The Value of Decentralization in Blockchain Technology
When is decentralizing on a blockchain valuable?
At the center of this analysis is the “locked-in effect.”
The concept of the "locked-in effect" suggests that users often find it difficult to leave a network once they have joined due to various reasons, such as switching costs and the personalization of algorithms. Business owners may be tempted to exploit this effect to increase profits, but they risk losing users who do not want to be taken advantage of. To prevent this, users may demand compensation upfront or refuse to join the network altogether. However, using a blockchain allows for decentralized governance and credible commitment to monetization decisions, which can alleviate user concerns and encourage participation in the network.
Therefore, decentralization through a blockchain is a viable option for businesses facing a strong locked-in effect.
Should you decentralize at the start?
Let's consider two edge cases.
In the first case, suppose there are no locked-in effects. This means there is no disadvantage to centralization since the lack of commitment not to exploit users in the future does not exist. In this scenario, centralization is generally preferred, especially if locked-in effects are very small.
In the second case, suppose locked-in effects are significant, making it difficult to attract users to the network due to the threat of future exploitation. Even offering monetary compensation or not monetizing the network during the growth phase may not be enough to overcome this threat. In this scenario, decentralization is clearly preferable as it allows users to participate in the network without the risk of future exploitation.
At what time should you decentralize?
It is common to start with a centralized network and gradually decentralize it over time. However, delaying the decision to decentralize can lead to a commitment problem, as the network may become too large and profitable to surrender control. It may be beneficial to delay decentralization until the commitment not to exploit users has become sufficiently valuable. It may also be advantageous to retain some degree of control over the network while it is being built. Still, decentralization must happen before the temptation to increase profits by retaining control becomes too large. Gradually distributing governance tokens over time can help reinforce the desired commitment. Regulatory considerations also influence the timing of decentralization and token issuance.
If you liked this post and want to learn more on this topic, make sure to read a16z’s article.
Reminder: None of this is financial advice. Do your own research.