Why Sufficient Decentralization Is No Longer Sufficient | Jesse Walden & Jake Chervinsky - Variant

everybody thank you so much for sticking around to the last panel um so my name is Tracy I was a former deputy edit editing Deputy managing editor at coindesk and now I'm a contribut writing as contributor contributing writing writer Rolling Stones excuse me um but we have two lovely panelists I'll let you introduce yourselves and also uh kind of tell us a little bit about your background um the VC fund that you work for and also um to for all of us that are uh staying around this late uh drop some Alpha on this panel okay um hi everyone I'm Jesse I'm the co-founder and general partner at variant we are an early stage crypto fund um we are investing in an Internet that makes people owners um and we do that across the full stack our focus is early stage investing so we try to be the first check in to help Founders go 0 to one in in crypto um and quick back background I got started in crypto about a decade ago as a Founder I co-founded a startup called media chain evidence in the name media chain we're focused on digital assets of of a different kind not Financial assets but today we call them nfts was a little early uh that company was acquired by Spotify and um I got into investing by joining Andre and harwitz and helping them to launch their first crypto fund and then started variant to focus on very early stage investing so that's my quick background and a little on variant and Jake awesome uh I am Jake trinsky I am chief legal officer at barant uh my job other than managing all of the firm's legal work uh is to help our portfolio companies you know our Founders and their lawyers navigate the very complex legal and Regulatory landscape here in the United States and around the world um I got my start in crypto in about 2017 at the time I was outside Council uh at a law firm focused on Regulatory Compliance and government enforcement defense uh mostly focused on the SEC and the cftc uh I then went full-time into crypto in 2019 uh as general Council for compound Labs uh where I led the you know legal work for Distributing the compound governance token and decentralizing the compound protocol uh and then spent about two years as head of policy for the blockchain association which is our industry's largest and most effective trade Association in Washington DC so trying help figure out what good policy for crypto looks like so that's me okay so the topic of our panel is decentralization and just walking around the booths you you see it on all these um banners as kind of like a buzzword right a decentralized AI decentralized Finance so let's I guess first start with what is decentralization to you if you could Define it if there are different types of it and the second part of this question is why is it so important for projects to be decentralized and I guess we'll start with you Jesse sure so yeah so it's a loaded term um decentralization right so what what is it right well I think everyone here has a has a good idea that you know things networks like ethereum like Bitcoin they the reason they exist is um they are these distributed compute networks that run on Independent machines all over the world and the these compute networks they have really sort of important properties they provide security guarantees and sensor sh resistant resistance and so that's you know that's that's the benefit of decentralization and on top of networks like ethereum you can build applications um and you know I I think the term decentralization gets dragged all the way up the stack to everything that people can conceive of building on these things and there's a reason for that and I I think the reason is in large part um because of the regulatory environment that we're we find ourselves in in the US here where where about four years ago or 2019 Bill Hinman said eth is not a security because it's sufficiently decentralized and henceforth the entire industry has tried to sort of run through this door of sufficient decentralization um but but I would make the claim that that's actually not great for a huge swats of projects building in the space particularly those building at the application layer where Progressive decentralization is is probably more optimal yeah I I mean I totally agree with that I guess to add a bit on the regulatory side when I think about decentralization what I think it means from a legal perspective is the absence of any one Central party who has outsized influence in an ecosystem or a protocol or some other blockchain based product or service such that it makes sense to regulate them because of whatever risk they create in that ecosystem so when we talk about sufficient decentralization really what we mean is having a an ecosystem or some other type of protocol where there is no party like that where regulation is Justified and that really was as Jesse said what uh what Bill Henman said when he initially used the term sufficient decentralization he said when you look at ether today there is no Central party who should be forced to make disclosures or otherwise comply with the Securities laws because there is no one party that has privileged access to information or some other role in the ethereum ecosystem so we've taken that same concept and tried to apply it to a lot of other different types of of protocols and products I think what we'll get to next though is this isn't a perfect way to solve the regulatory challenge that we face it's also not the only way to solve that regulatory Challenge and I think we've over indexed on sufficient decentralization as the only way to navigate that issue when we don't need to do that got it okay so what are some other ways to kind of satisfy the regulatory considerations that don't necessarily pertain to decentralization it does seem like we've kind of taken it too far a bit well so I can I'm going to posit a wishful thinking answer and then I'm going to let Jake posit the the actual answer or or or some potential actual answers so okay the wish The Wishful Thinking answer I like to draw an analogy to um the you know to to policy that emerged in the early as at the Advent of social media you know so as platforms like YouTube Facebook Instagram came online there was a whole swath of problems related to copyright law as you can imagine like user generated content kind of blew open the you know the the problem of copyrighted material propagating the internet at lightning speed um and what happened in response to that was regulation was passed the dmca regulation which is imperfect but it kind of came up with a protocol an adaptation of the copyright law laws for this new reality of user generated content on the internet and this this protocol the dmca compliance protocol it's basically like copyright light it's it's a way for platforms to deal with copyright copyrighted material on their platform without like getting sued to Oblivion um and similarly I think what we what I would love to see happen is um an adaptation of the Securities laws for the this new reality that we find ourselves in today where we have user generated assets so user generated content dmca we need dmca equivalent for user generated assets um and you know what so what what specifically might that look like well I think if maybe if you comply with some standards like your application runs on a smart contract platform that's public and the code's open source there's no information asymmetry which is the primary thing that the Securities laws are trying to get at and so you can comply with this kind of Securities Law light framework um and basically not have to file on S1 but this this kind of protocol would allow teams that are contributing to these projects to stay involved as opposed to stepping back like we've seen many projects in the space have to do in order to sort of fit this mold of being sufficiently decentralized as Jake was describing so that's that's my like wishful thinking you know idea yeah but uh I mean I couldn't agree more from a policy perspective I also sadly agree that it's wishful because that's not what the law is today and we heard commissioner Pur about an hour ago talk about this and I think the the sort of sad thing is this would require a change in the law either through Congress like the dmca which was legislation passed through Congress or rul making like the token Safe Harbor that commissioner Pur herself proposed which really addresses exactly what Jesse was saying right there is some risk the risk is an information asymmetry between the creator of a token and the holder of the token we will then require the creator of the token to make reasonable disclosures in order to address that risk that makes perfect sense unfortunately the current view of the SEC is not to allow that to happen and it's it's a political decision as much as it is a legal or or policy decision so I guess to get back to the to the question um and maybe to drop a little bit of of Alpha as you said at the end of the day here let me maybe give you sort of a a a theoretical framework conceptual framework for how to think about addressing regulatory risk either with decentralization or or without it whenever you think about a regulatory challenge you have to make a decision between two different options option one is comply with the regulation right look at the law and figure out what does it require you to do is it a registration requirement is it a licensing requirement is it some other type of due diligence requirement and then see if you can satisfy that requirement directly uh under the law the second way of doing this is to structure the product or the protocol or the service in a way so that the regulation doesn't apply at all all so you don't have any compliance obligations to begin with so every product has to sort of pick one of these two different options and when we talk about something like a registration regime under the Securities laws unfortunately it just does not work for the distribution of a token because tokens cannot be Securities and also trade in a decentralized permissionless environment so instead what we have to do for token distribution is figure out how do we make sure that tokens are not Securities right this is the issue we all talk about way too much um when you think about that sufficient decentralization as we've been discussing is one way to make sure that the Securities laws do not apply by negating right knocking out one of the four prongs of the hoe test well it's not the only prong that you can knock out and the other way that folks tend to distribute tokens is through airdrops and airdrops do not depend on decentralization at all an airdrop has nothing to do with sufficient decentralization an airdrop attacks a different prong of the hoe test the requirement of an investment of money and this makes sense because from a policy perspective again the reason the Securities laws apply is to protect investors if you have no investors then there's no reason for the Securities laws to apply so this is just one example of many where you can look at what the legal or regulatory requirement is and then figure out how to make sure that you do not create the risk that justifies regulation in the first place and you can do that all across various regulatory Frameworks that we deal with every day MH uh we'll eventually also talk about best practices but but just to kind of continue with their point um about kind of the two paths and one path could just be having the Securities laws not even be applied to you and so I do think if you've been in crypto for a while you've seen a lot of um industry practices that maybe a newcomer would scratch their head and and think hm why why are things like this and and I'm going to name off a few uh you know uh most protocols sometimes are are run by a Dao a decentralized autonomous organization um some sometime in the past two years I remember people stopped giving themselves titles and they were just call themselves contributors or core contributors uh and um you know uh entities would have kind of be this uh the the governance the structure of the organization would have like a Labs or Foundation component it was all very confusing because sometimes the names would not even be related and so it seems like all of these practices kind of were to uh decentralize The Entity or or what maybe some more cynical people would call decentralization theater and so maybe you guys can talk about kind of did any of this actually uh you know get towards the goal that they were trying get uh reach the goal that they were trying to kind of achieve and kind of what have we learned from kind of these experiments and and these structures so I I'll take a quick quick step so earlier I was saying you know decentralization at the base layer is a requirement it's the whole value proposition of networks like ethereum but we've dragged that all the way up to every application building on top many of which have launched Dows many of which now have a for-profit company and a nonprofit Foundation um and and this I would say in this is problematic for a number of reasons the primary reason being that for many of these projects especially building at the application layer if you're you know a startup you're looking to capture lightning in a bottle find product Market fit only thereafter do you really want to um sort of turn over control of the product of the community because once you do that you slow down your rate of progress quite a bit because you have to start making decisions by committee and the founders have to step back and start calling themselves contributors as opposed to Founders um and just basically be less less involved and and when you have lightning in a bottle or you're trying to catch it the last thing you want to do is slow down um so this is why it's sort of I would say kind of problematic um and you know the solutions that we've sort of seen in the space are you know let's take Dows as an example right Dows are meant to be decentralized but in practice many Dows the way they function is through some kind of hierarchical decision-making process delegation is the most popular one right where there are delegates in the ecosystem it's not quite a corporate entity but there's still kind of a hierarchy to decision-making because that's the really the best way we've figured out how to how to scale human decision- making over many millenniums of trying different things um and so I think it's important to just draw a contrast there are you know networks and and sort of uh protocols in crypto that are fully automated where no human decision- making is required like ethereum at the base layer there's rough consensus among the you know the devs at this conference on the direction of ethereum but the protocol itself does not have any humans in the loop there's protocols up the stack like Unis swap where there's no humans in the loop and then there's protocols that require Dynamic kind of parameterization where they there need to be humans in the loop making decisions and for those types of of projects I think you know decentralization can Al often slow things down quite a bit at the wrong time um so so I would say that you know that's on on on the back to your question what's worked and what hasn't worked I'd say um you know Dow governance in large part I think um is suboptimal for the vast majority of projects um that that jump into it too soon and and we want to find a way to kind of push that out um and let let the sort of Founders and core core people in these projects you know contribute for longer um I I totally agree with that and I I think um that is in a way a good description of the term that Tracy used which is decentralization theater and I I think it's important to talk about that just a little bit because I think what a lot of people do is they ignore the way that I again think about decentralization which is the absence of some Central party that has some privileged role in the ecosystem and what they want to do in the scope of decentralization theater is pretend like they are not playing that role but then continue playing that role anyway usually for regulatory purposes but sometimes also for Community signaling purposes or or other reasons and I think that that is a huge mistake just like Jess said both operationally I think it causes a lot of problems at a point when it is not necessary when as a Founder you need to be building as opposed to dealing with a community of token holders who are causing headaches for a bunch of reasons um and also like I said it's it's not always necessary so and I think that ultimately if you have conversations with Regulators your attempt to pull off decentralization theater will actually give you more trouble in the end than just being honest about what you're doing so I think I think for me to to go back to the question what has worked I think what has worked is being very honest about what you are doing and why and that includes when it comes to deciding whether and when you want to decentralize so to me decentralization is a trade-off right it's not all good I think in the industry because we love decentralization and it is indeed at the core of what we're doing we treat it as though it is sacred and always applicable and that's not true decentralization means means you will be very inefficient and very slow in exchange for being perhaps very secure or aligning incentives so that you don't have one group of people taking advantage of another group of people this is sort of the web 2 issue this is why I think a lot of us are here in the first place where we saw these large tech companies that were basically victimizing their own customers for the benefit of shareholders and part of the idea of decentralized governance is to to say it is the people who will be affected by these decisions who will also make those decisions it doesn't mean that it's going to be efficient it's intentionally going to be inefficient right the best example of decentralized governance that we have before crypto is the United States Congress if you've spent a minute looking at the United States Congress you can see it is not efficient it is very slow it almost never gets anything done and that is by Design so I think what works is know why you are decentralizing Embrace that tradeoff and then you know don't look back once you sort of make that decision to go from efficiency into inefficiency okay I think we have time for one more quick question um so we might have some Founders in the audience that are that could be potentially thinking about starting a project or launching a token what is one piece of kind of very useful practical advice that you would give them so I I think Jake just hit it hit on it but you know Progressive decentralization as opposed to sufficient decentralization which which basically implies do it step by step at the right time um and you know the pursuit of sufficient decentralization may not be the the only thing or the only path to align incentives with users and and spur growth and and so that's my quick take yeah I agree and with 15 seconds left I guess all I would say is don't let regulatory uncertainty or mean words from policy makers scare you out of doing the work that you want to do or out of doing it here in the United States there are ways that you can do that and that's what we are working on right now to help people do the business they want to do in a safe and compliant way here in the US and I think we can do that all right thank you so much let's give our panelists a big round of [Applause] applause thank you so much have a wonderful night good seeing you again