The current state of affairs in crypto (and to a lesser extent, risk markets broadly), could be succinctly described as “devastating”. While there’s no question it has been a painful exercise when glancing at prices throughout most of the year, this type of market does come with a silver lining. Namely, it allows us to revisit first principles, and examine whether our underlying assumptions concerning the entire ecosystem still hold true. For this report, we are going to look at the concept of “decentralization” – what does it mean, is it a good thing, and whether various protocols actually are decentralized.
Let’s get a definition out of the way. What does it mean to be decentralized? Simply put, a good or service is decentralized if it is run by a collective of participants using majority rule. Conversely, when decisions are made by a singular entity operating with full control, such a system would be centralized. While such systems can certainly operate with efficiency, they are also susceptible to attack, as there is a single point of failure. Moreover, there may often be conflicts of interest between the service provider and the end user; due to the imbalance of power inherent in the system, this can lead to friction and corruption.
As it applies to crypto, the topic couldn’t be more critical. Bitcoin was born out of the 2008 financial crisis, in response to policies enacted by central banks around the globe. Several big banks had just been bailed out by governments using taxpayer dollars. Whether or not those policies were requisite, effective, or undertaken in good faith and judgment, goes well beyond the scope of this report – but it is worthwhile to understand the context in which bitcoin was created (and, in turn, the ethos of crypto as a whole). The programmers, developers, and initial users of crypto believed the use of taxpayer money to bail out banks for their own failed investments, as well as the manipulation of interest rates through quantitative easing efforts undertaken by central banks, was unfair to the citizens who had no say in the matter.
The intended benefits of a decentralized offering will vary according to the “service” being provided. Bitcoin’s intended purpose is to create a “peer-to-peer electronic cash system to enable online payments directly from one party to another” (from the Bitcoin whitepaper). The centralized legacy system it seeks to replace, the fiat monetary system, is controlled by the various central banks that exist all over the world. A decentralized currency gains its value from the people who use it, and is not reliant upon any bank, authority, or third-party to function or exist. There are no gatekeepers; a user isn’t susceptible to a bank failure; payments are borderless; the monetary policy of bitcoin is immutable, with a fixed release schedule and capped supply; you only need access to the internet to create a wallet, as opposed to jumping through the numerous hoops necessary for opening a bank account (a much bigger issue in third world countries than one might think).
Ethereum expanded the scope of blockchain technology by implementing fully programmable smart contracts. It seeks to provide a platform for decentralized applications to build upon – it’s the main universe where “web3” is being built. Conceptually:
Web1.0 = read
Web2.0 = read and write
Web 3.0 = read and write and own
As such, the theoretical benefits of a decentralized protocol such as Ethereum will differ from that of Bitcoin. The key idea of Web3.0 is returning ownership and control of a user’s data, back to the user (rather than allowing centralized providers like Google, Facebook, etc. to profit from user data by selling it to advertisers). By creating and owning your digital identity and data, the possibilities of what can be achieved therein start to grow endless. Decentralized applications, or DApps, are being built and deployed across all types of industries. And because they are decentralized, these apps are “permissionless”, meaning no central authority can decide who is or isn’t allowed access. This is a major development that will go a long way towards eliminating prejudicial biases that have existed for decades, if not centuries. Additionally, since data won’t be controlled by single entities, we will see less corporate and government censorship, as well as a decrease in denial of service (DoS) cyber attacks.
While the benefits of a decentralized currency and web are numerous, there are some drawbacks. Namely, centralized entities can make decisions more rapidly, and generally in a more cost-efficient manner. This also allows centralized systems to scale quickly compared to their decentralized counterparts. One of the main challenges a blockchain enterprise faces is called “The Blockchain Trilemma”, dubbed by Ethereum cofounder Vitalik Buterin. Essentially, developers have three core concepts they must weigh against one another as they build: (1) decentralization (2) scalability and (3) security. As one is optimized, the other two can be compromised. It will be interesting to see how different platforms approach this problem and is partially why we at GBG believe we will one day live in a multi-chain world, where different chains offer different solutions for different needs.
The next question becomes “how is decentralization measured?” The answer is multi-faceted, and depends upon the consensus mechanism of a protocol. But it’s important to note that decentralization is a spectrum, not a binary property. For proof-of work blockchains, one measure is the hash rate (i.e. how much computational power per second is used by mining…or how difficult is it to win the mining race). However, you also need to look at the distribution and number of entities that are actively engaged in mining. A higher distribution of hash rate among a larger number of pools is preferred for decentralization.
For proof-of-stake blockchains, decentralization can be measured using the number of stake pools or validators, the token supply distribution across those pools, and the percentage of token supply that is currently staked. If that last number is too low, the easier it becomes for a bad actor to disrupt the network. It’s also worthwhile to examine the initial distribution of tokens to early investors in private sales.
For both types of chains, you can also look at ongoing governance and development initiatives. A decentralized protocol should be a place where improvement proposals can be submitted by anyone, and community-accepted updates are implemented quickly. In other words, the process of making changes to the protocol should be as democratic as possible.
Next week we will assess the levels of decentralization that various major protocols and applications are currently exhibiting.