On a high level, achieving sufficient decentralization entails distributing decision-making power and control over a project among a diverse group of stakeholders, as opposed to concentrating it in the hands of a select few individuals or entities.
Several factors contribute to a network's sufficient decentralization, including a distributed network of nodes, a diverse set of participants with varying interests and incentives, and a robust governance mechanism that facilitates fair decision-making within the network's community.
In this article, we will outline some of our observations around the crucial steps that Cosmos SDK chains (and other blockchains) take to launch a sufficiently decentralized network, starting from considerations during the early stages, up to their launch and beyond. Although “sufficient” in the context of decentralization has not yet received a legal definition, we aim to contribute to the discussion in light of the recent global development in securities laws.
We believe our research on the best practices for Web3 founders should be freely accessible for everyone. However, please note that we are not lawyers. We just want to get this information out there so you have a starting point before seeking legal council.
The Howey Test
To begin, let's consider the US securities laws as a starting point. While the legislative framework in this area is still evolving, sufficient decentralization can increase the likelihood of a network's native token not being classified as a security by US regulators. We take the US regulatory framework as the default because it is currently the most stringent legal framework, as well as the fact that failing to meet its standards could result in projects being unable to legally sell tokens to US investors. Consequently, they would have to exclude the US market entirely, including potential future listings on US exchanges, which could pose long-term challenges for a network. To provide further context, let's briefly examine the criteria of the Howey test, which US regulators employ to determine whether a network might fall under security regulations:
- Investment of money: When people put up assets in return for another asset such as equity or tokens.
- Expectation of profits: When people anticipate earning money or other forms of returns on their investment.
- Common enterprise and efforts of others: When people expect the profits to come primarily from the work or actions of someone else within a shared or linked enterprise.
Typically, for a token to be considered a security, all three criteria of the Howey test (investment of money, expectation of profits, and common enterprise) must be met. If any one of the criteria is not satisfied, the token may not be classified as a security.
In a blockchain network, the first prong of the Howey test, which is the investment of money, is typically met by default as participants contribute funds or assets to acquire tokens within the network. However, to potentially avoid being deemed a security, blockchain networks usually consider minimizing the elements that satisfy the second and third prongs of the Howey test.
When striving to avoid the second criteria, which is the expectation of profits, this can be achieved by emphasizing the utility and functionality of the tokens within the network, rather than positioning them primarily as investment opportunities. Focusing on the immediate use and utility value of the tokens can help to reduce the perception of speculative profit expectations.
To minimize the third criteria, which relates to the profits derived from the efforts of others, protocols generally promote decentralization and minimize the control and influence of a centralized entity or group such as the founders. This way blockchain networks can demonstrate that the success of the investment is not primarily dependent on the efforts of others but rather on the collective actions of network participants.
Effects of Pricing the Token
During the early stages of development, particularly in the pre-seed and seed stages, careful consideration is usually given to token pricing. Historically speaking, many founding teams have raised through fundraising instruments that set a price on the token, which has played right into the “expectations of profits” criterion in the Howey Test. Setting a fixed token price can create the perception that investors expect profits primarily from the efforts of the project's founders or team who made the decisions on the price and therefore assume that a group of individuals hold central control over the token. This perception of centralization and dependence on others, coupled with the expectation of profit, increases the likelihood of the token being classified as a security.
More recently, we’re seeing that fundraising documents are being structured to offer token options to investors, granting them future discounts on the token price. This can be achieved through the use of SAFEs (Simple Agreements for Future Equity) in combination with Token Warrants or Token Side Letters. These mechanisms enable the team to sell equity in their initial company, which can later be converted into tokens or provide investors with the right to purchase tokens.
Decentralized Protocol Launch
Launching a protocol and its token holds significant importance in authorities' assessment of the protocol's decentralization. A key question often asked is: Who was responsible for minting and distributing the token?
Many recently launched networks consider it crucial to avoid a scenario where the founders or core team take sole responsibility for minting the network's tokens during its launch. In the case of Cosmos SDK-based blockchains, decentralization is inherent by default. Although the founding team typically creates the genesis file, which contains information about token minting and distribution, they do not have the authority to decide whether the network should be launched. Validators play a vital role by initiating the launch through signing the genesis file and launching the network. To effectively create and distribute the majority of tokens, a joint decision must be made by two-thirds of the voting power in the genesis file.
During this phase, token allocation occurs based on the information specified in the genesis file. The file outlines the initial distribution of tokens to various stakeholders, including the founding team, investors, airdrop recipients, the community, and the network's treasury.
Disabling IBC & Token Transfers
During the initial launch, there is the option to temporarily disable Inter-Blockchain Communication (IBC) token transfers and Internal Token transfers. This serves as a precautionary measure to establish a controlled and secure environment for the mainnet's early stages, often referred to as a "Soft Launch."
Another benefit is that disabling IBC and token transfers prevent the immediate creation of secondary markets. This approach ensures that the community establishes secondary markets only after enabling IBC and token transfers, aligning them with the project's objectives and regulatory considerations.
Once the soft launch proves successful, all features are thoroughly reviewed, and a more decentralized distribution of voting power is achieved, the community can then enable IBC and token transfers through a governance parameter change proposal. Involving the community in decision-making reduces potential liabilities for both the founders and validators involved in the network’s launch. This, in turn, increases the decentralization of the decision-making process regarding the creation of secondary markets.
Decentralized Decision Making through Governance
Another key point is the implementation of decentralized decision-making within the network, which refers to the collective process by which participants shape the network's future evolution. It ensures active participation of token holders. Involving token holders in governance mitigates concentration of control, reducing the likelihood of meeting the “Common Enterprise” criterion of the Howey test. It demonstrates that the success or failure of an investment relies on the collective efforts and decisions of a decentralized network, rather than relying solely on a central authority.
Governance participation is typically facilitated through on-chain mechanisms via the Governance Module in Cosmos SDK chains, through which token holders exercise their voting rights to participate in decision-making processes. Any token holder can submit an on-chain governance proposal. While it is common for founders or the initial protocol-developing entity to submit proposals at the early stages, these proposals remain suggestions, and the final decision lies with the community of token holders. As the network progresses, the proposers become more diverse and broader, leading to increased decentralization over time.
Token holders vote on various matters, including parameter upgrades, protocol updates, and the addition of new features which can include critical changes to token economics or revenue models (such as fees and their distribution) that are crucial to the network’s trajectory.
Additionally, the community typically also votes on fund deployment from funds that are controlled by the community, such as the community pool or the strategic reserves. Funding is commonly allocated to development teams, grants programs, and independent projects within the community. A growing number of protocols attempt to increase the decentralization of development efforts by:
- deploying funds to an increasing amount of entities through proposals from different developer teams or entities over time
- doing so through a transparent governance process that includes the network’s community in the decision-making process
Besides funds that are directly controlled by token holders, blockchain networks generally have a foundation with a treasury for grants. This treasury is often spent in a more centralized fashion, in order to fund core development, marketing, and work.
The two models can exist simultaneously. While the community model through governance facilitates decentralization, the centralized foundation helps drive faster deployment of critical funding to development efforts in the early stages of the network (this can include service agreements with the initial developer company that started the protocol). It’s able to fund more effectively and precisely on critical tasks and responsibilities the community and on-chain governance is unable to execute at an early stage.
Decentralized decision-making as a whole is still ensured through a balanced distribution of voting power, which we’ll touch on in the next section.
Distribution of Voting Power & On-chain Control
Ensuring an equitable distribution of voting power is essential to avoid concentrated decision-making within the network. Several factors can be considered:
Initial Token Distribution
Protocols that consider decentralization a priority generally distribute their tokens in a manner that prevents any stakeholder from holding a majority of the voting power and exerting significant control over the network's trajectory. This includes careful consideration of token allocation at genesis. Allocating a substantial portion (30-50%) of the network's genesis supply to a strategic reserve controlled by a network’s foundation may be perceived as centralized decision-making power.
The portion of tokens allocated to community-controlled pools, the foundation, investors and team members should be carefully considered and well-balanced to prevent excessive voting power concentration. Even a 10% allocation to a single stakeholder can be considered significant and should be avoided. For example, if a combined allocation to the centrally controlled foundation and team members leads up to more than 50%, it may raise concerns about excessive control by specific parties with aligned interests.
If tokens are delegated in the genesis file, they should be distributed relatively fairly among all validators to further decentralize the voting power. Delegation programs can be implemented at a later stage.
Simple approaches, such as providing equal delegations to each validator, or more sophisticated programs like the Interchain Foundation's delegation policy, can incentivize positive contributions to the network.
While foundation votes can still override validator votes, a public commitment to refrain from voting and a consistent track record of upholding that commitment can help foster the perception that the founding team was not involved in key network decisions.
Enabling Decentralization Through Airdrops
Airdrops play a crucial role in the Cosmos ecosystem by distributing tokens widely and promoting community engagement. They are a powerful tool to bootstrap new projects and foster active participation in the network.
Often overlooked, airdrops contribute to decentralization by rapidly distributing ownership and voting power among a large number of individuals.
This democratic allocation of tokens ensures decision-making authority is shared among a large group of stakeholders rather than among a few entities. By utilizing airdrops, projects can establish a diverse and engaged token-holder community from the start, facilitating fair and inclusive governance. This strengthens the principles of decentralization and establishes a solid foundation for effective on-chain decision-making.
Market Creation & Token Sale
When it comes to token sale and the creation of token markets, it is important to approach these activities with caution and consider common practices to mitigate legal risks.
The traditional concept of an Initial Coin Offering (ICO) conducted by the founding team has faced regulatory scrutiny, making public token sales for fundraising legally problematic. To avoid the perception of centralized control, the founding team can refrain from initiating token sales or creating secondary markets themselves, as well as engaging in marketing activities related to secondary market sales which we’ll touch on in the next section. It is critical for the founding team to distance themselves from these activities to minimize potential regulatory scrutiny in the future.
One way to create a market for the token in a more decentralized manner is by having the founding team or core entity responsible for creating the protocol not directly involved in initiating the sale. As such, none of the founders or entities controlled by the founders receive funds directly. Instead, the protocol itself, such as a community or a network-owned pool, should be the receiving party and the decision to create the market should be made through a community vote by token holders.
This can be achieved through community-initiated market creation via a governance proposal. Anyone holding tokens can submit the proposal, including founders or core team members. In this case, the proposer presents the suggestion but the decision-making process is decentralized, as the community of voters ultimately makes the decision.
Tokens used for market creation can come from the community pool or another decentralized autonomous organization (DAO)-controlled pool specifically designated for market creation such as a “liquidity bootstrapping treasury”. Through this approach, no single individual or entity is directly responsible for a token sale or market creation.
Marketing around Secondary Market Creation
It is also important to understand that regulators closely scrutinize the promises and marketing related to the potential secondary trading of tokens. Regulators examine whether a project's founders or a core entity make promises or actively promote the token's future listing on trading platforms or exchanges.
If the founders or any central entity emphasize the token's tradability and the potential for value appreciation, it indicates an intention to create a tradable financial instrument and suggests an expectation of profit derived from the efforts of others. Therefore, it is generally suggested that entities related to the network refrain from:
- Making statements about the potential value or future performance of the token, implying any returns on investment.
- Promising high Annual Percentage Rates (APRs) on the chain.
- Providing false or incomplete information about the token sale, such as the number of tokens offered, token price, or total funds raised through the sale.
- Marketing a token as having a specific use case or function but failing to deliver on those promises.
Instead, successful teams have commonly adopted marketing strategies that:
- Clearly state that the tokens do not represent shares or equity in the project and derive their value primarily from utility within the network.
- Educate and emphasize the token's utility by creating informative materials, such as blog posts, articles, and tutorials, that explain the token's practical uses, its role within the network, and specific use cases.
By transparently communicating the token's practical applications and benefits, it helps set appropriate expectations for potential holders and reduces the likelihood of it being perceived as a speculative investment. Emphasizing the utility and functionality of the token within the network reduces the perception of it being primarily an investment opportunity.
By positioning the token as a means of accessing goods, services, or resources, the emphasis shifts away from being a traditional investment. This clarity and emphasis on utility within the network can also help mitigate the perception that token holders anticipate profits primarily from the efforts of others.
Post Launch Checklist: Further Decentralization & Maintenance
After the successful launch of a decentralized network on its mainnet, the focus shifts towards further decentralization and continued maintenance and development. This phase is critical for enhancing the network's resilience, promoting community-driven development, and ensuring long-term sustainability.
Generally speaking, protocols that aim to increase the decentralization of their network focus on two key areas:
- A wider distribution of development teams: this pertains to both core development of the protocol and developers who launch dApps on the network (if applicable). In the early stages of a protocol, it is not uncommon that a single developer company is responsible for most of the maintenance on the network. However, to decrease the likelihood to meet the criterion of the “common enterprise”, more entities need to be involved in the success of the network. We can look at the Ethereum Foundation as an example, where a large number of entities are responsible for core development, and an even larger amount is responsible for Ethereum’s impressive ecosystem. All of these parties contribute to the success of the ecosystem, and as an extension, its token. At this stage, an investor could not buy the token and be expected to believe their return on investment is dependent on the Ethereum Foundation alone.
- Increasing the number of entities funding the protocol’s development: a large number of development teams is only half of the story. If these teams continue to receive funding from a single entity, one could still argue that the success of the network is dependent on the funding entity. Besides a foundation’s treasury and a network’s community pool, protocols generally attempt to create lively ecosystems with multiple parties becoming successful. In an ideal world, these third parties contribute back to the development of the network through funding.
In conclusion, achieving decentralization is critical for blockchain projects that strive to navigate the regulatory landscape and foster a resilient and inclusive ecosystem. The measures outlined in this article, including token pricing considerations, decentralized protocol launches, airdrops, disabling token transfers, community-driven development, and maintenance, all contribute to the overall goal of decentralization. While these steps do not guarantee complete immunity from regulatory scrutiny, they demonstrate a commitment to decentralization, which could potentially strengthen a protocol’s case when engaging with regulators.
Ultimately, the path to decentralization is an ongoing journey that requires constant adaptation and community involvement. By striving for decentralization and engaging with regulators in a transparent and cooperative manner, blockchain projects can position themselves as pioneers in building decentralized systems that empower communities and drive innovation.