The Importance of Decentralization and How to Achieve It
I’m here to briefly share why decentralization is important and why startups should strive for it. So now the question is how to achieve decentralization.
Here are three main frameworks for decentralization… including a key example that illustrates why it’s also important legally.
#1 Technological Decentralization
Blockchain and smart contract protocols can create a trustless and autonomous ecosystem where people can conduct computations and transactions in a non-intermediary manner. The baseline barrier to achieving technological decentralization depends on the type of protocol you are developing.
For blockchains like Ethereum, technological decentralization is very challenging because it relies on protection against various attacks, such as from validators and node operators. Ultimately, the system and everything must be able to continue to operate autonomously, fund itself, and defend against attacks.
In contrast, if you look at a simple smart contract protocol – that is, if you want to deploy a smart contract and make it immutable – then you are likely to say it is immediately decentralized, because no one can intervene and make it immutable. Change it to a smart contract.
Therefore, technological decentralization is a moving barrier, depending on the protocol you are building.
#2 Economic Decentralization
When you introduce digital assets into the web3 ecosystem, you have a more complex product.
Again using Ethereum as an example, the system can use its own digital assets to reward people who provide services to the system (and conduct transactions), thus creating a decentralized economy around Ethereum. With the creation of this economy comes a new challenge – maintaining the decentralization of the economic system. If one person gains too much value, or one person can control the network by manipulating the token price, it will jeopardize the security and utility of the entire system.
#3 Legal Decentralization
Decentralization can eliminate some of the risks associated with asset transactions. In the financial sector, our entire legal system is largely designed around trying to reduce the money risks that one person has to trust another. We have many laws about intermediaries and how they operate – all of which are designed to protect consumers from the potential conflicts of interest of these intermediaries. In a peer-to-peer system, like a blockchain, you don’t need intermediaries. Therefore, there is no need for a mediator-based legal system.
For example, rules aimed at protecting investors from the influence of intermediaries at brokerage firms are largely unnecessary, as decentralized exchanges can facilitate non-intermediary peer-to-peer trading of digital assets. If conflicts of interest are not possible, rules regarding conflicts of interest are meaningless.
Similar concepts also apply to digital assets and securities laws. Securities laws are designed to address risks by requiring disclosure and creating a fair competitive environment where all investors are on an equal footing, otherwise it can lead to market manipulation and advantages of one person over another, ultimately leading to inefficient capital markets.
Our legal system typically views securities in a way that the most likely occurrence of information asymmetry is when management efforts drive the value of a particular asset.
Think about the difference between Apple stock and oil:
One of the reasons Apple stock is considered a security is that Tim Cook can have a lot of information that could affect the value of Apple stock. He knows how many iPhones they sold, how many they produced, and other various information that the general public cannot access. Therefore, to publicly trade Apple stock in the market, they are obligated to disclose all material information that could affect the asset price. For securities, issuer-based disclosure is necessary to maintain a fair competitive environment for investors.
Now compare that to oil. Oil is not a security. It is a commodity, and as a commodity, all information about oil and its price is potentially public. There may be organizations like OPEC that change the amount of oil they are going to produce, which can affect the price – but there are other organizations or countries that can take action to influence the price of oil. So you are not talking about the fundamental information asymmetry that exists in stocks. For commodities, asset-based disclosure helps establish a fair competitive environment for investors, and issuer-based disclosure is unnecessary.
So what do we do with digital assets in web3?
If a web3 system can eliminate significant information asymmetry and reliance on management efforts, then we can say that the system is sufficiently decentralized to no longer require application of securities laws.
(Of course, when it comes to legal decentralization, founders are often confused, and the rules are currently not as clear as they should be, as the SEC has not formulated them in a very explicit manner.)
For more information about builders’ understanding of decentralization – principles, models, ways – please visit here. Because in a web3 system, all three types of decentralization – technological, economic, and legal – must be considered comprehensively. A change in one may affect the others, and it’s a delicate balance.
