Decentralized Guide for Web3 Builders: Principles, Models, Methods

Author: Miles Jennings, General Counsel at a16z

Original Title: “Decentralization for Web3 Builders: Principles, Models, How”

Compiled by: Hu Tao, Chain Catcher

The promise of decentralized power has been widely discussed and debated, from why it matters to the larger question of who will control internet software. These questions are critical because, as we have seen, when control is concentrated in the hands of a few, the infringement on individual freedom, choice, and privacy is inherent. When a CEO decides on one strategy over another, "not doing evil" is very different from "being unable to do evil."

However, a decentralized internet has been difficult to achieve. Compared to the recognized efficiency and stability of centralized systems, decentralized systems have struggled to keep pace. Yet now, emerging crypto and Web3 technologies—particularly programmable blockchains, composable smart contracts, and digital assets—enable decentralized systems to achieve unprecedented levels of coordination and operational capability. This evolution has fostered new forms of governance and organization, networks and services owned and operated by communities, robust economic systems, and countless other innovations.

We have already seen the rise of specific categories like decentralized finance (DeFi) and core infrastructure projects, and we will soon see decentralized versions of existing Web2 categories such as social media, video games, music, and marketplaces. The success of these systems will depend on their ability to provide real benefits of decentralization, including fairer ownership among stakeholders, reduced censorship, and greater diversity. However, the more familiar decentralized models used for DeFi may not necessarily apply to these more complex systems (i.e., those with more UI features, richer client experiences, centralized products or services, or licensed IP).

Therefore, I believe it will be useful to share specific models and principles of decentralization collected over the past few years while closely collaborating with founders of crypto projects to guide Web3 builders in addressing the practical implications of decentralization in several specific scenarios.

I. Design Challenges of Decentralization in Web3

Decentralization of power can be viewed as a single design challenge that spans three distinct but interconnected elements: technology, economics, and law. Understanding the differences among these elements is key to designing Web3 systems, as design decisions regarding one element will affect the others.

Technological Decentralization

Technological decentralization primarily involves the security and structural mechanisms of Web3 systems. The core innovation behind programmable blockchains is that they can support technological decentralization by providing a permissionless, trustless, and verifiable ecosystem where value can be transferred and, more importantly, where Web3 products and services can be built.

This means that products and services can be deployed and operated without a trusted centralized intermediary, opening up a vast world of possibilities. For these reasons, technological decentralization forms the foundation for the other two types of decentralization: economic and legal.

Economic Decentralization

Economic decentralization relates to the economics of Web3 systems. The emergence of programmable blockchains (e.g., Ethereum, Solana, and Avalanche) and digital assets (e.g., ETH, SOL, and AVAX) has unlocked the potential for open-source and decentralized systems to ultimately possess their own decentralized economies (i.e., autonomy and market economics).

This is a critical breakthrough. Previous generations of technology (such as Web1, with protocols like HTTP, SMTP, FTP, etc.) stagnated in their open-source and decentralized protocols because they lacked the incentives to continue development and/or reinvest critical resources back into their systems. This left fertile ground for the emergence and success of centralized companies in Web2, as they could leverage their efficiencies and resources to build products and services that surpassed Web1. But this centralization also led to countless abuses of user rights and examples of exorbitant commission rates.

Now, the technologies supporting Web3 make it possible to create more complex open-source and decentralized systems—and allow decentralized economies to form around them—enabling Web3 products and services to compete with and ultimately surpass those of Web2.

Builders of Web3 systems can promote the formation of decentralized economies through careful design decisions that lead their systems to accumulate "value" from a wide range of sources—whether information, economic value, voting rights, or other forms—and fairly distribute that value among system stakeholders based on their contributions. To achieve this, Web3 systems need to grant meaningful power, control, and ownership to system stakeholders (through airdrops, other token distributions, decentralized governance, etc.). This, in turn, encourages stakeholders to contribute meaningful value, as they have a say in how their contributions are treated and rewarded.

The incentive mechanisms among stakeholders—developers, contributors, and consumers—can be continuously balanced to further drive value contributions to the entire system and benefit everyone. In other words: all the benefits of modern network effects, but without falling into the traps of centralized control and proprietary economies.

Legal Decentralization of Power

Legal decentralization relates to the legitimacy of Web3 systems. In this article, I primarily focus on U.S. securities law, which dictates how and whether Web3 systems can use their native digital assets. While "legal decentralization" does not have a codified standard, a first-principles analysis of U.S. securities law, case law, and SEC guidance (including the SEC's final guidance from April 2019) can help us formulate practical standards.

First, U.S. securities law generally aims to create a "fair playing field" for securities transactions by limiting the ability of those with more information to exploit those with less. This is the principle of information asymmetry, and U.S. securities law typically seeks to eliminate certain asymmetries in securities transactions by applying disclosure requirements.

This principle plays a role in the Howey test, which determines whether U.S. securities law should apply to the trading of digital assets through a subjective test that includes (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) primarily based on the efforts of others. The fourth aspect aims to address the issue of information asymmetry, as the risk of information asymmetry may be high when relying on "management efforts," thus making the application of securities law necessary.

Based on the above and SEC guidance, we can speculate that if a Web3 system can (a) eliminate the possibility of significant information asymmetry and (b) eliminate reliance on the essential management efforts of others to drive the success or failure of the enterprise, then the system may be "sufficiently decentralized," and thus the application of U.S. securities law to its digital assets should be unnecessary. For the purposes of this article, I will refer to such systems as legally decentralized. Admittedly, most enterprises may not meet the statutory threshold for decentralization, but as I outline below, the novel components of Web3 systems uniquely position them to meet such thresholds.

Overall, these three distinct aspects of power decentralization—technology, economics, and law—must be viewed holistically as a single design challenge, as design decisions regarding one aspect will impact the others.

Generally speaking, the interactions among technology, economics, and law are primarily additive rather than subtractive—where the development of one creates more possibilities in the others. For example: economic decentralization helps drive systems toward legal decentralization by prioritizing decentralized ownership among stakeholders, value appreciation from decentralized sources, and the distribution of value to decentralized stakeholders. All of this reduces the risks of information asymmetry and the need to rely on individual management efforts.

II. How to Achieve Decentralization Using Components of Web3 Systems

When Web3 systems are well-designed, decentralization becomes a virtuous cycle rather than a vicious cycle. Now that we have the framework for the decentralization design challenge, let’s quickly review how builders can use the following novel components of Web3 systems in practice to drive decentralization:

Blockchain Networks and Smart Contract Protocols

Fundamentally, blockchain networks and smart contract protocols can achieve technological decentralization. But they can also be designed to facilitate economic and legal power decentralization, including:

• By implementing transparency—e.g., anyone can currently see where the most digital assets are stored in Ethereum's DeFi ecosystem and where the most fees are earned;
• As open-source public goods—anyone can use and test functionalities for free to ensure security, promote a decentralized economy, etc.;
• By allowing data portability, mobility, and interoperability—users retain control over their data, purchases, and content in Web3 products and services;
• By prioritizing composability—elements can be programmed to interact with each other, making these programs building blocks that anyone can use.

Overall, these features reduce the risks of information asymmetry, diminish the importance of any proprietary technology in a Web3 system, and increase the significance of the network of contributors and consumers relative to its developers.

In other words: these features shift the value of the system from its technology stack to its network. Because networks are more open and decentralized than proprietary systems, this shift highlights why Web3 systems are better suited for achieving decentralization than Web2 systems.

Digital Assets

The decentralized economy of Web3 systems is driven by two types of incentives:

• Intrinsic incentives, based on the underlying characteristics of the system, such as user base, network effects, technology, etc., triggering the inherent willingness of third parties to participate in such systems.
• Extrinsic incentives, such as digital asset distributions, revenue sharing, etc.

Among these, digital assets are the most critical tools that Web3 builders must leverage to promote the formation and ongoing operation of their decentralized economies, as they can balance the incentive mechanisms among developers, contributors, and consumers.

Thus, if designed properly, the distribution of digital assets has the potential to drive the "flywheel" of network effects, making the entire system more valuable to more users as more people participate in the network. But unlike the network effects of Web2, Web3 digital assets allow users to shape their own experiences and benefit from their contributions.

Successful user acquisition and retention can significantly enhance the intrinsic incentives of Web3 systems for developers and contributors, thereby bringing greater value to the system and ultimately attracting more users, etc. Ethereum's growth over the past two years is a great example: from early 2020 to early 2022, the value of digital assets locked in Ethereum's DeFi protocols grew from just over $600 million to just over $150 billion. But this is not a narrative about numbers and their monetary value—rather, it shows how developer activity generates products and services that attract users, which in turn attracts more developers and additional products and services, further driving user growth.

In addition to potentially creating such a flywheel, the network effects of Web3 systems can also provide builders with a moat to prevent competitors from copying and redeploying their infrastructure, all of which is open-source. Why is this? Because for systems with strong network effects, mere replication is unlikely to incentivize users to switch to a new system.

This again emphasizes that the true value of Web3 systems will lie in their network of stakeholders—not in their technology stack, closed or proprietary systems, or other classic moats.

Decentralized Governance

The vast majority of blockchain networks and smart contract-based protocols feature decentralized governance managed by decentralized autonomous organizations (DAOs). Decentralized governance and DAOs provide many benefits along each of the three decentralization standards already discussed, including:

• Enhancing the security of Web3 systems by distributing technical control of such systems to decentralized groups—thus limiting any one party's ability to control system governance.
• Providing meaningful representation for stakeholders in decision-making and ensuring long-term incentive alignment among stakeholders. This feature, along with enhanced security, helps make decentralized governance more effective—contributing to the overall health and sustainability of the decentralized economy of Web3 systems.
• Supporting legal power decentralization by reducing stakeholders' reliance on any individual or group’s management efforts—thereby lowering the risk of potential information asymmetry.

When designing decentralized governance for any Web3 system, we can draw insights from several different models that have already been developed and implemented in the DeFi space. For example:

• SubDAOs. To streamline decision-making, some DAOs empower subDAOs with tailored permissions for certain categories of actions (e.g., legal, financial, development, etc.).
• Governance Minimization. To enhance the reliability of DeFi protocols and overcome the challenges of DAO participation rates, some advocate for minimizing the number of final decisions that DAOs need to make or creating a hierarchy where more significant decisions require a higher voting quorum.
• Incentivizing Participation. To ensure effective DAO governance, some DAOs incentivize active participation, including rewards for representation. Note that while grant programs may not work well here, retrospective reward programs can be very effective, as they defer the assessment and reward of contributions until after value delivery. If designed well, they can also help stimulate competition and open markets.
• Gradual Power Decentralization. To prevent malicious attacks, many DAOs employ "gradual decentralization," transferring greater control from the developing company to the community as the protocol/network's security improves.

Ultimately, Web3 builders should be cautious not to grant too much power to insiders. Instead, significant control should be given to the community. Where there are power imbalances, Web3 builders should seek delegation mechanisms to help decentralize it.

To achieve this balance, Web3 builders should also consider instilling protections against malicious attacks, including potential manipulation of decentralized governance for profit. While using off-chain governance mechanisms and multi-signature (requiring multiple multi-signature holders, each with their own key to authorize actions) is a common safeguard for this purpose, they have recently faced significant criticism, including their potential to undermine power decentralization.

III. Decentralization Models in Practice

Now let’s look at how the technological-economic-legal framework I shared earlier applies to several different decentralization models in practice. These models range from "fully" decentralized (where every component of the system is decentralized) to "open" decentralization (where independent third parties participate in a shared decentralized system). I also include models of open decentralization for specific applications, such as NFT projects and tokenization protocols.

Fully Decentralized: How to Decentralize DeFi and Other Simple Applications

Fully decentralized is currently the most common decentralization model in the DeFi space. As illustrated below, the transition from centralized models (like Web2) to decentralized models (like Web3) includes:

• Deploying open-source smart contract protocols on decentralized and programmable blockchain networks, forming the core infrastructure layer of Web3 systems—smart contract protocols provide the execution layer for all backend components that can be deployed on-chain (i.e., payments, messaging, etc.);
• Operating the "client" layer in a decentralized manner—clients represent all software running off-chain for the system and serve as gateways to the smart contract protocols (clients can be simple front-end websites or complex applications);
• Adding digital asset distributions—this could be airdrops to contributors and consumers; issuance to insiders (employees, advisors, and shareholders of the developing company); allocations to explicit incentive programs (e.g., liquidity mining in DeFi); and the formation of a treasury controlled by a DAO for future incentives;
• Launching DAO governance for the smart contract protocols and DAO treasury;
• Ensuring users own and retain their data (which is currently a significant controversy in Web2 systems).

This fully decentralized model assumes that the Web3 system is a novel smart contract protocol deployed on existing programmable blockchain networks. Here, "users" refer to both consumers and contributors.

For Web3 systems using this model, the decentralization of the blockchain network and smart contract protocols primarily stems from the technological decentralization of these layers, as well as the initiation of decentralized governance through a DAO to control the smart contract protocols created by the developing company. Deploying the smart contract protocols on a public blockchain and launching their DAO brings transparency and greater security and assurance to the system, meaning no individual or group controls the system.

The decentralization of the client layer then occurs in several different ways. In DeFi, most clients are simply front-end websites that provide gateways to the underlying smart contract protocols (i.e., they allow users to interact with the protocols), and most developing companies open-source their clients/websites and host them on decentralized file systems (e.g., IPFS).

With the open-sourcing of clients/websites, independent third parties often end up hosting their own clients/websites to provide access to the same underlying protocols. Additionally, independent third parties frequently build protocol gateways into their own aggregators and dashboards. This means that the gateway to the protocol is always available, regardless of whether the developing company's client/website is maintained.

The above steps primarily eliminate the possibility of information asymmetry—the driving force behind much of U.S. securities law—because (1) information about the protocol and its operations is transparent on the public blockchain's distributed ledger, and (2) the developing company that launched the protocol is no longer crucial to the success or failure of such protocols.

Moreover, since the blockchain and smart contract layers are operational and not controlled by any group or entity, the system is fully redundant and no longer relies on the developing company. DeFi primitives are a great example, as they require almost no ongoing development to continue providing utility to users. Thus, even without a fully functional decentralized economy, protocols implementing this decentralization model can be viewed as legally decentralized.

Limitations of Fully Decentralized Models

While fully decentralized models have been successfully used in DeFi, their simplicity may render them unsuitable for more complex Web3 systems. Builders should be aware of and plan for these factors that may introduce complexity:

• Complex Clients. Given that DeFi is relatively simple, the decentralization of clients in DeFi is somewhat straightforward—requiring few incentives for third parties to build independent and simple gateways for such protocols (primarily in the form of websites). However, as Web3 products and services become increasingly complex, building client layers that are computationally expensive/resource-intensive on top of the underlying smart contract protocols makes client decentralization more complex. For example, consider the difference in complexity between providing access to Uniswap and Compound via a client/website versus a hypothetical Web3 social media client that requires full functionality akin to Web2 applications like Twitter and Instagram. This complexity may reduce the willingness of third parties to build and/or host alternative clients or integrate access to the protocol layer into their own systems without explicit incentives.
• Need for Significant Improvements. Similarly, systems that require significant improvements after the release of digital assets may find it challenging to make those improvements in a decentralized manner. For instance, in DeFi, many protocols have struggled to successfully use explicit token incentives to drive ongoing meaningful development of their smart contract protocols.
• Ongoing Operations. Developing companies may intend to make significant operational improvements to enhance the value of their Web3 systems after the release of their digital assets. If additional value contributions do not come from independent third parties, this may undermine the system's decentralization. Furthermore, since governance tokens typically do not grant any rights to future products and services that the developing company may produce, the developing company should be careful not to leave any impression of such relationships existing with token holders.
• Retaining Proprietary Rights. If the original developing company (or others) retains proprietary rights to any intellectual property used in the system, this may undermine the system's complete decentralization. For example, if the developers of a complex Web3 social media client want to keep those clients proprietary, then full decentralization may be unattainable.

Each of these limitations can be overcome by Web3 systems that can stimulate significant economic decentralization and create a well-functioning decentralized economy. If a decentralized community composed of developers, contributors, and consumers builds and derives significant value—thereby diminishing the original developers' importance to the entire system—it will shift the system from a fully decentralized model to an open decentralized model.

Open Decentralization: How to Decentralize Complex Web3 Applications

Like the fully decentralized model, the open decentralized model includes decentralized blockchain and smart contract protocol layers, digital assets, and DAOs.

However, unlike the fully decentralized model, the open decentralized model also allows independent developers to build and operate multiple clients (which may be centralized) on top of the shared smart contract protocol layer. For example, consider the potential rich and complex clients for Web3 social media, which function similarly to Web2 applications like Twitter and Instagram, but all utilize a shared smart contract protocol rather than separate proprietary backend systems.

Web3 Open Decentralization Model

This model assumes that the Web3 system is a new type of smart contract protocol deployed on existing programmable blockchain networks. Here, "users" refer to both consumers and contributors.

In this open decentralized model, all clients will utilize the digital assets of the underlying smart contract protocol, and their creation and operation will be incentivized as follows:

• Initial Incentives. Initial development can be incentivized through explicit and implicit incentives, including rewards of digital assets from the DAO-controlled treasury of the smart contract protocol; the network effects of the protocol; and the fact that such developers can retain the intellectual property of their respective clients.
• Ongoing Incentives. Similarly, ongoing maintenance and continuous development can be incentivized based on performance metrics established by the DAO, automatically granting digital asset-based incentives. An example in DeFi is liquidity protocols that reward independent front-end websites hosting access to the protocol, rewarding economic activities driven by such front-end websites.

In more complex Web3 systems, we expect the prevalence of such rewards to increase significantly. For instance, in a decentralized social media ecosystem, user engagement could be measured and rewarded with tokens. Ultimately, in addition to the protocol's incentives, the operators of the clients will also be incentivized by any financial returns they can generate through their proprietary clients.

Builders seeking to decentralize their Web3 systems through the open decentralized model will need to design their incentive mechanisms and decentralized governance models to be "client-agnostic" to encourage participation from many actors. Additionally, they will need to ensure that no single client emerges with a significant power imbalance that allows it to dominate the entire ecosystem. If such an imbalance is easily achievable, then the builders of these clients may develop a negative view of the Web3 system and be less willing to invest time and resources in it. In some respects, such systems may face similar centralization and control issues as Web2 systems.

Builders using the open decentralized model should also prioritize transparency, open-source technology, data portability, and composability to further reduce the risk of power concentration in the hands of developers. These features eliminate information asymmetry, lower the barriers to entry for competing developers, and allow users to switch between clients—all of which promote a more open and decentralized ecosystem where users are not burdened or restricted by any single client. (This is a significant barrier in current Web2 systems, where user data is siloed across each proprietary Web2 system.)

Finally, to ensure that the decentralized economy of the system is truly resilient, the success or failure of the entire Web3 system should not depend on any individual or group, including any individual client. If this condition, along with the aforementioned economic decentralization conditions, is met for the Web3 system, then the risk of significant information asymmetry arising within such systems will be greatly reduced, thereby allowing for its legitimate decentralization.

At first glance, it may seem counterintuitive for developing companies to prioritize the above design decisions, as they effectively incentivize their own competition. However, doing so will help form a functional decentralized economy built on shared infrastructure, which in turn will lead to a much broader and richer ecosystem than any single company could build alone.

In other words, these actions expand the entire pie rather than prioritizing a portion of it.

Web3 Versions of Web2

To understand how these principles play out in practice, let’s apply the open decentralized model to create simplified Web3 versions of familiar Web2 applications. The promise of Web3 is not just to decentralize known functionalities and applications, as it enables entirely new things; but for illustrative purposes, I will highlight a few simple examples.

Web3 gaming might require a system containing multiple games, implementing shared smart contract protocols and governance tokens; having separate in-game currencies and NFTs; and allowing both participants and contributors to earn digital assets. These assets could also be transferable across the ecosystem. Then, the most played games could earn the largest share of governance tokens allocated by the system DAO, leading game creators to fund further development of their games.

Web3 social media might require a system with multiple iterations of social media services and messaging services, each built as a separate client on the same open-source smart contract protocol. Since the protocol would share a native governance token: consumers would earn tokens based on usage, contributors would earn tokens based on the content they create, and clients would earn tokens based on various metrics established by the DAO.

Web3 marketplaces might require a system where a set of smart contracts and clients coordinate service providers and facilitate their interactions and arrangements with customers. Developers could then build white-label versions of these clients, allowing providers to offer many different levels of customized services or products. Both customers and service providers would earn the same governance tokens based on their contributions to the system. Increasingly, examples show that Web3 enterprises are already using token economics to create and capture long-term value.

Ultimately, the open infrastructure composed of the blockchain network and smart contract protocols in this model provides a rich environment for various specialized products and services built on top of its layers. By leveraging this shared infrastructure, builders can create Web3 products and services at a cost that is only a fraction of building centralized Web2 applications from scratch.

Gradual Open Decentralization

A challenge arising from the interaction between economic decentralization and legal decentralization in the open decentralized model is that it often leads to a chicken-or-egg paradox: true economic decentralization may require the use of digital assets (i.e., legal decentralization), but the use of digital assets requires economic and legal power decentralization. This issue is particularly acute in the open decentralized model, which requires a fully functional decentralized economy (unlike DeFi protocols using fully decentralized models, which do not necessarily require economic decentralization).

While there are many ways to address this issue from both technical and practical perspectives, Web3 systems can leverage a gradual decentralization process and take precautions regarding the distribution of digital assets before achieving full decentralization. Among other things, these precautions may include limiting transferability and restricting issuance and listing in the U.S. until the system is fully decentralized.

Open Decentralization: How to Decentralize Projects Using IP (and Third-Party Resources)

An iteration of the open decentralized model worth further exploration is the contribution of resources by third parties to Web3 systems, aimed at allowing system clients to use them for their products and services.

This can take the form of licensed intellectual property (video game engines, data assets, marketplaces, etc.), as well as a range of services that anyone in the ecosystem can use (including regulatory compliance, marketing, and business development) for or incorporated into their own clients. The following model reflects the intellectual property contributed to Web3 systems:

Introducing proprietary intellectual property seems to restore some of the decentralized economy of the system back to the owner-controlled Web2 economy, especially if the developers/operators of the clients are unwilling to let their products and services be subject to the whims and control of the intellectual property owners.

However, such risks can be mitigated through licensing contract terms (via irrevocable/perpetual terms, rights to modify/improve, etc.). An important consideration in this regard is what services and intellectual property require ongoing maintenance, and whether such services and maintenance (if any) can be provided by independent third parties—because greater reliance on a single third-party owner of intellectual property may undermine the overall economic decentralization of the system.

Ultimately, if the terms of the Web3 system are structured correctly, its decentralized economy will remain intact. For example, a Web3 system that utilizes widely available APIs (application programming interfaces) in its clients will not undermine the overall decentralization of the Web3 system but may enhance it.

From the perspective of legal power decentralization, the key question to consider is: are the essential management efforts of the intellectual property providers necessary to drive the success or failure of the Web3 system? Is there a risk of significant information asymmetry? Even if the intellectual property is critical to the success of the system, if the intellectual property owner cannot revoke it at any time, the answers to both questions may be negative—thus supporting the system's legitimate decentralization. This would also be the case if the intellectual property owner must seek DAO approval before making any significant changes to the intellectual property.

This concept can extend to other resources beyond intellectual property that may also be contributed or licensed to Web3 systems. For example, if third-party regulatory compliance services allow DeFi protocols to verify their users as accredited Americans, such services should not undermine the decentralization of the Web3 system. Similarly, it is conceivable that third parties provide marketing and business development-related services for the protocols—independent of the activities of any single client business.

While introducing third-party resources may undermine the decentralization of the system in various ways, such risks can often be mitigated through structural and contractual mechanisms (as discussed above).

Open Decentralization: How to Decentralize NFT Projects

Non-fungible token (NFT) projects and their communities represent an emerging and increasingly popular type of Web3 system, providing a great opportunity to discuss some other concepts of open decentralization.

First, it is important to understand why most art NFTs can be excluded from U.S. securities law on a legal basis, namely that they fail the fourth aspect of the Howey test: the value of NFTs is largely intrinsic rather than derived from the management efforts of others. However, as NFT projects become increasingly complex, the analysis under Howey becomes less straightforward. NFT projects now often involve additional content creation/additional NFT drops, implementing NFTs in video games, community-driven product development, and other activities—all of which may increase NFT holders' reliance on the management efforts of others.

Therefore, NFT projects should consider incorporating decentralization principles into their Web3 systems, especially if they intend to combine the project with NFTs. What would a decentralized model for NFT projects look like? The following diagram provides an example. It reflects: (1) a collection of NFTs minted on the blockchain and held by various users; (2) intellectual property contributed to the NFT community, likely related to the NFTs themselves (holders can "stake" them to the community) and any lore created by the community; (3) digital asset distributions and incentive mechanisms; (4) DAO governance over community intellectual property and the DAO treasury; (5) the launch of derivative projects; and (6) hosting social gatherings and events.

In this model, the economic decentralization of NFT projects can be achieved through several steps:

First, the DAO can use its initial resources for community engagement (e.g., Twitter, Discord, etc.) and fund social gatherings and other activities—thereby enhancing the community's implicit incentives (i.e., its popularity).

Second, these implicit incentives—along with explicit incentives (such as fungible token rewards, proceeds from NFT sales, etc.)—can be used to incentivize the creation of derivative projects utilizing the community's intellectual property. Developers will be rewarded for developing such projects, while consumers will be rewarded for using them. For example, the DAO could hire third-party developers to create a game that monetizes through gameplay, featuring a token economy based on the community's native digital assets. In this regard, the behavior of derivative projects is similar to the clients described in earlier open decentralized models, thereby reducing the system's reliance on any single source to bring value to NFT holders, which helps limit the risk of significant information asymmetry.

Finally, another important tool available to NFT projects is the royalties from secondary sales of NFTs generated by the DAO, which can drive their decentralized economy. During periods when derivative projects may not generate sufficient returns for the system, these royalties will provide the DAO with a decentralized revenue stream.

Ultimately, the combined value brought to the ecosystem by derivative projects and secondary sales can drive the creation of a healthy decentralized economy for NFT projects.

From the perspective of legal power decentralization, the key question again is: are the essential management efforts of any third party necessary to drive the success or failure of the Web3 system? Is there a risk of significant information asymmetry? The answers to these two questions will depend on many of the same considerations discussed above.

However, in this case, the intellectual property in the NFT space may promote rather than hinder the overall decentralization of the community. Why? Because the intellectual property is contributed to the DAO from decentralized sources (NFT holders). Furthermore, if the DAO is to control the distribution of tokens, the minting of additional NFTs, and the governance of decentralized intellectual property—and the decentralized revenue streams (from royalties or derivative projects)—the system is less likely to generate significant information asymmetry.

Most NFT projects are still in their early stages, so we have not yet seen many examples of NFT projects deploying decentralized token economics, but we hope to see various mechanisms emerge. At the same time, many lessons can also be integrated into NFT projects of other Web3 systems.

Open Decentralization: How to Decentralize Tokenization Protocols

Tokenization protocols represent another emerging type of Web3 system. In these systems, assets are loaded onto the blockchain, tokenized through smart contract protocols, and then sold or used for other purposes. Types of tokenization protocols include serial NFT minting projects, digital asset marketplaces, and protocols for tokenizing real-world assets.

The following open decentralization model reflects:

• Bringing assets from multiple providers onto the chain through shared smart contract protocols;
• Smart contract protocols that tokenize such assets;
• Multiple clients selling or using such tokenized assets;
• Native digital asset distributions and incentive mechanisms;
• DAO governance launching over community intellectual property and the DAO treasury.

In this model, economic decentralization is achieved through a fully diversified input (asset providers) and output (asset acquirers) and the decentralization of the layers through which tokenized assets flow (blockchain, smart contracts, and clients).

The DAO of the protocol can also use explicit incentives (fungible token rewards, no commissions/fees, etc.) to:

• Incentivize asset providers to contribute assets to the system;
• Incentivize clients to market the tokenized assets;
• Incentivize acquirers to acquire or consume such assets.

While the initial developing company may initially play a significant role in any of these roles (asset provider, client operator, asset acquirer), once the system is decentralized, the developing company will ultimately be just one of many participants in any given role. This will limit the risk of any significant information asymmetry arising from its involvement and reduce reliance on its management efforts. Additionally, the DAO and/or subDAOs can take on many roles.

Over time, explicit incentives can also be adjusted to address potential shortages on the supply or demand side. For example, in a decentralized marketplace, token incentives for sellers (supply side) can be increased to bring more goods onto the platform for sale; and token incentives for buyers (demand side) can be increased to encourage more purchases.

From the perspective of legal power decentralization, the key question again is: are the essential management efforts of any third party necessary to drive the success or failure of the Web3 system? Is there a risk of significant information asymmetry? The answers to these two questions depend on whether the DAO can effectively manage its balancing incentives for supply and demand, as in the examples above—but more broadly, it is to prevent any single asset provider, asset acquirer, or client from becoming so important that the success of the entire system relies on the efforts of any one entity.

* * *

Builders of Web3 systems currently face many challenges in launching, managing, and scaling decentralization. However, even if regulatory requirements may change, framing decentralization as a single design challenge encompassing technology, economics, and law should provide a robust reference guide to help builders leverage the new components of Web3 systems to overcome these challenges.

Failing to consider all three of these elements will lead us to miss the future of Web3 that blockchain technology and cryptocurrencies can realize. By building thoughtfully designed decentralized systems, builders can create digital infrastructure and invigorate decentralized economies that will form the foundation of the internet for decades to come. It is time to build that internet and that future.