a16z: Decoding the Key Elements of Decentralization in Web3 Protocols, Driving Decentralization Tools

a16z: Understanding Decentralization in Web3 Protocols and Tools

Decentralization is key to unlocking the potential of Web3 and addressing regulatory uncertainty. However, achieving decentralization is not easy.

Original title: “Factors of decentralization of web3 protocols: Tools for planning greater decentralization”

Written by: Miles Jennings, Stephen Wink, Adam Zuckerman

Translated by: Sissi

Decentralization is a key innovation brought about by blockchain technology and one of the most important features of Web3 protocols. As a result, Web3 participants, policymakers, and regulators must collectively form a more unified and detailed understanding of decentralization in order to more accurately assess and compare the degree of decentralization of various Web3 protocols. Doing so will not only better enable Web3 regulation and policy to adapt to the decentralized nature of Web3, understand and consider how decentralization reduces risk, but also ultimately incentivize Web3 builders to pursue decentralization in order to maximize the public interest promised by Web3.

To this end, we define three types of decentralization and propose relevant elements for each type, applicable to tokenized blockchain protocols (such as Bitcoin, Ethereum, Polygon, Solana, Optimism, Arbitrum, zksync, etc. layer1 and layer2 blockchains) and tokenized smart contract protocols deployed on blockchains (such as Uniswap, Aave, Compound, Curve, etc.). We also provide two tables, one for tokenized blockchain protocols (Figure 1) and one for tokenized smart contract protocols (Figure 2), which will help enumerate the components of decentralization to provide a more specific and standardized definition.

For a decentralization analysis of a blockchain protocol or smart contract protocol, all relevant circumstances related to the protocol must be considered. The elements we propose here are intended to provide a direction for such analysis.

Figure 1

Figure 2

Why is decentralization necessary?

Web3 leads a new era of the internet – an era of “read, write, and own”. The technology that supports Web3 enables “trustless computing”, eliminating the need for centralized entities to browse the internet and databases. This allows us to develop more complex and advanced protocols that can provide the functionality of the modern internet while being truly owned by users. For example, a decentralized social media protocol can support the construction of multiple applications and distribute ownership and control of the protocol to a large number of developers and users through token ownership.

Decentralization is a key feature of web3 protocols that is driving a paradigm shift. Decentralization will drive the creation of a democratized internet and enable three important changes: promoting competition, protecting freedom, and rewarding stakeholders.

First, decentralization makes web3 systems reliable and neutral (1) (they cannot discriminate against any individual stakeholders or stakeholder groups), which is crucial for incentivizing developers to build applications in the ecosystem. They are also composable (2) (like Lego blocks, software components can be mixed and matched). Therefore, web3 systems are more like public infrastructure than proprietary technology platforms. Unlike closed software in web2, web3 protocols provide distributed internet infrastructure that anyone can build and innovate on. Importantly, this can be done without permission from the original protocol deployer or reliance on centralized interfaces. For example, compare Twitter to a web3 protocol that provides a social media underlying data architecture controlled by the public through token ownership. In such a system, anyone can build their own client or application on top of the protocol and gain access to its user network.

This concept is somewhat abstract, so consider a diagram of the web3 ecosystem (Figure 3), which includes a decentralized blockchain, a decentralized smart contract protocol managed by DAOs of token holders, and several proprietary clients that operate as independent businesses in traditional entity form. Each blockchain and smart contract protocol serves as a decentralized internet infrastructure on top of which enterprises can build, compete, and innovate.

Figure 3

Second, decentralization requires widespread distribution of control and participation in web3 protocols, ensuring that the development and use of the network reflects the opinions of various stakeholders, not just the companies that create these protocols. By properly constructed protocols that promote decentralization, it is possible to limit situations where power is concentrated in the hands of one or a few companies. Therefore, decentralization should limit corporate or individual control over the barriers to entry and ensure that any changes to the protocol are consistent with the broad user ecosystem that holds tokens and ultimately manages the network.

Third, decentralization enables the design of systems that prioritize stakeholder capitalism – systems that aim to more fairly serve the interests of all participants, rather than just catering to specific subsets. Token-incentivized stakeholder capitalism distributes ownership and control to a broader set of stakeholders, rather than placing equity holders above all other stakeholders, including customers and employees. As a result, web3 protocols and networks represent a diverse design space that can more fairly serve the interests of all stakeholders. Such decentralized protocols offer a more stable internet infrastructure, instilling confidence in a broader set of stakeholders to build upon it.

Types of decentralization

We can view decentralization from three distinct but interrelated perspectives: technical, economic, and legal. All three are important, but often compete for interests, resulting in complex design challenges in maximizing overall decentralization and utility.

Technical decentralization (T)

Technical decentralization primarily concerns the security and structural mechanisms of web3 systems. Programmable blockchains and autonomous smart contract protocols support technical decentralization by providing a self-sovereign, permissionless, trustless, and verifiable ecosystem for value transfer. Products and services can be deployed and run without reliance on trusted, centralized intermediaries, opening up vast possibilities.

For blockchain protocols, technical decentralization is a highly challenging problem that requires balancing multiple competing forces. But for smart contract protocols, this type of decentralization can be relatively quick and easy to achieve by making smart contracts immutable (i.e. uncontrollable and un-upgradable by anyone). For more examples, see here and here. (3) (4)

Economic decentralization (E)

Blockchains and smart contract protocols, by utilizing their native tokens, unlock the potential for these open-source and decentralized systems to have their own decentralized economies (i.e. autonomous free-market economies), enabling more people to participate and benefit from these decentralized ecosystems.

By making careful design decisions, builders of web3 systems can facilitate the formation of decentralized economies where value can be exchanged and accumulated from various sources, including informational, economic, and voting rights. If constructed correctly, a decentralized ecosystem can incentivize participants to contribute value to the ecosystem through token rewards and more fairly distribute value to stakeholders based on their contributions. To achieve this, web3 systems need to give power, control, and ownership to ecosystem stakeholders (through airdrops, token distribution, decentralized governance, etc.). As a result, the value of the entire ecosystem will belong to a broader set of participants, not just concentrated in a central entity and its shareholders.

A continuous incentive balance between stakeholders (developers, contributors, and consumers) can drive more value contribution to the system as a whole, benefiting everyone. In other words, this is all the benefits of modern network effects (5) without the downsides of centralized control and closed economies.

Legal decentralization (L)

Legal decentralization depends on whether a system’s decentralization eliminates the risks a particular regulation seeks to address.

For example, technically decentralized blockchains and smart-contract protocols can eliminate risks associated with trusted intermediaries. Therefore, such systems, when dealing with regulations aimed at trusted intermediaries, are technically decentralized and legally decentralized as well.

For technical and economic decentralization, other risks can also be eliminated, including risks associated with web3 systems’ tokens and their potential value. Such decentralization would eliminate the need to apply US securities laws to token transactions, which could otherwise severely limit the broad distribution of tokens.

According to SEC guidance, we can define legal decentralization as a web3 system’s ability to eliminate potential risks of significant information asymmetry and not depend on significant managerial efforts of others to drive the enterprise’s success or failure. Once this threshold is reached, the system may be considered “sufficiently decentralized” and thus not subject to US securities laws for its tokens. As a threshold matter, this requires that particular tokens not confer any contractual rights to holders relating to the issuer or its affiliates’ ongoing efforts, assets, income, or resources.

Decentralization elements

In web3 systems that use local tokens, all three types of decentralization – technical, economic, and legal – must be considered in full. These types interact with each other, and changes to one may affect the other two. For example, decentralized economics can drive a system towards legal decentralization by prioritizing decentralized ownership by stakeholders, value accumulation from decentralized sources, and distributing value to decentralized stakeholders. All of these factors reduce the risk of information asymmetry and reduce dependence on individual management efforts.

On the other hand, if the value of a web3 system’s digital assets depends on ongoing management efforts by the original development team, the decentralization of the system at the technical, economic, and legal levels may be threatened. For example, the departure of the management team may put significant downward pressure on the price of digital assets, making the system more vulnerable to the effects of a 51% attack.

Given this interdependence, we break down decentralization into many factors that may influence it. Figures 1 and 2 provide comprehensive lists of the most important elements of tokenized consensus blockchain protocols and tokenized smart contract protocols, respectively. These elements are divided into categories by type (technical, economic, and legal) and category (computation, development, governance, value accumulation, and use and accessibility).

Decentralization is an evaluative process, not based on absolute standards but on a range of circumstances, including all web3 systems. The relative importance of factors will vary depending on the web3 system and the evaluator’s purpose. In addition, trade-offs between different types of decentralization may vary depending on the project and the people involved.

Figures 1 and 2 should be useful tools for providing more specific and standardized definitions of decentralization. Hopefully, this will enable web3 participants to contribute to the construction of more decentralized projects, while allowing decision makers and regulators to design regulatory frameworks that recognize the power of decentralization to reduce and eliminate risks.

Original reference link:

1/ https://messari.io/report/credible-neutrality-as-a-guiding-principle

2/ https://a16zcrypto.com/posts/article/composability-is-to-software-as-compounding-interest-is-to-finance/

3/ https://a16zcrypto.com/posts/article/regulate-web3-apps-not-protocols-Blockingrt-ii-framework-for-regulating-web3-apps/

4/ https://a16zcrypto.com/posts/article/regulate-web3-apps-not-protocols-practical-application/

5/ https://a16zcrypto.com/2018/12/13/network-effects-dynamics-in-practice/

6/‍‍‍ https://www.coindesk.com/learn/what-is-a-51-attack/

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