Layers Of Decentralization
In todays globalized world, centralized web2 players take an ever more important part in our lives. By using the data their users give away eagerly and with consent, they are able to influence which news we read online, which content we consume, which ads trick us into buying things we don’t really need and many other business models. The vision of a decentralized web3 challenges business models of data-driven internet giants. It aims to give back data ownership to individual users. Unfortunately, decentralization in itself does not only bring benefits to users. It also comes with a whole new set of challenges, risks and attack angles.
Exploiting a concept.
Decentralization is occasionally being used as a keyword or concept to cover up projects embedded within a global grey zone of anonymous “DAOs” that are trying to evade any form of legal responsibility for damaging and self-enriching behaviour, or to straight up exploit the lack of legislation to set up and commit fraud. Rug Pulls and deliberately installed backdoors to exploit, hack and steal users assets are unfortunately not an isolated instance in the world of crypto assets.
One of the most famous and blunt cases was the (claimed to be) “decentralized and trustless network” Squid Game Token. Claiming to be part of a bigger soon to be launched blockchain gaming application, it created an immense wave of hype. Even mainstream media fired it up, and eventually it ended up as a massive rug pull when user noticed there was no way to exit from the project and all of a sudden the liquidity pools were drained. But how can such a disaster happen with a “decentralized” and “DAO governed” project?
What is “Decentralization”?
The three main pillars of blockchain technology are immutability, transparency, and decentralization. Even though all of them are in the end equally important to the concept, the decentralization pillar is often misunderstood. Digital assets tend to be (if we count out certain outliers such as Tether or very early stage projects) decentralized. That simply means that a certain number of validators draw a blockchain consensus. That effectively eliminates “centralized” counterparty risk and exploitation by this centralized entity.
Despite most commonly known digital assets formally being decentralized, there are big differences in their level of decentralization. Decentralized Autonomous Organisations (DAOs) serve as a backbone for the decentralized economy. They receive a lot of attention in the sphere of decentralization and decentralized governance. Decentralized Autonomous Organisations have formed more or less naturally and gained attention as a response to very high counterparty risk in the poorly regulated and supervised digital asset ecosystem. A good example of counterparty risk that has caused a sizeable financial woe to investors is the recent case of FTX. In this case customer assets were either gambled away or seized in bankruptcy proceedings.
What the concept of DAO is trying to do differently is that it allows full transparency over the whole project. That includes treasury of foundations, staked assets, assets bonded in smart contracts, and self-custodianship over personal assets. You can interact with open and transparent protocols. You can also commit to changing and improving the product. However, the private keys remain under your control.
Centralization risk of Decentralized Autonomous Organizations
Even though DAOs are here to reduce counter-party risk and create trustless networks managed by an open and transparent governing body, sadly cases like Squid Game Token are still happening due to their close connection with the projects and the lack of decentralization at their core. Decentralized Autonomous Organizations function on a basis of vote proposals and voting to apply changes on the blockchain. The more assets an individual has staked, the more votes the individual has. As DAO functions on the Proof of Stake mechanism. One or a few stakeholders can highly centralize the voting power by making the whole protocol centralized in its core.
In case DAO governs the protocol, but de facto has highly centralized voting power on a single entity, the entity can run changes however they see fit. Liquidity pools can be drained, rewards can be locked, and tokenomics proposals can be rigged in the favor of the controlling group.
Not every ‘relatively centralized’ DAO intends to engage in fraudulent behavior
The main problem with a high level of decentralization is, besides the fragmented thus slower network, the cost to run the network. Decentralization requires a higher number of validators. They will need a financial incentive to run the hardware, as well as stake themselves or in delegated PoS attract (aka share financial incentives with) a significant sum of assets to become qualified validators. The cost is a primary reason why a lot of projects opt for a more centralized type of governance until the project gains sufficient traction and becomes self-sustaining with a larger number of validators. Once the project has sufficient traction and revenue generation, it is financially feasible to keep the high number of validators content and committed to the project.
The best alpha potential lies with early-stage projects. These projects tend to be more centralized due to limitations in sharing financial incentives with many validators. Therefore, filtering out good and harmful projects is crucial.
In the beginning of the project, high level decentralisation allows the team to fix the issues and add features far faster than it would otherwise while operating much leaner. But there is always this risk of things going in the wrong direction. The path between an “efficient” early stage, and centralization being too high of a risk can be very narrow.
The way one can reduce this specific potential risks is to perform a strict due diligence process. This process consists of deep research of numerous parts of the project. KYC of the team behind the project, genesis token supply distribution, governance functionality design, decentralization ramp up roadmap, tokenomics proposals, governance proposals, initial asset distribution plan, and many more. Anybody carrying out this type of DD could have easily avoided falling into a trap such as Squid Game Token.
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Author: David Teufel