Are The Cryptos You Bought Really Decentralized?
How to assess the decentralization of your cryptocurrencies by looking at 4 key aspects.
Different aspects play a role in a cryptocurrency’s success such as use cases, network effects, marketing, the underlying technology, and a currency’s decentralization. The latter is important because it ties into the trustworthiness of a network.
As a consequence, many investors in cryptocurrencies base their decision to buy a currency on how dispersed it is.
But what does decentralized in Crypto actually mean?
In this article, I will shed some light on this and show you the leading indicators you can use to analyze a coin.
Let’s dive in!
What Is Decentralization And Why Is It Important?
Decentralization means that no single entity or only a few entities have control over a system or process. Instead, control is distributed among all participants. Decentralization is important because it avoids the abuse of power by a central authority.
What Does It Mean When A Cryptocurrency Is Decentralized?
According to Vitalik Buterin, decentralization in a cryptocurrency means that:
- There is no single point of failure (architectural decentralization).
- There is no individual or single organization that controls the whole system (political decentralization).
- The network can be cut into half and each half functions like an independent unit (logistical decentralization).
Is Crypto Really Decentralized?
It depends. While most currencies and applications in Crypto are decentralized to a certain degree, there are also some coins that are more centralized on purpose or which exist in closed systems.
If you want to assess the centralization or decentralization of a cryptocurrency, there are a number of aspects you should take into account: The consensus mechanisms, mining, distribution, and leadership structures of a coin.
I will explain these points in detail by using the following 4 cryptocurrencies as examples: Bitcoin, Ethereum, Litecoin, and Dash. I chose them because they are large and established networks for which a lot of data is available. But the following points apply to any other coin as well.
1. Distribution of Nodes
Nodes, among other things, maintain the consensus in the network and verify transactions on the blockchain. In other words, nodes guarantee the trustworthiness of a network. But that is not all. In order to have a decentralized and resilient blockchain, you want to have as many nodes in as many different geographical locations as possible. This is to ensure that a few players don’t gain too much control.
Clearly, well-established cryptocurrencies have an advantage here. The following graph shows the approximate number and distribution of nodes by country in the Bitcoin, Ethereum, Litecoin, and Dash networks.
What we can see here is that all 4 coins have a lot of nodes and a wide geographical distribution. There are many other cryptocurrencies with thousands or hundreds of nodes. Things look different, though, when we take a look at many smaller coins which rely on only a few nodes to run things.
Thus, investing in such cryptocurrencies comes with additional risks.
Does that mean, all you need is to pick a coin with a lot of nodes and you’re good?
Even a large number of nodes does not automatically mean that a blockchain is truly decentralized.
2. Mining Operations
Bitcoin and many other coins rely on the proof-of-work (PoW) mechanism. This means that in return for a financial reward, miners operate nodes on the network to validate new blocks.
What was once a task you could run on your laptop now requires some serious hardware.
Various mining pools formed and combined mining resources to validate blocks and earn rewards more efficiently. This has pushed out many individual and small miners with the result that a few large pools control a majority of the hash rate.
This chart shows the share that mining pools hold in the Bitcoin, Ethereum, Litecoin, and Dash networks.
Only a handful of mining pools amass a large part of the total hash power in the Bitcoin, Ethereum, Litecoin, and Dash networks.
In theory, this opens the door for 51% attacks. While launching such attacks would be very difficult and expensive, it is not impossible.
To deal with this problem of centralization and increasing hardware and energy demands, some cryptocurrencies are using or implementing the proof-of-stake (PoS) mechanism. Instead of miners, so-called validators are validating new blocks with their nodes. The size of the reward depends on the number of coins staked in the verification process.
Contrary to PoW, PoS doesn’t favor centralization in order to make operations more efficient.
But there’s a catch-22 to this method as well.
3. Distribution of Currency
In order to earn more rewards with PoS, validators don’t need to pool resources. Instead, they increase their stake and deposit more of a cryptocurrency.
What happens then if some whales show up?
Take a look at the following chart that visualizes how much of a cryptocurrency’s total worth is held by the top 100 wallets in the Bitcoin, Ethereum, Litecoin, and Dash networks.
We see a similar picture as above, where a few big players wield a lot of power. In this case, because they hold large proportions of the total amount of a coin.
Why is this a problem with PoS?
Depending on the nature of the PoS algorithm, a varying amount of validators is needed to validate a new block. In theory, the biggest stakers could band together to launch an attack on the network. In the case of Ethereum 67% of validators (about equal to the top 1,000 Ethereum wallets) need to agree to finalize a block. While this scenario is highly unlikely, it is still a possibility.
However, the distribution of wealth in Crypto is gradually becoming more dispersed which is a good sign.
If you want to read more about inequalities affecting Crypto, I recommend you to check out this article I wrote on the topic:
The Centralized World’s Inequality is Mirrored in Crypto-Investments
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4. Leadership Structure
One of the most criticized points in crypto projects concerns leadership.
This is due to the fact that a core group of developers or CEOs set the direction for cryptocurrencies. Among other things, these leaders decide on a coin’s vision, road map, and features to implement. Well-known examples are Ethereum’s Vitalik Buterin or Litecoin’s Charlie Lee.
To further illustrate this, let’s take DeFi (decentralized finance) as an example. Financial institutions such as banks hate DeFi because it revolutionizes finance. It decentralizes data storage, increases transparency, is permissionless and borderless. As a result, users are treated more fairly and get faster services.
While DeFi is architecturally decentralized, this is not the case when we look at leadership structures. DeFi projects rely on CEOs and core teams because of a number of reasons:
- Programmers and software engineers need to be compensated for their work.
- Even if volunteers can contribute to a project on Github, competent people are needed to combine and test the code.
- Other people with special skills and knowledge such as marketers are needed to drive the project in the right direction.
- When a project grows, so do requirements regarding planning, coordination, and administration. All of that needs to be coordinated.
For all of this, just relying on the community is not enough. Some form of centralized authority is necessary. But the need for leadership structures also leaves the door open for various problems.
A wrong decision can damage or even destroy a Crypto project. A recent example comes from Litecoin Association whose members retweeted a false statement that Walmart was collaborating with Litecoin. And sometimes just the fact that there is a prominent leading figure can cause issues. In 2017, an online hoax claimed that Vitalik Buterin had died. As a result, ETH price crashed from $300 to $260.
Taking a step back and looking at the points above it becomes clear that no cryptocurrency or Crypto platform can be fully decentralized. That is because compromises have to be made with every project.
Even if Crypto is still far from ideal in terms of decentralization, it already represents an important alternative to traditional and centralized solutions. This opens up many exciting opportunities for users as well as investors.