What makes a Web3 project decentralized?
Complete decentralization of operations is at the core of Web3 companies. That decentralization has several characteristics, including:
- absence of centralized administrators, moderators, and managers. In comparison, directors and shareholders would be those centralized managers in Web2 companies;
- lack of centralized servers, hostings, and domain providers, as the viability of a Web3 project is ensured by decentralized blockchain networks; and
- ownerless and permissionless principles, woven into the essence of Web3 ventures, making the latter autonomous and independent to the highest possible degree.
What are smart contracts and the “on-chain entity'' in Web3 projects?
Smart contracts are autonomous software algorithms comprising Web3 projects and functioning within blockchain networks like Ethereum, NEAR, or Solana. Typically, a Web3 project will consist of several smart contracts, each responsible for a particular process within the Web3 company. For example, these smart contracts could:
- enable transactions or swaps of one virtual asset to another;
- issue tokens and support tokenomics by performing additional issues and burning tokens;
- accumulate the Liquidity Pool and hold the Reserve Fund to guarantee that tokens are backed; or
- generate Treasury, which is used to support the ecosystem and issue grants.
Because a system of smart contracts “lives and works” within a decentralized blockchain network it is also referred to as an “on-chain entity”.
What is off-chain management in Web3 projects?
The ultimate goal that founders of Web3 projects are trying to achieve is to make their Web3 project as autonomous and decentralized as possible. However, in the early stages of development, it is practically impossible to do this, because many concepts and aspects of the project still need to be tested. In order to have the flexibility and ability to iterate quickly, one would need to manually intervene with the operation of smart contracts.
From a technical standpoint, such an intervention is available to those Web3 project participants who hold the private keys to the smart contracts that make up the project. And because this type of intervention originates from the outside (centralized) world, it is referred to as off-chain management.
What does the off-chain management of Web3 projects include?
Off-chain intervention in the operation of smart contracts is possible in the following situations:
- issuing additional tokens or burning some of the tokens issued before;
- amending smart contracts’ rules of operation, in particular, changing the commissions that smart contracts take from each transaction for deductions made to the Treasury;
- increasing the Liquidity Pool and/or Reserve Fund in case either the price or liquidity of the token is threatened;
- managing the Treasury by issuing grants to ecosystem participants.
At the dawn of the Web3 project, founders hold the private keys allowing them to make changes to smart contracts. However, when the main hypotheses have been tested and the necessary changes have been made, most Web3 founders start to prepare to transfer off-chain management rights to the participants of the Web3 project ecosystem, thus decentralizing its governance.
What makes up the decentralized governance design?
When Web3 founders are ready to decentralize the governance of their project, they need to develop a “design” for that decentralized governance. The founders need to answer the following questions to reach this goal:
- Which of the Web3 ecosystem participants will receive governance rights? For example, all the ecosystem participants holding tokens or only specific categories of contributors?
- What method of issuing voting rights will be pursued in the project? For example, providing voting rights to the participants who staked their tokens and received Liquidity Pool (LP) tokens or issuing separate governance tokens?
- What types of decisions can be made through decentralized governance?
- What is the procedure for making such decisions, including how proposals are published, which bodies organize voting, and which bodies ensure the implementation of decisions?
- Which document regulates decentralized governance, in other words, which document makes voting legally binding?
Forming a DAO with a Legal Wrapper
After developing the concept of decentralized governance for their on-chain entity, the Web3 founders proceed to organize a group of people to participate in the project’s decentralized governance. An on-chain entity, backed by a decentralized community of people managing it, is called a Decentralized Autonomous Organization (DAO). In turn, this makes members of such a community DAO members.
Before launching a DAO Web3, founders need to take care of two things:
- legal protection of DAO members who will participate in the decentralized governance of the project; and
- preparing a legal document that will set the rules of decentralized governance.
To tackle the first task, it is necessary to create a Legal Wrapper for the DAO, which will act as a “legal shield” for the DAO members and protect them from unlimited liability resulting from the DAO’s activities. The second task is solved by preparing a DAO Constitution, which reflects the project’s decentralized governance principles. Its provisions are subsequently used for the statutory documents of the DAO Legal Wrapper to make the process legally binding.
Disclaimer: the information in this guide is provided for informational purposes only. You should not construe any such information as legal, tax, investment, trading, financial, or other advice.
Nestor is a Co-founder & Head of Web3 Legal at Legal Nodes. Having over seven years of legal consulting experience, Nestor loves working with innovative startups and Web3 projects, helping them navigate the regulations and scale on global markets.