One of the key characteristics of blockchain is that it is decentralized. This property not only enables peer-to-peer transactions but also hopes to achieve an ecosystem where many players can equally participate and share. This utopic ideal, like it often happens, does not translate in practice. But before we go further ……
Picture taken from Vitalik Buterin’s medium post: “The Meaning of Decentralization”
To give historical context, before cloud computing, centralization (A) was a natural state of providing services. You had to go to the store to buy your tickets for your next vacation. The internet changed this, but even in its beginning, it too was centralized. This was because servers needed to be set in place for the company to function. This made the system highly vulnerable and prone to downtime. Shutting down the server implied a critical failure for the company, as it translated into the inability to provide the service. The advent of cloud computing solved in a very elegant way this critical vulnerability. It decentralized (B) service provision across multiple servers. This meant that if a server were to go down, the company could still operate online, albeit at a slower pace. Blockchain is bigger than cloud computing. It scales the idea of decentralization by distributing © a shared database across all members of the network. This further reduces critical chokepoints in the network and effectively reduces downtime to zero. At the same time, it imbues the network with the following two prosperities:
- Direct communication across computers without an intermediary; and
- If a server is turned off or inaccessible, it does not corrupt the contents of the database, since all the other computers share the same database.
These are the two most important properties of blockchain since they reduce the complexity and security of logistical problems by orders of magnitude. Take for instance the case of sending money from US to Indonesia. For the transaction to occur, it takes many banks (among them the two respective Central Banks) to coordinate the transfer of money. This is why transaction times tend to take weeks to happen. Sending money, as trivial as it sounds, is an extremely complex logistical problem. The same transaction using blockchain technology would take seconds and would not require any intermediaries. The reason why this is possible is precisely because there is a shared database (a ledger in the case of cryptocurrencies such as Bitcoin) which enables the network to verify transactions without the need of a third-party. Therefore, blockchain reduces the number of intermediaries from “n” parties to “two,” and the reason why it is particularly suitable for solving complex logistical problems. Decentralization matters.
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But… is it decentralized?
The unfortunate truth is that from theory to practice there is a chasm. The economic incentives behind mining, which is the mechanism that gives blockchain its decentralized and security properties, rewarded heavily early entrants. This caused much of the computing power across the major blockchain networks to be centralized and chipped away from the original ideal of a diverse market place environment. In fact, the crypto mining industry feels much more like an oligopoly rather than a perfectly competitive market one would expect if it were truly decentralized[1]. In Ethereum’s case, 63% of the computing power of the network is controlled by just two miners[2] and in Bitcoin’s network around four miners have the same power. This boils down to an unfortunate truth: Crypto assets are not as decentralized[3] as people think.
Before answering the question, let’s first explore how blockchain networks work as a way of giving context to the answer. Without diving into the technical details, in general, there are two roles to every network. The development team, who oversees the maintenance and upgrading of the code, and the miners, who lend their computing power for the network to exist and operate. These two groups have a symbiotic relationship. Developers need miners to run their code and miners need code to run. Unfortunately, these two groups are often at odds with each other. This is because their respective incentives are very different. Development teams want to improve the product and reduce costs of using the network. Miners want to increase their payoff by increasing transaction fees and block formation rewards.
Why is this important you ask? Because for an upgrade/change of the code to occur miners have to first agree to use the new code. This process is called “consensus” and is an important feature of blockchain network governance. Often times developers and miners don’t agree, and this is one of the primary causes why hard forks occur. Therefore, if the computing power of a network is concentrated, then the large miners have a lot of leverage on the direction of the cryptocurrency. This is an issue since the motivations of miners are unlikely to be properly aligned with the overall vision of a blockchain network. It’s like asking a miner what coal should be used for. They may have ideas, but it’s not the same vision a scientist or an engineer can have. This is why it’s important to be aware of these underlying dynamics. At DigiCor, we analyze these dynamics carefully as they provide important clues on the state of the governance structure and long-term sustainability of a crypto asset.
Conclusion
As it often happens, theory must be adapted to the reality it inhabits. As a consequence, at least Bitcoin and Ethereum, are not truly decentralized networks. It’s worth mentioning that blockchain development teams are well aware of this problem, and they are taking steps to mitigate it. For instance, the deployment of the proof of stake algorithm to clear transaction in the Ethereum network[4]. Development efforts are impacted by the influence of miners. Since at the end of the day, without miners, there is no network. Therefore, it is critical to understand the miner vs development team dynamic during the drafting of an investment case for any digital asset.
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DigiCor’s recent publications:
· The Battle of Consensus — Sometimes You Just Have to Fork it Out
Why do hard forks happen and what happens to the price of the original coin when they do?
· Safety First: Navigating Through the Crypto Anarchy
The question on many investors’ minds is: how safe is my Bitcoin?
· Rising from the Ashes — A Tale of Bitcoin Crashes
What is the history of Bitcoin’s crashes and how do they stack up to the one in 2018.
· How About a Sprinkle of Crypto in your Portfolio?
Should you invest in crypto and if so what percentage of your portfolio should you allocate.
· U.S. Crypto Regulation: Where are we going?
Currently, U.S. cryptocurrency regulation overlaps between multiple federal agencies creating confusion and uncertainty in the market. How is this effecting the crypto market today.
· The DigiCor Thesis — Why We Think Everyone Should Invest in Crypto
[1] This implies that many game theory models can be applied to understand the underlying sustainability, robustness, and interactions of the crypto mining industry. A great example is a recent paper by Budish from the University of Chicago Booth School of Business,
[2] Many of these are mining pools. However, because the owners of the pools control the software which enables the computer to join the mining pool, we believe they can be thought of as the same entity. Since at the end of the day, it is the owner of the software, i.e. the mining company, who will decide which code gets accepted.
[3] At least in the number of entities controlling the computing power.
[4] It remains to be seen if it will indeed create a more level playing field or if it will simply shift around centralization to other miners.
Important Disclosure
This publication contains information obtained from sources believed to be authentic and highly regarded. Reprinted material is used with permission, and sources are indicated. Reasonable effort has been made to publish reliable data and information, but the author cannot assume responsibility for the validity of all materials or for the consequences of their use. Certain information contained herein may be dated and no longer applicable: information was obtained from sources believed to be reliable at the time of original publication, but not guaranteed.
The views contained herein are the authors but not necessarily those of DigiCor Asset Management. Such opinions are subject to change without notice. This publication has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.
References to specific digital assets are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. The author or DigiCor Asset Management may or may not own or have owned the digital assets referenced and if such digital assets are owned, no representation is being made that such digital assets will continue to be held.
This material contains hypothetical illustrations and no part of this material is representative of any DigiCor Asset Management product or service. Nothing contained herein is intended to constitute accounting, legal, tax, security or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. Readers should be aware that all investment carry risk and may.
Originally published at blog.digicor.io on June 15, 2018.