Sufficient Decentralization for Web3 Projects: A Legal Overview
In my first post, I provided a high-level overview of how to launch a token that is not a security.
As a recap, the Howey test is most often used to determine whether something satisfied the criteria to be an investment contract (i.e. a security). That test requires that there be:
- An investment of funds,
- Into a common enterprise,
- With a reasonable expectation of profit,
- Derived from the effort of others.
There are different approaches to launching a token that isn’t a security, including:
- Sufficient Decentralization, where the expectation of profit is not derived from the managerial efforts of a centralized entity (the focus of this post).
- Transfer Restrictions, where there is no investment of funds and/or no reasonable expectation of profit (the focus of future posts).
But what constitutes sufficient decentralization, and how do you know when you’ve achieved it?
The most widely followed playbook used by lawyers and executives on how Web3 projects can operate in a sufficiently decentralized fashion was written by Marc Boiron, when he was legal director of dYdX Trading. For this article I will summarize that playbook, and add additional observations specific to web3 and NFT brands.
Why Sufficient Decentralization Matters
Sufficient Decentralization is one of the established paths that Web3 projects can take under the Howey test to sell non-security tokens. Marc lays out the logic well:
In short, if someone reasonably expects to profit from a crypto-asset because of someone else’s entrepreneurial or managerial efforts, including the efforts of active participants, then the sale of that crypto-asset satisfies the final prong of the Howey test. But if that person reasonably expects to profit from the uncoordinated efforts of a broad range of people, that prong should not be satisfied; the protocol and the activities related to it should be considered “sufficiently decentralized” and no investment contract should be deemed to have been sold.
Sufficient Decentralization Takes Time and Effort
One of the challenges with sufficient decentralization as a token strategy is that it can be a lengthy and complex process. In order to satisfy the criteria, both the on-chain and off-chain activities must be sufficiently decentralized.
On-Chain Decentralization: There is no “one size fits all” path to on-chain decentralization as there is no clear delineation of when a project crosses the threshold. And the level of difficulty varies based on the type of project involved.
For a DeFi protocol with a native token, for example, one could measure on-chain decentralization by the number of active token holders, how many of those holders participate in governance (and how much decision making power is given to token holders), or how the token is utilized by the protocol.
In the case of NFT projects, it is particularly challenging to define and measure the level of on-chain decentralization. Do NFT trading volumes or number of unique holders accurately reflect the level of decentralization of an NFT project? Probably not, at least not well. For example, if NFTs are infrequently traded, is that a good fact (because the community is engaged) or a bad fact (because the community is disengaged). Is a project with a small number of unique holders decentralized? It may be impossible to tell simply from on-chain data.
Ultimately, the facts and circumstances for each project matter. There is no “one size fits all” approach to sufficient on-chain decentralization.
Off-Chain Decentralization: There are a host of off-chain activities that likely should be decentralized. Marc’s article lays out five:
- Protocol Development: is the community sufficiently involved in building the protocol?
- Business Development: are business development activities distributed to any interested party, with sufficient resources?
- Growth and Marketing: can the community drive their own marketing efforts?
- Intellectual property: have trademarks been abandoned or transferred to a community legal structure?
- Governance: does the community meaningfully participate in governance over the token and project?
Intellectual Property & Creative Development: For creative projects that launch a fungible token, they must also consider the extent to which the stories and narrative are decentralized. This concept relates to and expands on the IP thoughts discussed above.
One question a project might ask is whether the level of community feedback and ownership over the stories is sufficiently high? Are ideas sourced from the community? Are derivative fan works embraced? Or are creative decisions restricted to a few key members of the founding team?
Is Decentralization a Worthwhile Goal?
While there are many reasons a project may want to launch a token, there are fewer reasons to want to be decentralized. For some projects, like Ethereum, the benefits are obvious. For creative projects the benefits of decentralization may depend on the specifics of the project and the stage of the project’s lifecycle.
For instance, at the outset, a creative project may want to have control of the direction and narrative evolution. As we’ve established, tokens can provide a host of benefits given how effective they are at creating reward programs and providing community members additional utility. So how can a project unlock these benefits while being mindful of existing regulations?
In addition to sufficient decentralization, there are alternate paths projects can pursue to launch a token that is not a security, such as applying token transfer restrictions at the outset, which we will discuss in future articles.
Conclusion
Decentralization is hard, though it can also be very rewarding. It may seem overwhelming for projects just staring out. The path to sufficient decentralization can be progressive, allowing projects to take incremental steps towards achieving it over time, which is the topic we will focus on in our next article in this series.
Disclaimer: This post is meant for education purposes only, and is not meant as a substitute for legal advice.
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