Centralized and Decentralized Cryptocurrency

If you probe the developers of a decentralized finance project a little, and ask why, say, just a handful of people hold the keys to hundreds of millions of dollars or why only a select few can make updates to the protocol, you might receive the following response: “Decentralization is a spectrum.” Dig a little deeper and that might perhaps be followed by, “We’re an early-stage project and we plan to decentralize.” Question too much and they might say, “Go away! Leave us alone! Get a life!”

The topic of decentralization is a touchy subject for the cryptocurrency community. This may strike you as surprising, given that cryptocurrencies are so frequently marketed as decentralized currencies that require no intermediaries, like banks or governments, to operate. The libertarian dream they follow is for the entire financial system to be maintained not by CEOs of opaque companies or dictators of failing states, but anonymous actors spread across the world. However, this is just an ideal, and under the surface is a whole spectrum of decentralization.

In this article, we will describe some features of cryptocurrencies and “decentralized” finance that are not decentralized at all, and explain why some projects have strayed, often quite reasonably, from the ethos of true decentralization. We’ll then explain which big projects are decentralized and which feature some aspects of decentralization.

What makes cryptocurrencies and blockchains decentralized

Cryptocurrencies are forms of digital cash. Popular examples include Bitcoin and Ethereum. (These may also be called digital assets or coins. The cryptocurrencies that are minted on blockchain networks are often called tokens). Cryptocurrencies, as you may know, run on blockchains. Blockchains are huge ledgers of financial transactions. They log who sent cryptocurrencies to whom. You don’t have to record your name on the blockchain; it just records the name of your wallet’s address.

While Mastercard and Visa maintain similar ledgers themselves with large computers, blockchains operate quite differently. They are what’s known as distributed, or decentralized, since the work to process these transactions is split across anonymous computers, known as miners or stakers (depending on how the network is set up). These computers perform the task of verifying transactions, and the blockchain network rewards these computers for confirming batches of these transactions (known as blocks) with newly minted coins. Huge warehouses full of powerful computers do nothing but mine cryptocurrencies…

Anyone can run a cryptocurrency miner with a powerful computer to make mining cryptocurrency profitable. Staking, a newer version of mining that accomplishes the same thing, requires no powerful computers and sucks up far less energy. This feature of blockchains means that anyone from any country can help maintain a blockchain network. Crucially, all these nodes on the blockchain have to agree on the same version of the ledger, and nobody can exert influence over the ledger unless they hold more than 50% of the mining power on the network. For this reason, blockchains are considered decentralized technologies. The opposite of this is, say, a central bank, which, due to its monopoly on the creation of a nation’s paper money and coins, is considered centralized.

There’s another reason why cryptocurrencies, in their purest ambition, are decentralized: Anyone can create another version of the cryptocurrency whenever they want. This is called “forking” the cryptocurrency and has happened many times with Bitcoin. Litecoin and Bitcoin Cash, for instance, are forks of Bitcoin created by people who didn’t like how the Bitcoin blockchain operated. This is clearly not possible with centralized currencies like the Canadian dollar. The government wouldn’t let you create a rival version of the Canadian dollar, since the Royal Canadian Mint is the only entity that can legally create new coins.

Bitcoin: A decentralized cryptocurrency

Bitcoin, proposed created in 2008 by a pseudonymous developer called Satoshi Nakamoto, is the first cryptocurrency. Its distributed mining technology is pretty decentralized, and the only way to alter the network is if more than 50% of the network voted in favor of a change. Its launch was decentralized, too. Nakamoto kept a lot of coins for himself, but he hasn’t touched them in years. No venture capitalists were offered early access to the sale, either. Anyone can develop Bitcoin’s code, although all changes will be reviewed by other developers. Some consider Bitcoin the most decentralized coin.

Such decentralization comes at a cost. While the network is very secure, it is slower than its rivals and transactions are comparatively expensive. As of December 3, 2021, it costs about $3 to send Bitcoin to another wallet. Fees are dependent on network congestion, and a single transaction cost $62 on April 21, 2021. That’s quite different from Bitcoin Cash, a version of Bitcoin that is near-identical save for its block size, which increases the number of transactions that can be processed at any one time but makes it more expensive. Bitcoin Cash fees cost a fraction of a penny, but lots of people (namely Bitcoin fans) argue that it sacrificed on decentralization to achieve that feat since the higher cost of mining hardware means that fewer people can afford to validate transactions on the network.

However, there are certain features of Bitcoin that make it less decentralized than you might think. For starters, until the spring of 2021, mining pools were mostly concentrated in China and run by a handful of Chinese companies. That’s changed a little after China banned Bitcoin mining—new hotspots include Kazakhstan, North America, and Iran—but mining is so expensive that power has quickly become concentrated in the hands of the few who can afford to buy mining machines. And because Bitcoin is so technical and developers charge so much money for their time, just a few people have the expertise to influence its development.

Centralization vs decentralization

So-called “private” blockchains are inherently less centralized than their “public” counterparts. Private blockchains are purpose-built blockchain networks that can be controlled by the people who deploy them. This introduces an element of controlled centralization while maintaining some of the benefits of blockchains, such as immutability, transparency, and security.

A food company, for instance, might run an instance of a private blockchain to verify the provenance of meat. Vaccine distributors might do the same to ensure that nobody is messing with their vaccines. These private blockchains might be cheaper and faster to run, plus you can be sure that anyone running a node and verifying a transaction is who you say they are. So, private blockchains are still decentralized blockchains, but less so than public blockchains.

Certain public blockchains, like EOS or the Binance Smart Chain, also delegate huge amounts of power to a small group of people on the network to hasten transactions and make them cheaper. This is often considered less centralized than Bitcoin because it’s highly possible to keep just a few people in control by voting them into power. In the case of Binance Smart Chain, it’s widely assumed that the people in control are just… Binance itself. Binance also runs one of the largest centralized cryptocurrency platforms.

Some coins themselves are also not centralized. Take the US Dollar Coin (USDC), or Tether (USDT). USDT is an example of a US dollar stablecoin—a cryptocurrency that stays pegged to the US dollar by maintaining vast reserves of cash and cash equivalents. These reserves are controlled by companies, not by code. This is in contrast with decentralized stablecoins like DAI or Frax, which maintain (with some reliance on stablecoins) their peg to the US dollar through complicated algorithms and decentralized money markets.

The centralization of Tether and USDC is a frequent source of tension for the cryptocurrency market. Tether, the largest stablecoin, is not transparent about how it invests its money. It says it invests it in commercial paper but never says which ones; a Bloomberg article revealed that one of its clients was Celsius, another cryptocurrency company, meaning that its backing is in part dependent on the viability of loans to another cryptocurrency company. A New York Attorney General investigation against USDT accused it of lying about its backing; Tether once said that it was 100% backed by US dollars, but in 2019 the company since admitted that it was just 74% 78% backed. Other sources allege that its backing has historically been far lower.

The launch of some projects often triggers concerns over decentralization. When lists of venture capitalists, friends of the developers, and the team itself are given or sold tokens before anyone else, they have a chance to acquire extra power. Take the idea of the “premine,” something involved in such coins as Ethereum, Steemit, and Bitcoin, which let certain people amass heaps of coins before anyone else. A lot of people think this is unfair. As a response, newer non-fungible token projects often let everyone mint their NFT at the same time, giving everyone a fair chance. Some newer governance tokens, like the Ethereum Name System and Uniswap, distribute tokens to anyone who used the platform to make launches fairer (although the team often gets a lot of extra tokens, too, as a reward for building the protocol).

Plenty of decentralized finance projects start out relatively centralized. Uniswap, Aave, and Compound all retained a degree of centralization when they were starting out. The developers built the code by themselves before launch and only decentralized things a while later. The reasoning for this may be likely to do with practicality. When a project is just starting out, it’s often easiest to start working on it in a small team rather than opening it up to decentralized governance straight away. As time went on, these projects began to decentralize by opening up governance decisions to decentralized autonomous organizations, or DAOs. These DAOs let governance token holders (like UNI, AAVE, and COMP) call the shots over how the protocol is run.

Centralizing, however, comes with legal risks for the developers. The US Securities and Exchange Commission cracks down on centralized projects that issue tokens, claiming that this is no different from a company issuing stock, albeit without registration and regulatory oversight. That’s why lots of DeFi developers like the idea, proposed by SEC Commissioner Hester Peirce, of a “safe harbour” that would give new projects several years within which to decentralize.

The bottom line

In sum, when developers say that “decentralization is a spectrum,” they really mean it. Decentralization has huge impacts on the way a project is run and who is in control. But like most ideals, decentralization is impossible to achieve without any sacrifices, and a degree of centralization is often necessary to get a project off the ground. At its worst, decentralization is little more than theatre. But when done correctly, it’s foundational to a decentralized project’s long-term success.