The concept of progressive decentralization was first proposed in 2021 by several well-known Web3 VCs, including Variant Fund and a16z. The goal of progressive decentralization is to provide Web3 builders with a clear roadmap to guide their protocols toward a state of “sufficient decentralization”.

Why is achieving "sufficient decentralization" important for protocols? Several years before the first publications on progressive decentralization, a statement along with some case law materials and public comments from SEC officials appeared on the SEC website. They asserted that cryptocurrencies Ether and Bitcoin were recognized as outside the scope of securities laws, as they were issued as native tokens of blockchain networks that are sufficiently decentralized. In 2023, a similar approach was supported in the European Markets in Crypto-Assets Regulation (MiCA), which stated that fully decentralized protocols are outside the scope of CASP regulations. Since then, “sufficient decentralization” has become the market benchmark that most developers of decentralized protocols have begun to strive for.

However, building a fully decentralized or even “sufficiently decentralized” protocol from day one turned out to be nothing short of impossible. Instead, to achieve this, a gradual enhancement of the protocol’s state of decentralization is required. Enter “progressive decentralization". In this article, we will explore the concept to help Web3 builders understand exactly what each stage involves. We will also explore the legal works and requirements of each stage of a project’s gradual decentralization.

Stages of “decentralization” of the protocol

As previously discussed, Web3 builders strive for “sufficient decentralization” in their protocols for various reasons. These include addressing security concerns, making the protocol resistant to censorship, and notably, minimizing their own influence on the protocol. The latter is particularly crucial due to the legal risks it poses for protocol developers.

A basic rule of thumb for assessing the legal risks for Web3 builders is “The more influence on the protocol, the more responsibility for its operation”. A comprehensive risk analysis begins with evaluating the developers' position concerning protocol users, which is determined by their control over the protocol, namely:

1. Having significant control over the protocol positions developers as “insiders” and creates an informational asymmetry between them and users / the market.
2. This control fosters expectations among protocol users that the success of the protocol depends on the managerial efforts of a specific group of developers working on the protocol.

This situation creates legal consequences, wherein the group of developers may be recognized as a common enterprise. Additionally, the native protocol tokens might be deemed securities and the services that the protocol provides might be considered regulated activities. Therefore, builders who have chosen a strategy of centralization and control over the protocol may need to halt at this stage. For more information on the various legal strategies for Web3 projects, check out the first article in this series: How to Approach Legal Strategy for Your Web3 Project. Builders who are on the path to “centralization” will require a legal structuring roadmap that involves obtaining licenses, ensuring compliance, and establishing traditional financial compliance for their protocol.