<aside> <img src="/icons/info-alternate_blue.svg" alt="/icons/info-alternate_blue.svg" width="40px" /> 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.
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<aside> <img src="/icons/error_gray.svg" alt="/icons/error_gray.svg" width="40px" /> 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.
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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:
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.
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.
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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.