Ever since the Securities and Exchange Commission (SEC) introduced the concept of "full decentralization" in 2018, Web3 builders have been keeping an eye on the content. This process has also prompted builders to shift the distribution of crypto work from centralized companies to decentralized community members who share common goals.
Because blockchain is an emerging technology, most securities law proposals at this stage focus on decentralizing the Web3 technology stack at the expense of decentralizing the "off-chain activities" of community contributors. These off-chain activities include the development and improvement of protocols or software, and the curation and marketing of related businesses.
At the same time, these off-chain activities are difficult to be carried out automatically through smart contracts like on-chain activities, and there is a risk of forming "bureaucracy", so in order to achieve more "adequate and balanced" decentralization, the community must think about how to carry out on-chain and off-chain activities.
This article applies to
(1) Web3 founders who are compliant with U.S. securities laws and wish to effectively decentralize off-chain activities.
(2) Web3 attorneys who advise these founders.
This article covers what it means to be "fully decentralized," how it affects off-chain activity, common mistakes that lead to the centralization of DAOs, and how to effectively form a community in order to be fully decentralized.
While this article offers suggestions, it does not mean that these constructions are the only way to go: there is no single paradigm for full decentralization, and there is no "perfect" way to achieve it. At this stage, companies and communities are adopting methods that are conservative enough to be inefficient from a regulatory standpoint.
Getting Started: Investment Contracts
In the U.S., issuers must register with the SEC before issuing securities and must disclose information about their business, the market and the securities being offered. These disclosures can better help investors weigh their investment behavior, and can also curb a certain degree of "insider trading" and create a "level playing field".
For example, an "investment contract" is a type of security, and in order to determine whether the attributes of a contract, program or transaction belong to an investment contract, the U.S. courts mainly rely on the "Howey test" (Howey test), which originated in 1946. SEC v. Howey Co.
The final definition of an investment contract is
(1) Involving the investment of money, i.e., the provision of funds in the form of cash as consideration
(2) An investment in a public project (Common Enterprise)
(3) The investor has an expectation of return (profit)
(4) Profits result from the efforts of others (project sponsors), not from investor behavior. Practical experience in the event
This test is also used today to determine whether a particular crypto asset is an investment contract type.
Point 4 is key to determining the attributes of an investment contract, i.e., whether the investor expects to profit from the project sponsor's business management efforts; and so is the key to determining the attributes of a crypto asset's investment contract: whether one is counting on the Web3 contributor's contribution to the growth of the value of the cryptocurrency (including off-chain activity).
What does full decentralization mean?
In June 2018, William Hinman, Director of the SEC's Division of Corporation Finance, proposed "sufficient decentralization" in a speech in which Hinman said, "If tokens or the operational networks behind them are sufficiently decentralized, that is, if purchasers no longer expect an individual (or a group) to to make the necessary management operating efforts, such assets are not investment contracts." Based on this logic, Hinman argues that Ether is not a sale of securities because the current Ether network is sufficiently decentralized.
Hinman's notion of "sufficient decentralization" is a manifestation of point 4 of the Howey test, which assesses whose efforts influence buyers' expectations of crypto asset profits. If a protocol (or network) is less decentralized, then the public will naturally associate the value of a crypto asset with the "coordination" of the centralized team. The opposite is true if the protocol is sufficiently decentralized, as there is no specific team driving the value of the crypto asset for the public to expect.
In April 2019, the SEC's Center for Innovation and Financial Technology Strategies (FinHub) refined the concept of sufficient decentralization through its "Framework for Analyzing Investment Contracts for Digital Assets." The FinHub framework provides detailed guidance on the four points of the Howe test and introduces, in connection with point 4 of the Howe test, the following The concept of "Active Participants": i.e., "the initiator, sponsor, or other third party and its "associated" teams (groups with "nepotistic" ties to the third party)". groups that have "nepotistic" relationships with the third party.
The FinHub framework treats "Active Participants" as potential third party "affiliate" groups, which may differ from the definition of "affiliate" in the SEC regulations when it comes to the definition of the term "affiliate". This may differ from the definition of "affiliation" in the SEC's regulations insofar as it relates to the definition of the term "affiliation", which focuses on the "degree of coordination of behavior" among a group of "third-party teams". Third-party teams working under an agreement are supposed to be "uncoordinated" with each other (just follow the process and don't need to communicate with each other much, not in a pejorative sense), while "coordinated" third-party teams have access to "insider information" (e.g., the "inside information"). "insider information". （For example, company A needs to outsource a certain business (possibly for security reasons), and a is the person in charge of it, but a outsources it to company B, which is actually controlled by himself, and a and B are "nepotistic" as above; one can also interpret "coordination" as the ability of two third-party groups to communicate with each other, without much interaction between them. "(which can also be interpreted as the "likelihood of complicity" or "fit" between the two third-party groups, in a non-pejorative sense).
Within the FinHub framework, "reliance on the efforts of others" is measured by reference to whether essential tasks or responsibilities are performed by "active participants" or by independent, decentralized community members.
Indeed, even if a crypto-asset is initially sold as an investment contract (a security), the FinHub framework provides a way for it to be converted to a non-security at a later stage: by severing the "link" between the management efforts of "Active Participants" (including would-be Active Participants) and the success of the digital asset. connection" between the success of the digital asset and the efforts of the "active participants" (including potential active participants) to manage it.
Simply put, if an investor attributes the causality of the profitability of a crypto-asset to the efforts of a small number of other people (including active participants), then the asset is a security; conversely, if the investor attributes the causality to a wide range of (uncoordinated) people, then the agreement and related activities satisfy the "sufficiently decentralized" quality and are not considered an investment contract. The agreement and related activities satisfy the quality of "sufficient decentralization" and are not considered as an investment contract.
Legal counsel advising Web3 participants often combine the concepts of "sufficiently decentralized" and "active participant"; thus, wise participants have begun to replace the "active participant" aspect of a centralized agreement with a decentralized, uncoordinated group of contributors. "active participants" in centralized protocols.
However, the technology of the protocol and its level of automation is not the only factor affecting the value of crypto-assets; off-chain activities should also be considered as one of the driving factors; therefore, in order to mitigate risk, the community should also seek to decentralize off-chain activities, including:
Development and marketing
Intellectual property rights
Off-chain activities also influence the measurement of "reliance on the efforts of others", such as the design of the protocol, the target market and the choice of governance mechanisms.
For example, in the early stages of a protocol or when it is easy to integrate with other protocols, the behavior of the community can have a significant impact on driving the value of crypto-assets; whereas in communities where the protocol design is well established or where protocol integration is difficult, greater value can be created through the curation of the business, the development model, the choice of marketing tools, and the governance.
Scope of decentralization?
In Web3, there seems to be a constant tension between the efficiency of centralization and the ideology of decentralization (e.g., censorship resistance), with each community wanting to combine the speed, cost, and operational efficiency of centralization with the consensus, censorship resistance, transparency, and independence of decentralization. Thus based on different visions, communities have different levels of centralization.
To improve performance and efficiency, more centralization is needed; to maximize decentralization, efficiency must be sacrificed. Imagining centralization and decentralization as two segments of a line segment, each community intentionally or unintentionally places off-chain activities on the line segment: at the centralized end, one person or one company or a small group of people can participate in all off-chain activities; at the decentralized end, no one needs to obtain permission to participate in any off-chain activity at any time.
From a technical point of view, those "Ether killers" achieve faster and cheaper transactions than Ether at the cost of higher centralization. This compromise is unacceptable to many in the Ether community, but it is cost-effective for the "Ether killers" (who also believe that their protocols will one day have the same degree of decentralization as Ether).
A similar compromise applies to off-chain activities, which may be more efficiently centralized, such as a centralized marketing campaign through a marketing agency, where a marketing manager can direct a team of "gold medallists" to run multimedia campaigns on social channels such as Discord, Twitter, Telegram, and so on. This ensures efficiency and consistency of messaging, based on the fact that the agency has sole control over the social channels and the content that is published.
On the contrary, a completely decentralized community allows anyone to participate in any off-chain activity, which can in fact be inefficient; to follow up on the example above, if there is no manager coordinating the community's marketing efforts, anyone can choose whether or not to engage in spontaneous promotion, and at the same time, such promotion may not always have a positive effect (sometimes it takes a professional to do a professional's job).
For the purposes of the Howell test, the more centralized the community, the greater the risk that this crypto asset will be treated as a security; and there are many other factors that can affect the degree to which a community is decentralized:
The culture of the community
Historical development of activities down the chain within the community
Risk of censorship associated with the community's activities
Leadership within the community
Strategies for protocol development
Adjustments to protocol parameters or other
The role of startups in off-chain activities
When startups become overly involved in off-chain activities, they increase the risk that the community will rely on their efforts in anticipation of expected profits, which may force the team to relinquish its "important role" in off-chain activities. Only when the community takes over important off-chain activities will there be enough room for startups to participate in off-chain activities.
Startups need to be mindful not only of the role they might play in off-chain activities, but also of what they should avoid:
Creating expectations: the possibility of startup teams seeking to increase the value of a crypto asset when they hold the corresponding crypto asset should be avoided.
Over-promoting the role of the startup team: most startup teams want to attribute results to themselves (which may in fact be true for the startup team), but this can increase dependency, and the team should seek to balance this by promoting more of the achievements of the uninvolved community (the results of other community members).
Make a centralization statement: this implies reliance on the efforts of the centralized party. There should be a balance between the risk of public disclosure of the protocol and disclosure that leads to potential liability.
Discussing off-chain activities or on-chain operations of the protocol implies that the startup team is performing certain operations: English teachers will teach students to write in the active voice, but all descriptions of off-chain and on-chain activities should be in the passive voice. Passive voice accurately describes on-chain activity and avoids any expectation of profit from anyone's off-chain activity.
When posting or sharing social media content, it is not desirable to give credit for obtaining the initial content to the team that first shared it: if the team disagrees with the content of the retweeted tweet, this should be made clear.
Inappropriate terminology to refer to the startup team: e.g. "leadership" or "core" team should be referred to as "early contributors".
Involvement in protocol governance: When startup teams are involved in governance, crypto asset holders will continue to rely on the team's strategic decisions to create value, rather than letting the community make the decisions.
Startup teams may argue that some of the behaviors described above will not result in third parties expecting to profit from their efforts. For example, privately engaging with an exchange to list crypto assets for trading should be viewed as an expectation of profit from the team's efforts, but the team's efforts are unknown to the public. However, perception matters and it is best to avoid this issue.
While this article only intends to address the issue of "full decentralization," startup teams should consider actions to prevent the creation of a "holder has no expectation of profit" position, including:
Taking any action to list crypto assets on the secondary market (CEX or DEX); disguising access to the secondary market by partnering with a third party (e.g., market maker).
Making statements about the appreciation of crypto assets or claiming a profit expectation that does not yet exist.
Discuss the market structure of crypto assets, such as liquidity, selling pressure and demand.
There is no perfect way to achieve full decentralization, and in the future there will still be a growing number of Web3 communities testing countless new ways to achieve full decentralization; and creating and developing more Web3-native tools for the community and facilitating communication between teams. As long as the community maintains the principle of openness, it will be possible to achieve full decentralization while effectively participating in off-chain activities.