- Decentralized Autonomous Organizations (DAO) have grown rapidly in recent years. DAOs typically emerge around the management of decentralized financial applications (DeFi) and thus benefit from the rapid growth of innovation in this sector.
- Global regulators increasingly voice the intent to regulate DeFi activity. This may impose an excessive compliance burden on DAOs unless they are deemed sufficiently decentralized to be regulated. Yet, decentralization is an abstract concept with scarce legal precedence.
- We investigate dimensions of decentralization through thematic analysis, combining extant literature with a series of expert interviews. We propose a definition of “sufficient decentralization” and present a general framework for the assessment of decentralization.
- We derive five dimensions for the assessment of decentralization in DAOs: Token-weighted voting, Infrastructure, Governance, Escalation, and Reputation (TIGER).
- We present a discretionary sample application of the framework and five propositions on the future regulation and supervision of DAOs.
H. Axelsen, J. R. Jensen, and O. Ross, “When is a DAO Decentralized?” Complex Systems Informatics and Modeling Quarterly, CSIMQ, no. 31, pp. 51–75, 2022. Available: When is a DAO Decentralized? | Axelsen | Complex Systems Informatics and Modeling Quarterly
When is a DAO (sufficiently) decentralized?
- Compliance in crypto: Regulators view blockchain as transformational and imperative to innovation, growth, and global competitiveness. While crypto remains primarily unregulated, regulators across the globe are motivating and implementing crypto regulation to meet the challenge of ensuring consumer protection, innovation, and growth without stifling innovation.
- Decentralization: As the first major bloc, the EU passed the Markets in Crypto Asset regulation in June 2022 to become effective in Q1, 2023. If a DAO is sufficiently decentralized, it may be able to conduct otherwise regulated financial activity without compliance constraints such as capital, liquidity, and centralized control and reporting. Yet, no definition of decentralization is provided by regulators.
- Origins of decentralization: The concept of decentralization has been applied mainly within the government of nation-states and political science, administration, fiscal area, and environment, but also across a diverse range of disciplines, such as complex systems engineering, space safety engineering, cybernetics, management science, economics around principal agents theory, finance, law and technology, and crypto-economic systems. Within the nascent literature on crypto, the most applied definition of decentralization was proposed by Ethereum co-founder Vitalik Buterin with the introduction of the term “DAO” in 2013.
- DAO reference model: DAO tends to operate through bottom-up interaction and coordination among a set of independent and distributed rational agents, mitigating principal-agent problems through shifting power dynamics. Centralized attack vectors exist in multiple dimensions – in the protocol layer, the application layer, and the interface and user layers, through which a DAO community functions.
- As a working definition, we propose that “sufficient decentralization” is defined as a verifiable state, where (1) the design of the DAO is collusion resistant and based on long-term equilibrium; (2) its governance processes have unrestricted and transparent access.
- Given the pseudonymous nature of blockchain, it can be difficult to assess to what extent a DAO is decentralized. Through literature review and industry stakeholder and expert input, we investigate elements of decentralization across political, technological, social, and economic dimensions.
- Through analysis of how verifiably independent agents behave and interact with each other in critical DAO business systems, we develop a pragmatic framework for assessing decentralization
- The artifact was ex-ante field-tested with a DeFi expert from an EU financial regulator. Second, we applied the framework to assess the level of decentralization on Compound Finance, an algorithmic money market DAO operating on the Ethereum blockchain.
- We chose thematic analysis as a method to reflect and unravel the surface of the “reality” of DAO decentralization through eight expert interviews and literature review. We analyzed the data in six phases: (1) familiarize yourself with the data, (2) generate initial codes, (3) search for themes, (4) review themes, (5) define and name themes, and (6) produce the report.
- The coding procedure comprised several rounds of analysis and refinements of the codes. The topic of decentralization is multi-dimensional and complicated. In the search for themes, we clustered initial 52 first-order concepts across 7 DAO subsystems, 4 policy dimensions, and 4 technical architectural layers, further synthesizing these into 15 second-order themes across 5 aggregate dimensions. Once we had derived the first-order concepts, second-order themes, and aggregate dimensions, we built the data structure. Example of theme coding structure as follows:
- Evaluation was 2-fold: (1) ex-ante field testing with a DeFi expert from a European financial services regulator as well as (2) desktop study and assessment of algorithmic money market DAO Compound Finance, which operates on the Ethereum blockchain.
- To assess whether agents operate independently and if each critical dimension of a DAO meets the definition of sufficient decentralization, we define 3 types of agents (Verifiably Independent Agent (VIA), Presumably Independent Agent (PIA) and Unidentifiable Agents (UIA)
- We assess decentralization using a pragmatic framework with 15 components across 5 dimensions: Token Weighted Voting; Infrastructure; Governance, Escalation, and Reputation (“TIGER”) where we assess each component and the aggregate dimension either quantitatively (11 components) or qualitatively (4 components) assigning a score of 1-5, as exemplified below:
|Token Weighted Voting and Incentives|
|Token distribution at launch||Did the team conduct a “fair” token launch designed to balance incentives for further decentralization with requirements for long-term funding and investor returns?||Percentage of units allocated to addresses associated with insiders, including core-team members, advisors, investors, early collaborators, and service providers.|
|Promoting a non-collusive oligopoly||Does the DAO algorithmically incentivize multilateral participation by rewarding non-colluding groups of agents for strategic participation?||Percentage of units allocated to clearly differentiated stakeholder groups indicated by a misalignment in assumed preferences|
|The concentration of voting power||How distributed are governance tokens amongst active/passive stakeholders?||Number of VIAs required to mount >51% of voting power in majority voting schemes?|
- We present a cursory application of the TIGER framework, utilizing a score-card methodology in which we assign a score between 1–5 for each dimension. While there are clearly identifiable areas of improvement, we assess that the Compound DAO is “sufficiently decentralized” when we factor in the protocol age. Over time, we expect a gradually increasing decentralization as the protocol matures and increasingly larger private and institutional stakeholders join the DAO.
- From a regulatory perspective, an alternative approach could simply be to analyze (1) if the DAO is conducting a regulated activity, and if so, (2) if there is an accountable legal or physical person upon whom regulation can be enforced; if not, then the DAO being sufficiently decentralized must be acknowledged. In our view, such an approach is too simplistic and does not accept the fundamental premise that DLT/Blockchain is a transformative technology that will foster innovation and growth.
- We extrapolate our contributions into the following generalized propositions:
- P1: The concept of technology-neutral regulation is challenged by DLT/Blockchain. DAOs exist and realize benefits through increasing degrees of decentralization. DAO legal design should therefore support the internal decentralization accomplished by the DAO so that a balance is achieved between external and internal decentralization, not the other way around.
- P2: Regulators need to embrace the concept of a “grace period” for a DAO to achieve sufficient decentralization. The MiCA regulation did not include this, but it seems challenging to embrace DeFi and the concept of sufficient decentralization without it. We suggest an assessment approach where not only the point-in-time assessment is material to the decision of decentralization but also the design intent, thereby introducing a grace period from a risk-based perspective.
- P3: In the short term, for “Institutional DeFi,” a level playing field needs to be developed by financial regulators and supervisors, including a “cut-off” strategy, with clear boundaries for acceptable centralized activity, to allow DLT/Blockchain-based businesses to develop properly, respecting the new technological feature regime. Regulators must accept that a new playing field for DAOs will develop over the coming years.
- P4: Regulatory practices around DAO decentralization will evolve across blockchains and business models, each with its own strengths and weaknesses regarding centralized attack vectors and regulatory importance. A risk-based approach to DAO supervision, where required, will therefore need to be developed with a holistic view of decentralization across political, technological, social, and economic dimensions, as well as across underlying technology infrastructures that behave very differently from a risk perspective. We foresee regulators will designate some blockchains to have more systemic risk than others.
- P5: DLT/Blockchain will transform how regulators supervise and enforce the regulation. The number of DAOs grew by a factor of 8x in the past year. With the increasing certainty on the regulation of crypto, the number of DAOs will likely continue to evolve, and the growth of the token economy and innovation of blockchain-based business models as well. Regulators need to adapt to this development with improved toolkits, competencies and more automated supervisory methods.
- Our findings suggest that decentralization in DAOs is not a myth. Still, due to the technical features of blockchains, it can be complicated to investigate and assess the true level of DAO decentralization. Our contribution is a pragmatic framework that can guide aspiring DAOs, regulators, and supervisors to advance the decentralization agenda as the crypto and traditional economies increasingly overlap and integrate.