In the ever-evolving landscape of blockchain technology, the decentralization of decision-making processes plays a pivotal role in establishing trust, transparency, and community participation. The launch of a protocol and its associated token holds immense significance, often being scrutinized by regulatory bodies to determine the extent of which decentralization has been achieved. A critical question arises: who wields the power to mint and distribute tokens?
This article delves into the nuances of decentralized decision-making, exploring key distinctions between blockchain networks and smart contracts, highlighting the potential of airdrops for distributing voting power, and shedding light on strategies for navigating public token sales, on-chain control, and future community-driven development.
It emphasizes the essential role of marketing, communication, and transparent disclosure in reinforcing the decentralized ethos and fostering community engagement. Through comprehensive strategies, the blockchain ecosystem can chart a path towards true decentralization, fortifying the foundation of trust and collaboration.
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.
Launching the Protocol
The launch of a protocol and its token is often seen by authorities as a key point in their assessment of whether a protocol is decentralized. The main question being: who was responsible for minting and distributing the token? The most relevant distinction to explore is the one between launching a blockchain network versus a smart contract.
Smart contracts need an owner that remains in control of the contract and can update the protocol when needed. More often than not, this owner is a multisignature wallet, although those tend to have a limited number of members. The creation of the contract, and by extension the minting and distribution of the token, is often decided upon by a relatively small number of individuals (usually the founders of a project). If your protocol is smart contract based and launched on a third party layer-1 chain, consider setting up an on-chain DAO to initialize the contract and maintain future governance of the network. This DAO should have a large number of members, ideally from multiple jurisdictions, while only a limited number of members are part of the founding team.
If your protocol is a CosmWasm based contract on a separate layer-1 chain, consider using DAODAO to set up your governance group.
Cosmos SDK-based blockchains inherit this decentralization by default. Although the founding team is usually responsible for creating the genesis file containing the information about the token’s minting and distribution details, the decision on whether to launch the network is not theirs. In order to launch the network, and effectively create and distribute the majority of tokens, 2/3rds of the validators that have been assigned voting power in the genesis file have to make a joint-decision on doing so.
Again, we must emphasize that founders should not have a significant stake in this decision making process. This effectively means not having any significant block producing power. Ideally the founders would not even be running a validator themselves, and if tokens are somehow delegated already in the genesis file, these should be distributed fairly over all validators. In the best case scenario validators would not even receive any delegations from the founding team (or the foundation’s treasury) during the initial genesis, although delegation programs likely possible at a later stage of the network.
The exact number of people that are needed to make a network launch “truly” decentralized remains unclear, as legislation around this topic remains lacking. As such, validators, or DAO members need to be aware that they are potentially legally liable for the minting of tokens that may wind up being deemed a security.
Decentralization Through Airdrops
Airdrops are often seen as just a promotional tool or a way to incentivize specific user behavior. A less commonly understood benefit is the fact you quickly distribute voting power over a large number of people through a relatively easy process. This multi-beneficial outcome makes airdrops such an effective tool in the arsenal of protocol founders.
By distributing voting power through an airdrop, you increase the likelihood that the founding team won’t be held responsible for making critical decisions such as launching a public token sale or the creation of liquidity pools that price the network.
Disabling IBC & Token Transfers
The pricing of a token through secondary markets is another key factor in determining whether or not a token should be deemed a security. Although secondary markets are impossible to avoid in most cases, the decision on making the token available does not need to rest on the founding team’s shoulders. By running a soft mainnet launch, with IBC and token transfers disabled, protocols gain several benefits:
- The system can afford to fail while validators are slowly coming online and key features are getting a final check
- The token has no price when the airdrop is distributed (if done before enabling transfers), likely improving the tax situation for users receiving tokens
- Secondary markets are not available by default. Enabling them requires a majority of token holders to agree, likely reducing the liability of the founding team and the validators.
In an ideal situation, a protocol would wait until an adequately decentralized voting power distribution has been achieved before enabling IBC and token transfers through a governance parameter change proposal.
Public Token Sale
The initial coin offering (ICO) that was popularized in the 2017 bull market has received much public scrutiny from oversight institutions like the SEC. As such, the ICO, as originally conceived as a public sale executed by the founding team, is not considered legally viable at this point. Alternatives have propped up, such as Liquidity Bootstrapping Pools (LBPs), Initial DEX Offerings (IDOs), and more recently in Cosmos, StreamSwaps. These are all attempts at decentralizing the public sale of tokens, although it remains unclear whether this is legally safe to do so.
We generally consider any form of public token sale for the purpose of fundraising to be legally risky, seeing as the founding party is usually on the receiving end of the sale, with the expectation that the funds are used for the work needed to improve the network. This plays right into the three prongs of the Howey test: an investment of money (the sale), in a common enterprise (the founding team), with the expectation of profits (token number go up).
A more decentralized version of the public sale would entail a process such as an LBP, IDO or StreamSwap, but the receiving party is the protocol itself, or some other sufficiently large DAO where the founding team has no significant voting power. This remains legally murky territory, but one potential path to explore would be a community launched token sale with funds from the community pool. The receiving party of the sale could be that same community pool, or some other fund managed directly by token holders. If the community then decides to fund the developer company for continuing work on the protocol, the outcome is relatively similar (i.e. the developers have the funds to continue working), but no founder was involved in the decision making process, greatly increasing the decentralization of the entire process itself.
On-Chain Control: Updates & Parameter Changes
Once the protocol has launched and tokens have been distributed through its genesis, an airdrop and a potential public sale, the decentralization of a network has hopefully already made enormous progress compared to the initial launch under a selected group of multisig holders or validators. However, future upgrades and other key decisions on the network continue to be needed.
Although perhaps obvious, it remains critical that no admin backdoors or multisig ownership is maintained on the protocol, regardless of whether you’re building a sovereign app-chain or a smart contract on a layer-1. A less obvious concern is the voting power of the foundation. In most protocol launches, we’ve observed a common foundation token allocation of anywhere between 30 and 50% of the genesis mint. If we then include the percentage that the founding team received, it’s not unlikely to imagine that the founders effectively hold a 51% majority of the chain.
There are several things you can do to avoid this problem:
- Running a delegation program can help decentralize the voting power throughout the active validator set. The lowest effort version of this would be an equal delegation to each validator in the active set. But more sophisticated programs like the Interchain Foundation’s delegation policy can help incentivize positive contributions to the network. While votes can still be overruled by the foundation, a public commitment to never vote and a solid track record of keeping to that promise can help drive the narrative that the founding team was not involved in some of the key decisions.
- Disabling direct voting rights for the founding team’s initial token allocation would substantially help towards decentralizing the network. This would require a modification of the governance module as no solution for this has been implemented at this stage. Although not a trivial problem to solve, the tokens would ideally still be used to secure the network through Proof-of-Stake while not being counted in governance.
- Reducing the foundation’s allocation, although a possibility, is not always recommended, but highly depends on the future plans for the protocol itself.
Future Maintenance & Community Driven Development
The idea for Community Driven Development is to foster an open and inclusive development process where contributions and improvements come from a diverse community of developers, rather than relying heavily on the efforts of a centralized development team.
The primary reason why this is important is important is to avoid falling under securities laws by meeting the second prong of the HOWEY Test: investment in a common enterprise (the founding team)
Often the development starts in a centralized way via the Developer Company which also raises the initial funds for the project through venture fund investments. Ideally tho, once the network has launched, its development shifts to being distributed to several contributing engineering companies and developer teams or even individual developers who build products that tie directly into the network.
To achieve this networks implement the following:
Grants Programs:
Grant programs in blockchain ecosystems are initiatives designed to provide financial support to teams or individuals who propose innovative ideas, contribute to the development of the ecosystem, or build applications on top of the underlying blockchain protocol.
Goals:
- Grants provide financial support to projects that may not have access to traditional funding sources.
- Grant programs aim to promote the development of the blockchain ecosystem by encouraging innovative projects that expand the functionality, adoption, and use cases of the underlying blockchain protocol.
- Grant programs foster community participation and engagement by encouraging individuals and teams to actively contribute to the ecosystem.
- Developer Grants and Incentives to provide financial support to teams or individuals who propose innovative ideas, contribute to the development of the ecosystem, or build applications on top of the underlying blockchain protocol.
Bug Bounties
- Bug Bounties and Security Audits to encourage community members to actively participate in the network's security. Bug bounties incentivize individuals to discover and report vulnerabilities.
Community Pools
Example: Osmosis > launched quite centralized (50% voting power to treasury & devco) to now have permission CosmWasm & multiple companies building products that tie directly into the Osmosis App, this has been achieved by grants program.
Marketing, Communication & Transparent Disclosure
As much as it is important to take the actual steps to decentralize the network through a decentralized token distribution and decentralized governance and decision making process, it is just as important to be sure to market and communicate the decentralization of the network, educate the community how it works to emphasize community participation and therefore decentralization in the first place. If it isn’t clearly communicated to the public, users might not even know that they can or should participate and the network won't gain a sufficient number of participants that actually make it decentralized.
Additionally it is crucial to provide comprehensive information about the project for two reasons:
- The token’s utility and potential risks for investors to be able make informed decisions based on the token's intrinsic value. Therefore transparent disclosure shifts the focus from speculative profit-seeking to a genuine understanding of the network's utility, reducing the likelihood of the token being classified as a security.
- Communicating about the projects decentralization and decentralized contributions will reduce the likelihood of investors expecting profits derived from the efforts of a central entity, hence the founding team which would meet prong 2 of the HOWEY test and therefore be deemed a security.
Foster Community Participation
Overall, fostering community participation requires creating an inclusive and engaging environment that values the contributions and involvement of community members. It involves providing the necessary tools, resources, and platforms for collaboration, governance, and decision-making within the decentralized blockchain network. This includes providing educational materials, such as blog posts, videos, and FAQs, that emphasize the long-term value proposition of the network and the benefits of token ownership beyond monetary gains. Maintain open and transparent communication channels with the community, providing regular updates on the project's progress, developments, and any regulatory considerations. This can be done through:
- Education and Awareness: Educating the community about the technology, its benefits, and use cases is essential to increase awareness and attract more individuals to participate in the network through:
- Educate potential investors about the technology, the project's goals, and the token's utility value.
- Provide educational materials, such as blog posts, videos, and FAQs, that emphasize the long-term value proposition of the network and the benefits of token ownership beyond monetary gains.
- Maintain open and transparent communication channels with the community, providing regular updates on the project's progress, developments.
- Community Forums and Communication Channels: Creating dedicated community forums, chat groups, or online platforms helps facilitate discussions, collaboration, and knowledge-sharing among participants. These channels provide a space for community members to ask questions, share ideas, propose improvements, and contribute their expertise to the network.
- Open Source Development for developers and community members to actively participate in improving and maintaining the network's codebase.
- Developer Grants and Incentives to provide financial support to teams or individuals who propose innovative ideas, contribute to the development of the ecosystem, or build applications on top of the underlying blockchain protocol.
- Bug Bounties and Security Audits to encourage community members to actively participate in the network's security. Bug bounties incentivize individuals to discover and report vulnerabilities.
Marketing around the token and its utility
In regards to how tokens are marketed it includes promoting the tokens through advertisements, social media, or other marketing channels, and making false or misleading statements this could potentially lead to a violation of securities laws. By implementing transparent disclosure practices, projects can foster trust, manage investor expectations, and minimize the perception of the token as an investment opportunity promising significant profits.
DON’T
- Don’t market a token as having a specific use case or function, but fail to deliver on those promises. this could also be considered a violation of securities laws.
- Don’t provide false or incomplete information about the token sale, such as the number of tokens being offered, the price of the tokens, or the total amount of funds that will be raised through the sale.
- Don’t make statements about the potential value or future performance of the token. For instance, if a token as a surefire investment opportunity that will generate high returns, without providing adequate disclosure about the risks involved, this could be a violation of securities laws.
- Don’t make promises on high APRs on the chain
DO
- Create a comprehensive and easily accessible whitepaper or documentation that outlines the potential risks associated with token ownership, including market volatility, regulatory uncertainties, and technological risks.
- Clearly state that the tokens do not represent shares or equity in the project, and that their value is derived primarily from their utility within the network.
- Encourage potential investors to seek independent legal or financial advice to fully understand the risks involved before making any investment decisions.
- Develop clear terms and conditions that explicitly state the purpose of the token, its limitations, and the absence of any promises or guarantees of investment returns. Ensure that potential token buyers have easy access to and understanding of these terms and conditions.
→ All this info can be implemented on the network’s website that is easily accessible to users and token buyers.