Most of the rules by which popular blockchain projects operate involve a number of trade-offs in terms of decentralization. In return, participants receive more customized and useful solutions.
Decentralization is a key feature of cryptocurrencies. The absence of a regulator or “node” that makes its own decisions, in theory, makes it possible to build an alternative finance culture. This is a collective bargaining model – only the majority of voluntary network participants can confirm transactions. The state i.e. issuer, value guarantor and supervisory authority is absent.
The decentralized network code has its own rules of the game. For example, the procedure for the issuance and payment of prizes, the presence and frequency of halving, block size, etc. repaired. If, for some reason, these conditions change, then a hard fork is carried out – the main way of leveling contradictions in the relationships of network participants.
According to Buterin, a decentralized network has three advantages. First, it is fault tolerant, because failure of all components is unlikely. Second, resistance to attack, given its high cost and complexity, is more effective. In addition, decentralized networks are more successful against collusion: it is difficult to “make” networks work for minorities.
It is possible to get rid of one “trusted person”, to some degree, due to the blockchain architecture – a special case of distributed ledger (DLT). However, the use of the technology itself does not guarantee a high degree of decentralization.
The size of the “independence” of the token is determined by the specifications of the source code, certain rules of issuance and circulation, the scheme for reaching consensus, the rights and abilities of network participants, etc. In practice, there are a number of complaints about most cryptocurrencies.
Each token is “decentralized” in its own way
Bitcoin, the first cryptocurrency and the first use case for blockchain technology, is often considered the benchmark of decentralization. There is no master node in the network, no organization or individual controls the operation of the system and token issuance. The basic principle of operation is defined in the source code. Anyone can make a knot.
However, questions also arise about the decentralized format of the bitcoin network. First of all, more than half of the hash rate over the past year has been concentrated in the hands of a few companies with Chinese roots. Currently, the mining market is oligopolistic. This has the potential to open up the possibility of collusion and 51% of attacks against the network.
Anyone can really make a knot. However, with today’s network complexity, it takes hardware that is strong enough to compete for new tokens. This creates a barrier to market entry.
In addition, it is believed that Bitcoin Core client developers have a centralized influence on the network. Nikita Zhavoronkov, founder of Blockchair blockchain columnist and course instructor at MIPT, wrote about this, in particular. Moreover, in his presentation against the Taproot update, he claimed that the developers were promoting this innovation for their own benefit.
The decentralized bitcoin network has another drawback. In the maintenance process, users are faced with functional limitations. Transaction processing speed is not high enough to solve the big problems of the real economy. At the same time, the commissions are high enough to encourage network members to support their work.
Consensus within the Ethereum network is reached based on the Proof-of-Work algorithm. Similar to bitcoin, some pools control more than 50% of the network hashrate.
The new version of the ETH 2.0 network offers a solution to this problem by transitioning to the Proof-of-Stake algorithm. This implies that those with more coins get more voting weight.
According to the Blockchair website, 72 million ETH was distributed with zero blocks, at the end of September – 60% of the current circulation (118 million tokens). As a result, the remaining 40% is mined in the mining process across the entire existence of the network. According to Coinmetrics, the number of daily earnings of miners since the launch of Ethereum is only around 46 million tokens.
It turned out that the developers initially received one and a half times more tokens than all the network participants had mined in six years. By switching to PoS, developers will gain control over the network.
Data that more than 70 million tokens were distributed with the first block on the Ethereum network is also available on the Coinmarketcap website. And despite the availability of information about the downside risks of network decentralization in the future, the second largest cryptocurrency by capitalization is one of the most popular platforms for building Dapps. In particular, most of the projects in the emerging DeFi market are based on the Ethereum blockchain. The volume of funds blocked in the protocol based on the second cryptocurrency was more than $100 billion at the end of October, according to Defipulse.
The Ripple token is very different from bitcoin and Ethereum. First of all, it cannot be mined, the entire cryptocurrency is issued at the time the network is created. Currently, some are in circulation, and some are blocked in Ripple Labs.
Transactions are not confirmed by Proof-of-Work or Proof-of-Stake algorithms, but by a consensus mechanism developed by Ripple. Unique Node List (UNL) contains a list of trusted nodes on the XRP network. They all exchanged data, agreeing on the current state of the register. As of October 13, there are 45 such validators on the list.
The blockchain idea described when bitcoin was created hardly applies to XRP. Important aspects of decentralization such as the procedure for issuing tokens are set in the code, the presence of mining as an economic incentive for network participants to maintain its operations, and the sizable number of peer nodes does not exist.
However, the XRP consensus mechanism results in less transaction energy consumption and significantly increases network speed. Due to technological differences and the centralization of the XRP Ledger network, this platform has a large throughput: processing 1,500 transactions per second instead of 10 like bitcoin. Average network fees thousands of times less: Average fees for 2021 on the bitcoin network exceed XRP by nearly 9,000 times, according to coinmetrics.
It is these parameters of the network’s functionality that make it a suitable analog for cross-border bank transfers. In addition, this network feature enables the development of Ripple and XRP tokens for use in CBDCs. The financial institution Banque de France is leaning toward the idea that Ledger’s XRP infrastructure could form the basis for a digital euro.
Tether publicly admits in its white paper that it is not a fully decentralized solution, as it has a centralized repository of backup assets.
Tether Ltd fully controls the issuance of tokens. At the same time, he claims he takes out one USDT for every dollar that goes into the safe. In theory, this is what the 1:1 USDT/USD exchange rate provides. It is not possible to verify this based on the information contained in any of the blockchains that issue USDT. This raises the question of trusting directly to Tether – a sign of a centralized marketplace.
Read also: Lies, Big Lies and Tether?
The same reasoning applies to the second most popular stablecoin, USD Coin. The emission scheme is not spelled out in the source code, but is controlled by the Center initiative (founders: Circle and Coinbase) depending on USDC requests.
The difference between stablecoins is that market participants trust USD Coin more than Tether. This is due to the frequency and transparency of backup audits. However, this does not apply to the decentralized level of the network. And the need for audits shows that the network does not provide the level of trust inherent in a decentralized structure.
However, stablecoins play an important role in reducing the risk of cryptocurrency volatility in investors’ portfolios. Nearly two-thirds of bitcoin trades were paired with USDT in the third quarter of 2021, according to CryptoCompare. In addition, throughout the year, the capitalization of this token has more than quadrupled, and the capitalization of USDC has grown almost 12 times. This implies that there is a high demand for stablecoins on the part of market participants, despite claims of decentralization.
Centralized Infrastructure – Good or Bad?
Among market infrastructure players, wallets, exchanges, custodians, etc. fairly centralized ones are most often found. On the one hand, they provide a convenient and functional interface and offer the requested services. On the other hand, they can threaten the principles of distributed networks and their assets.
First of all, the security of funds and user data directly depends on the security system of a particular company. Classic centralized cryptocurrency exchanges are vulnerable to hacker attacks. Even big players have vulnerabilities from time to time. For example, in early October, attackers gained access to the accounts of 6,000 Coinbase customers.
The DeFi market partially solves the problem of a centralized “superstructure”. The protocol replaces certain financial services companies.
For example, there are a number of key differences between a DEX and a centralized exchange. Firstly, users store cryptocurrencies in their wallets while trading and are responsible for their own security. DEX does not require user verification, i.e. the anonymity of the process is maintained. Additional services such as margin trading and stop loss are often not available.
Decentralized exchanges allow trading via smart contracts. This means that each of them is primarily based on one blockchain, for example, Ethereum or Binance Smart Chain. Thus, trading within a single DEX is only possible with tokens issued on a specific blockchain. This feature of a decentralized exchange reduces the number of trading pairs available.
Limited functionality, fewer trading pairs and the need to be responsible for the safety of your own funds lead to the fact that centralized exchanges generate multiple times the liquidity. DEX trading volume in October was $116 billion, according to Dune Analytics. At the same time, trading on centralized exchanges totaled $1.25 trillion over the same period, according to The Block. These numbers show that users are opting for a centralized counterparty despite having a distributed option.
People don’t get tired of debating how important the degree of decentralization is, both for the tokens themselves and for the infrastructure that goes with them. In addition to the ideological aspect, as a rule, we are talking about the risks of manipulation of exchange rates and the security of user data. The potential benefits of reduced energy costs and increased network speed were not taken into account by all market participants. Lastly, it remains unclear to what extent “independent” assets can coexist with traditional instruments and strict regulatory frameworks.