The Art of Balancing the Scale: Sufficient Decentralization and Its Implications on Mass Adoption
Should developers consider sacrificing some level of decentralization for purposes of efficiency?
By: Nick Corso
Decentralization is a fundamental principle of blockchain technologies and Web3 at large. It also plays a crucial role in a protocol’s conformance with securities laws. Courts employ the four-pronged Howey test to determine which agreements constitute an investment contract. The United States Supreme Court held in SEC v. Howey Co., 328 U.S. 293 (1946) an investment contract:
(1) involves an investment of money
(2) in a common enterprise
(3) with a reasonable expectation of profit
(4) solely based upon the efforts of others,
Lower courts and regulators have since interpreted the fourth prong such that the reasonable expectation of profits is derived primarily–not merely solely–from the entrepreneurial or managerial efforts of others. For the fourth prong to remain unsatisfied, “sufficient decentralization” must be achieved. The genesis of this idea originates from William Hinman, a former director of the SEC’s Division of Corporation Finance. Hinman stated:
“If the network on which the token or coin is to function is sufficiently decentralized where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts – the assets may not represent an investment contract.”
The Framework for the Investment Contract Analysis of Digital Assets by the SEC’s Strategic Hub for Innovation and Financial Technology (FinHub) formalized this idea by concluding that if a person has a reasonable expectation of profit from an uncoordinated and wide range of people–the protocol is sufficiently decentralized and thus, not an investment contract subject to SEC registration and jurisdiction.
Sufficient Decentralization and Mass Adoption
Achieving sufficient decentralization requires protocols to decentralize their off-chain activities and ensure the initial development team’s efforts do not cause crypto-asset holders to reasonably expect profits as a consequence of those efforts. To promote decentralization, founders and developers can maintain open source and allow for easy public integration with original protocols. This enables community members outside the initial developers to modify and build on top of the primary protocol. Also, implementing a distributed governance system would further decentralize the protocol by providing asset holders with voting rights and the ability to suggest or reject different proposals, ranging from project implementations to marketing strategies. Furthermore, to achieve sufficient decentralization a protocol could split responsibilities, such as development and governance, into different subDAOs and ensure these subDAOs are as independent from each other as possible.
While reaching sufficient decentralization is necessary to avoid the obligation to register as a security, balancing decentralization and efficiency is most likely needed to reach mass adoption, at least sooner rather than later. But the more decentralized a protocol becomes the higher likelihood of inefficiencies from a managerial and development standpoint. In a more centralized protocol, reaching consensus can be more efficient because only a handful of participants must agree. Decentralized systems, however, carry a higher likelihood for disagreements, slowing down the decision making process. This can increase convolution depending on the amount of different subDAOs a protocol has as well.
While the average blockchain protocol user is likely technologically savvy, one of the greatest barriers of entry to the space remains the usability and educational threshold of projects and tools. For mass adoption to occur, the usability of software wallets, staking mechanisms, and other decentralized applications must improve. Therefore, it is advantageous to balance decentralization and efficiency to more quickly reach these technological requirements, thus pushing web3 closer to mass adoption. Blockchain idealists may fear sacrificing any amount of decentralization for efficiency, but it may be necessary for web3 to preserve its ability to provide decentralized finance as the space grows.
Furthermore, if slower decentralized protocols continue struggling to develop the technology required to scale, the potential for centralized, legacy companies to step in and provide these solutions increases, resulting in the erosion of blockchain idealism and the disintegration of Web3 community goals of censorship resistance. Ultimately, decentralization is essential to the values of Web3 and the utility it can provide, but it is important to strike a balance of decentralization and efficiency for the blockchain to reach mass adoption.
You can learn more about Sufficient Decentralization by reading crypto attorney Marc Boiron’s Playbook Guide for Attorney’s grappling with the problem, or David Kerr and Bruno Lulinski’s DAO Research Collective-funded piece The Center Will Not Hold: How Decentralization is Reshaping Technology and Governance.
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