Decentralization in dApps vs L1
The benefits are quite different.
In the previous section, I pointed out that the current approach toward progressive decentralization falls short of what is required. In this section, I will go back to the fundamentals and examine what decentralization in the dApp layer even provides.
Decentralization in decentralized applications (dApps) and Layer 1 (L1) protocols is a topic that often receives attention, but the nuances and differences between the two are rarely explored in depth. To truly comprehend decentralized governance, we must first examine what decentralization means for both L1 and dApps, and whether the trade-offs involved are the same.
When an L1 is decentralized, block generation and validation are conducted by a large number of independent validators or miners, which are geographically and jurisdictionally diverse, and use a variety of software and hardware solutions. This offers benefits such as censorship resistance, heightened security and liveness guarantees, and improved data availability due to fault tolerance.
For dApps, decentralization provides drastically different benefits. First of all, for a dApp, it does not need to worry about any of the issues listed above (immutability, trustless computation, data availability, and censorship resistance) because the L1 takes care of that. And it is the reason why Ethereum was built in the first place - so protocols do not need to rebuild the base layer over and over again (Ethereum Foundation, 2016).
For dApps, however, decentralization provides a distinct set of advantages. Since the L1 takes care of aspects like immutability, trustless computation, data availability, and censorship resistance, dApps can focus on other elements. Decentralization in dApps is often discussed in the context of regulatory compliance, with token distribution playing a key role in avoiding classification as a security.
Decentralization in dApps can deliver a combination of the following benefits:
Regulatory shielding for continuous operation and innovation.
Removing platform risks.
Legitimacy preservation.
Regulatory shielding for continuous operation and innovation
Adopting a decentralized governance and operational framework makes it more difficult for regulatory agencies to stop a project's operation, enabling continuous innovation. This is especially relevant for DeFi protocols, where lending and borrowing, exchanges, and stablecoin issuance are heavily regulated businesses in many jurisdictions. By decentralizing the operators across different jurisdictions, DeFi protocols can minimize single points of failure within the organization to achieve higher liveness guarantees, similar to an L1. Decentralizing the governance process to numerous token holders behind pseudonymous addresses also enables DeFi protocols to move the controlling organization from a single jurisdiction to an on-chain DAO.
Removing platform risks
Decentralizing governance and distributing control to various platform participants can help minimize the risk of a platform acting against the best interests of its users (Jesse Walden, 2020; Marc Boiron, 2022; a16z, 2022). In the Web2 world, platform risks are materialized when platform participants feel the platform is no longer serving their best interests, as seen in cases like Uber and its drivers, Apple and its 30% take-rate, and Amazon and Amazon Basics.
In crypto/web3, builders have hypothesized that removing platform risks could be done by decentralizing the governance process by distributing governance of the protocol to different participants on the platform. This is demonstrated through examples like Uniswap and Lido, which have implemented decentralized governance structures to create checks and balances on the platform itself. Uniswap distributed its governance token across swappers, liquidity providers, and the development team (Uniswap, 2020). Specifically, 5% is distributed to liquidity providers and 10% is distributed to swappers - while the team and investors hold 40%. Lido, a decentralized staking solution, instead of distributing its governance tokens to its depositors, is planning to give its depositors specific governance power around vetoing.
The goal of these decentralization efforts aims to increase the efforts needed by the platform to move against other participants, serving as a check-and-balance on the platform itself. In the L1 world, similar mechanisms exist to limit miners’ power on the system through user-activated-soft-forks (UASF).
Legitimacy preservation
Decentralizing the governance of a dApp can enhance its legitimacy, facilitating more effective interactions among various parties. Vitalik Buterin defined legitimacy as a pattern of higher-order acceptance, functioning as a coordination mechanism in human collaboration.
Take Uniswap V2 as an example: its legitimacy allows liquidity providers and swappers to coordinate on the blockchain. Uniswap V2 operates under the General Public License (GPL), which means anyone can copy and commercialize the code without consent from Uniswap. So, how do swappers and liquidity providers coordinate using this particular piece of code deployed by Uniswap, rather than an alternative version? The answer lies in legitimacy. By establishing legitimacy, swappers and liquidity providers can agree on a social level that if they both utilize the Uniswap V2 contract, they can both benefit (swappers obtain better execution and liquidity providers earn more fees). Note: Uniswap V3 operates under a Business Source License (BSL) 1.1, which incorporates copyright law and allows Uniswap governance to restrict unauthorized commercialization of an entity's source code for two years.
While the use of the Uniswap V2 contract involves more than just the legitimacy derived from decentralization, by relinquishing control, the protocol can gain greater social legitimacy in the long term (a16z, 2022). Decentralizing the decision-making process among multiple stakeholders and parties means that the public perceives decisions passed through the governance process as more fair and neutral.
As a result, decentralization in dApps can help preserve their legitimacy over time, acting as a defense mechanism against the open-source nature of these protocols.
Coming next…
Having distinguished the different benefits of decentralization in L1 and dApps, it is also important to consider the trade-offs of decentralization in the context of a dApp. The decentralization trade-offs in L1s are well-documented as the blockchain trilemma, which posits that decentralization comes at the cost of scalability—the more decentralized a network is, the less scalable it becomes. However, in the context of dApps, the trade-offs are less well understood and documented.
In the next article, I will explore the trade-off of decentralization at the dApp layer and what it means for dApp builders.