products and services which use existing products and services. This reduces the amount of labor needed to create new products and services, lowering the barrier to entry and increasing overall economic decentralization and activity.
Virtual Assets
Virtual assets are a key feature of decentralized systems; they are used to facilitate transactions and incentivize participation. The Financial Action Task Force (FATF) states:
“Virtual assets (crypto assets) refer to any digital representation of value that can be digitally traded, transferred or used for payment. It does not include digital representation of fiat currencies.”
Virtual assets are created and managed using cryptography, enabling secure and transparent transactions to take place without intermediaries. This facilitates the creation of decentralized, trustless systems. Ethereum is one example; its virtual asset ETH is a cryptocurrency that relies on a public ledger to record all transactions.
Types of Virtual Assets
Virtual assets can be broadly categorized into three main types: cryptocurrencies, utility tokens, and security tokens. Each virtual asset category offers unique features and potential use cases. Although separately categorized here, they are often integrated.
Cryptocurrencies are virtual assets that primarily function as a medium of exchange, similar to traditional fiat currencies like the US dollar. In theory, they can operate independently of government or financial institutions.
Utility tokens are virtual assets designed to provide access to a particular product or service on a blockchain-based platform. Filecoin, for example, is a utility token used to pay for data storage on the Filecoin network.
Security tokens are virtual assets that represent ownership of a real-world asset, such as a share in a company or a piece of property. They are subject to securities regulations, and should be registered with the relevant authorities. Security tokens offer ways to represent and transfer ownership of assets more efficiently and transparently than traditional financial instruments. Proper categorization of security tokens is a contentious current issue.
Decentralized Governance
Decentralized governance, another core web3 concept, refers to the distribution of decision-making power among a network of participants without reliance on central authorities. This model differs from traditional governance structures that place decision-making power in the hands of a few individuals or central governing bodies. Decentralized governance is a complex approach with many pitfalls, especially when combined with economic decentralization.
For a deeper dive into decentralized governance, review the following article.
Decentralized governance is vital in web3 for many reasons. First, it enhances the security of the system by distributing control, making it difficult for any one party to perform a majority attack and seize control of the network. Second, it offers meaningful representation to stakeholders through decision-making processes, which helps to create alignment between long-term incentives and stakeholders. Effective decentralized governance serves the overall health and sustainability of decentralized economies; it supports legal decentralization by reducing stakeholder reliance on the managerial efforts of any individual or group, which can further reduce information asymmetries.
Several models of decentralized governance have been developed and implemented across web3. One common entity is the decentralized autonomous organization (DAO), which is a collectively owned, blockchain-governed organization working toward a shared mission (Ethereum.org, 2023).
DAOs often use voting systems, which enable them to maintain specified control rights over smart contracts and treasuries of virtual assets for the underlying protocol. The smart contracts that form and govern the DAO disintermediate transactions between counterparties through the automation of decision-making and administrative processes.
To streamline decision-making, DAOs may choose to empower subDAOs with the relevant authority in certain categories such as legal, finance, and development. Moreover, to increase dependability and overcome challenges of DAO governance participation rates (e.g. voter apathy), some DAOs aim for governance minimization by reducing the number of decisions required or creating hierarchical structures requiring higher voting quorums for more impactful decisions.
Some DAOs choose to incentivize active participation by compensating delegates. Known as incentivized participation, this model is frequently used in progressive decentralization as greater control is handed from the developer company to the community in accordance with safety guidelines of the protocol and network. This model can also serve as an element of legal decentralization.
In summary, each decentralized model has strengths and limitations. The choice of a governance model should be case-specific, depending on context, requirements, and goals.
Models of Decentralization
Web3 ecosystems may apply decentralization principles in various ways. Often the intention is to enhance security, transparency, and community involvement. Models of decentralization include "full" decentralization, involving all parts of a system, and "open" decentralization, in which independent third parties participate in a shared decentralized system.
How might web3 developers achieve true decentralization and choose the appropriate model for their needs, given that more is not necessarily better?
The Full Decentralization Model
Many projects, especially in the DeFi sector, aspire toward full decentralization. In this model, every component of the system must be decentralized. This entails the deployment of an open source smart contract protocol to a decentralized and programmable blockchain network to form the core infrastructure layer of the system in question.
For a primer on decentralization, review the following article.
Some web2 centralized models may transition to web3 models by launching a DAO with governance over a smart contract protocol and treasury. Virtual asset distributions and incentivization mechanisms from the smart contract protocol should be implemented, and user data should be owned and retained by the user. The decentralization of the blockchain network and smart contract protocol is initiated through technical decentralization and the launch of decentralized governance.
The decentralization of the client layer happens in various ways. Developers frequently make their client/app open source and host it on a decentralized file system (such as IPFS or ZeroNet). Independent third parties then host their own client/website providing access to the same underlying protocol. Third parties often build funnels and gateways to the protocol into their aggregators and dashboards so access to the protocol is always available, regardless of whether the developer's client/app is maintained.
However, limiting factors could make the full decentralization model unsuitable for some web3 systems. These factors include complex clients, the need for significant improvements, and ongoing operations. Complex clients may reduce the pool of third parties willing to build and/or host alternative clients. Systems that need significant improvements after asset launches may find it increasingly difficult to make those improvements in a decentralized manner. Lastly, developers intending to undertake significant operations to enhance the value of their system after asset launches may undermine the decentralization of the system.
The Open Decentralization Model
The open decentralization model involves independent developers building and operating multiple clients upon a shared protocol layer. Multiple clients use the virtual assets of the protocol to provide initial and ongoing incentives.
- Initial incentives: Initial development could be incentivized through a combination of explicit and implicit incentives. Examples include awards of virtual assets from DAO-controlled treasuries, current and projected network effects of the protocol, and the fact that developers could retain IP rights for their respective clients.
- Ongoing incentives: Ongoing maintenance and continued development of clients could be similarly incentivized with virtual asset-based rewards. Liquity Protocol, for example, rewards the hosts of independent front-end websites that provide access to the protocol with awards tied to the economic activity driven by the client sites.
To encourage participation from many actors, web3 systems should design their decentralized governance models to be "client agnostic," prioritizing transparency, data portability, open source technology, and composability. Economic and legal decentralization can help minimize the impact on the system caused by failures of individual clients. The open decentralization model entails the use of purpose-built blockchains to decentralize at both the protocol and blockchain network levels.
Open Decentralization Using Third-Party Resources
Another iteration of the open model involves a third party contributing a resource to the web3 system, e.g. an IP license or array of services, under the condition that the clients of the system use it for their products and/or services.
From an economic decentralization perspective, the introduction of proprietary IP may appear to revert some of the system’s economy to a developer/owner-controlled web2 economy. This potential risk can be mitigated through licensing terms, such as irrevocable or perpetual duration and rights to modify or improve the property. A key consideration is whether or not the ongoing maintenance and services of the IP can be provided by independent third parties. The greater the reliance on the owner of the IP, the more likely it is to undermine the system’s overall decentralization.
From a legal decentralization perspective, it is critical to consider whether the essential managerial efforts of the IP provider are necessary for the success of the web3 system and whether there is potential for significant information asymmetries to arise. Again, this risk can be mitigated through structural and contractual terms and mechanisms. For example, the terms might include a stipulation that the owners of the IP must seek approval from the DAO before making any critical changes to that IP.
This concept can be extended beyond IP. Third-party services for regulatory compliance and business development should not undermine the decentralization of the system. Although open decentralization using third-party resources has the potential to enhance a decentralized economy, if navigated poorly there may be increased risk of legal and technical complications.
Decentralization of NFT Projects
In the context of NFT projects, economic decentralization could be achieved in a variety of ways. One example of this is a three-step method:
- First, the DAO may use its initial resources on community generation and engagement by funding digital or physical social gatherings and events, with the goal of increasing implicit incentives.
- Second, the DAO may use implicit and explicit incentives to encourage the creation of additional derivative projects utilizing the community’s IP, with developers receiving rewards for creating such projects and consumers receiving rewards for using them.
- Third, royalties on secondary sales of NFTs could accrue to the DAO. Ideally, this can provide a decentralized revenue stream during periods in which derivative projects may not be producing sufficient returns.
Key questions for legal decentralization involve the Howey test, whether third-party managerial efforts are needed, and the potential for significant information asymmetries.
Answers to these questions depend on the considerations mentioned earlier in this article. However, IP may contribute to the community’s overall decentralization since it is from a decentralized source: the NFT holders.The underlying blockchain and clients can decentralize the layers through which tokenized assets flow. If navigated wisely, NFT projects might increase their economic security and help reduce the risk of potential securities law complications.
While decentralized NFT projects are still in their infancy, there are some successful implementations. The Bored Ape Yacht Club, for example, has its own DAO governance model and a community-driven roadmap. The holders control the IP, and the project has generated significant interest and value.
Another example is CryptoPunks, one of the earliest and most famous NFT projects. Described as "digital collectibles,” CryptoPunks were originally given away for free. They have become highly sought after, and due to scarcity and demand their value has increased significantly. The project is fully decentralized, as the NFT holders have complete ownership and control over the virtual assets.
Decentralization of Tokenized Protocols
Tokenized protocols have several key features that facilitate economic and legal decentralization. Assets can be brought onchain from multiple providers through a shared protocol, and represented as a token. Tokenization allows these assets to be easily bought, sold, and traded by multiple clients. Distribution mechanisms may be used to incentivize asset providers to provide or lend assets to the system and create markets for the tokenized assets.
Collective Decentralization
An emerging concept in web3, collective decentralization, uses DAO structures. Groups of people act together to manage assets, provide services, or create and sell art and literature without the need for a centralized authority. Smart contracts and blockchain technology facilitate collective decision-making and coordination.
For more on decision-making, review the following article.
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Collective decentralization enables trustless collaboration, since participants do not need to rely on centralized intermediaries to verify or enforce agreements. In theory this leads to greater efficiency, transparency, and fairness; the rules and incentives of a system are encoded in smart contracts and enforced without human intervention. However, there are inherent risks, including exploits and governance manipulation.
The collective model holds potential for more democratic and inclusive decision-making when all participants have equitable governance input. When structured and managed competently, collective decentralization can help mitigate power imbalances and ensure that systems operate in the best interests of their stakeholders and protocols.
Examples of potential collective decentralization include:
- MakerDAO, a DeFi protocol governed by a DAO, which allows users to participate in the decision-making process and earn rewards for contributing to the system.
- SudoSwap, an art platform that enables artists to buy and sell digital art without centralized marketplaces or galleries. While this platform is not fully governed by a DAO, there is potential to allow artists and collectors to participate in curation and management.
- Lens Protocol, a web3 social network enabling users to connect, collect, and share content without centralized platforms or algorithms. Lens is not fully governed by a DAO, but could allow users to participate in moderation and governance.
Leveraging the power of DAOs, users, and blockchain technology allows for greater participation, transparency, and efficiency.
Further Design Considerations for Decentralization Models
Progressive decentralization is a strategy used by many crypto product teams to transition centralized applications toward full decentralization. Certain functions are managed by a centralized entity, team, or developer, and gradually handed over to a community over time. In this way, teams can create a feasible working product in a short amount of time while mitigating the regulatory and legal risks associated with operating in a decentralized environment.
Starting with a centralized position enables teams to launch their products quickly and with a focus on user experience, including expedient data and feedback gathering to inform their future decentralization strategy.
Potential risks with progressive decentralization include the impact of US securities laws. The SEC and prominent groups and individuals have recently taken a more aggressive stance toward cryptocurrency regulation. Crypto product teams must navigate a complex legal landscape of securities laws with an eye toward potential future implications and impact on their target market.
One potential mitigation is a regulatory safe harbor for decentralized applications. This would provide teams with a period during which they could build and operate their platforms without danger of legal repercussions.
Another challenge of progressive decentralization is the need for significant coordination and communication among team members and stakeholders. With increased decentralization, it becomes ever more important to ensure that all parties involved remain apprised of the objectives, challenges, and potential risks of the transition.
Utility and Social Tokens
Utility tokens are virtual assets that provide holders with access to specific services or products. These tokens can be used to pay fees, access special features, or participate in governance decisions. One example is the Basic Attention Token (BAT), which is used within the Brave browser to reward users, publishers, content creators, and advertisers.
Social tokens are virtual assets that represent the value of an individual or community's social capital within specific parameters. These tokens can be used to access exclusive content, merchandise, or events. Unless they are “soulbound,” they can be traded or exchanged like any other virtual asset. Social tokens allow diverse groups to monetize their social capital and build more decentralized economies.
Utility and social tokens may help increase the likelihood of mass adoption and sustained usage, contributing to the stability of decentralized systems. However, like all new technology, they raise new regulatory challenges. While some argue that these tokens should not be subject to US securities laws because they provide users with tangible benefits, many of those who hold the majority of power (i.e., regulators) think otherwise. The SEC has previously pursued token sales that it deems to be securities, and has recently renewed its efforts.
To navigate the rapidly changing regulatory landscape, projects employing utility and social tokens can work with legal counsel and compliance experts to ensure that their offerings comply with relevant securities laws. It may be prudent to conduct extensive due diligence, obtain regulatory approval where possible, and implement precise compliance and governance frameworks.
For many web3 systems, network effects are insufficient to support resilient decentralized economies. Rather than relying on implicit incentives only, these entities employ explicit incentives to gain and maintain contributor and developer participation.
A prime example of explicit incentives is liquidity mining programs, which offer token rewards to users who provide liquidity to a protocol. Another explicit incentive option is grant programs, which offer funding to developers working on projects deemed valuable to a system. However, many DAOs find grant programs difficult to manage. It can be challenging to determine which projects will contribute value and which developers are the best positioned to work on specific projects.
Retroactive awards programs may be more conducive to decentralized systems than grant programs. These programs defer the assessment and awarding of contributions until after value has been produced. The idea is to lessen the determination burden and incentivize an open marketplace of ideas, spurring competition and technological innovation. Open marketplaces allow for positive sum games through a combination of retroactive awards, incentives, and network effects that make it more gainful for contributors to develop on top of protocols rather than build competitive alternate products.
Conclusion
Decentralization holds the potential to revolutionize the ways we interact with digital technologies, disrupting sectors such as finance and art. While decentralization may be exciting, it is sensible to maintain healthy caution and skepticism. With web3 still in its infancy, many challenges must be addressed before its full potential can be realized.
One of the critical challenges for web3 is the need for a solid foundation: robust and scalable infrastructure. To achieve a balance between innovation and consumer protection, regulatory frameworks must adjust to the unique challenges posed by decentralized technologies, and web3 organizations must reciprocate.
New web3 projects and novel initiatives emerge every day. There is a growing appetite for decentralized systems and the value they bring. As fresh technologies and innovations emerge, we will see new use cases, products, and applications that have not yet been conceived. The trials that will be encountered and overcome will become the strength and scaffold upon which future successes may build.
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