a16z: Analyzing the Key Elements of Decentralization in Web3 Protocols

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

Authors: Miles Jennings, Stephen Wink & Adam Zuckerman

Compiled by: Sissi

Decentralization is a key innovation brought by blockchain technology and one of the most important features of web3 protocols. Therefore, to accurately assess and compare the degree of decentralization of various web3 protocols, web3 participants, policymakers, and regulators must collectively form a more unified and detailed understanding of decentralization. Doing so will not only better enable web3 regulation and policy to adapt to the characteristics of decentralization, understanding and considering how decentralization reduces risks, but also ultimately incentivize web3 builders to pursue decentralization to maximize the public good promised by web3.

To this end, we define three types of decentralization and propose relevant factors for each type, applicable to tokenized blockchain protocols (such as Bitcoin, Ethereum, Polygon, Solana, Optimism, Arbitrum, zksync, etc. layer 1 and layer 2 blockchains) as well as tokenized smart contract protocols deployed on the blockchain (such as Uniswap, Aave, Compound, Curve, etc.).

We also provide two tables, one for tokenized blockchain protocols and the other for tokenized smart contract protocols, which will help enumerate the components of decentralization to provide more specific and standardized definitions.

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

1. Why is decentralization needed?

Web3 leads a new era of the internet—the era of "reading, writing, and owning." The technology supporting web3 enables "trustless computation," eliminating the need to rely on centralized entities to browse the internet and databases. This allows us to develop more complex and advanced protocols that provide the functionalities 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 broad base of developers and users through token ownership.

Decentralization is a key feature of web3 protocols, driving this paradigm shift. Decentralization will promote the creation of a democratized internet and achieve three important transformations: fostering competition, protecting freedom, and rewarding stakeholders.

First, decentralization enables web3 systems to possess credible neutrality (they cannot discriminate against any individual stakeholder or group of stakeholders), which is crucial for incentivizing developers to build applications within the ecosystem. At the same time, they also possess composability (like Lego blocks, software components can be mixed and matched).

Thus, web3 systems resemble public infrastructure rather than proprietary technology platforms. Unlike the closed software of web2, web3 protocols provide distributed internet infrastructure on which anyone can build and create internet businesses. Importantly, in web3, this can be done without the permission of the original protocol deployers or the use of centralized control interfaces.

For example, one can compare Twitter with a web3 protocol that provides an underlying data architecture for social media controlled by public 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; one can consider a schematic diagram of the web3 ecosystem, which includes a decentralized blockchain, a decentralized smart contract protocol managed by token holders' DAOs, and several proprietary clients operating as independent businesses in traditional entity forms. Each blockchain and smart contract protocol serves as decentralized internet infrastructure, allowing businesses to build, compete, and innovate upon it.

Second, decentralization requires the broad distribution of control and participation rights in web3 protocols, ensuring that the development and use of the network reflect the opinions of various stakeholders, not just the companies that created these protocols. By appropriately constructing protocols that promote decentralization, the concentration of power in one or a few companies can be limited. Therefore, decentralization should restrict the control of thresholds by enterprises or individuals and ensure that any changes to the protocol align with the broad user ecosystem that holds tokens and ultimately manages the network.

Third, decentralization allows for the design of systems that focus more on stakeholder capitalism—these systems aim to meet the interests of all participants more fairly, rather than serving only a specific subset of people. Token-incentivized stakeholder capitalism distributes ownership and control to a broader range of stakeholders rather than placing shareholders above other stakeholders (including customers and employees).

Thus, web3 protocols and networks become a diverse design space that can meet the interests of all stakeholders more equitably. Such decentralized protocols provide a more stable internet infrastructure, allowing a broader range of stakeholders to confidently build upon it.

2. Types of Decentralization

We can view decentralization from three different but interconnected perspectives: technical, economic, and legal. All three perspectives are important, but they often involve competing interests, thus facing complex design challenges in maximizing overall decentralization and utility.

2.1, #Technical Decentralization (T)

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

For blockchain protocols, technical decentralization is a highly challenging issue that requires balancing multiple competing forces. However, for smart contract protocols, this type of decentralization can be achieved relatively quickly and easily by making smart contracts immutable (i.e., no one can control or upgrade them). For more examples, see here and here.

2.2, #Economic Decentralization (E)

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

Through careful design decisions, builders of web3 systems can facilitate the formation of a decentralized economy that exchanges and accumulates value from various sources (including informational value, economic value, voting rights, etc.). If constructed correctly, decentralized ecosystems can utilize token incentives to encourage participants to contribute value to the ecosystem and distribute value more equitably to the stakeholders of the system based on their contributions.

To achieve this, web3 systems need to empower system stakeholders with power, control, and ownership (through airdrops, token distributions, decentralized governance, etc.). Therefore, the value of the entire ecosystem will belong to a broader range of participants rather than being concentrated in a central entity and its shareholders.

The ongoing balance of incentives among stakeholders (developers, contributors, and consumers) can drive more value contributions to the entire system, benefiting everyone. In other words, this is the modern network effect bringing all the benefits without the downsides of centralized control and closed economies.

2.3, #Legal Decentralization (L)

Legal decentralization depends on whether a system's decentralization eliminates the risks that specific regulations aim to address.

For example, technically decentralized blockchain and smart contract protocols can eliminate risks associated with trusted intermediaries. Therefore, such systems, when it comes to regulations targeting trusted intermediaries, also mean they are legally decentralized.

For technical and economic decentralization, other risks can also be eliminated, including those related to the tokens of web3 systems and their potential value. This decentralization will eliminate the need to apply U.S. securities laws to token transactions, which could otherwise severely restrict the widespread distribution of tokens.

According to SEC guidance, we can define legal decentralization as the extent to which a web3 system can eliminate potential risks of significant information asymmetry and does not rely on others' significant management efforts to drive the success or failure of the enterprise. Once this threshold is reached, the system may be considered "sufficiently decentralized," thus exempting its tokens from U.S. securities laws. As a threshold issue, this requires that specific tokens do not confer any contractual rights to holders related to the ongoing efforts, assets, income, or resources of the issuer or its affiliates.

3. Decentralization Factors

In web3 systems using native tokens, it is essential to comprehensively consider the three types of decentralization: technical, economic, and legal. These types influence each other, and changing one may affect the other two. For example, a decentralized economy can drive the system toward legal decentralization by prioritizing decentralized ownership for stakeholders, accumulating value from decentralized sources, and distributing value to decentralized stakeholders. All these factors reduce the risks of information asymmetry and lessen reliance on individual management efforts.

Conversely, if the value of a web3 system's digital assets depends on the ongoing management efforts of the original development team, then the decentralization of the system on technical, economic, and legal levels may be threatened. For instance, the departure of the management team could exert significant downward pressure on the price of digital assets, making the system more susceptible to 51% attacks.

Given this interdependence, we break down decentralization into many factors that may influence it. The chart provides a comprehensive list of the most important factors for tokenized consensus blockchain protocols and tokenized smart contract protocols. These factors are categorized by type (technical, economic, and legal) and category (computation, development, governance, value accumulation, and usage and accessibility).

Decentralization is an evaluative process, not based on absolute standards, but on a range of circumstances that include all aspects of any web3 system. The relative importance of factors will change based on the web3 system and the evaluator's objectives. Moreover, the trade-offs between different types of decentralization may vary by project and individual.

The two tables mentioned in this article should serve as useful tools for providing more specific and standardized definitions of decentralization. It is hoped that this will enable web3 participants to contribute to building more decentralized projects while allowing policymakers and regulators to design regulatory frameworks that recognize the power of decentralization to reduce and eliminate risks.