Centralization of Decentralized World

Image Source: Nasdaq

Cryptocurrencies are digital tokens used to transfer value all around the world without needing intermediaries. At least this is the main idea. However, the situation in practice might not be exactly how it is claimed to be.

Distributed vs Decentralized

First, we need to distinguish two terms that are used interchangeably by some people: Distributed and decentralized. Here, we will use the term ‘distributed’ to indicate that the data is not stored by a single node but by several different nodes in the network. We use the term ‘decentralized’ to indicate that the data flow is not controlled by a single central entity.

In theory, public and permissionless blockchains, the type of Blockchain used by most well-known cryptocurrencies such as Bitcoin and Ethereum, are distributed, as the all data is stored by several nodes (miners in the case of Bitcoin and Ethereum), and decentralized, as the data that will be put on the main chain is determined not by a single authority but by a consensus mechanism involving other participants in the network.

Is it really p2p now?

Decentralization and distribution work fine if participants use the system as a p2p (peer-to-peer) mechanism. In fact, this was the main purpose of Bitcoin as expressed in its whitepaper, written by Satoshi Nakamoto, with the following sentences:

What is needed is an electronic payment system based on cryptographic proof instead of trust allowing any two willing parties to transact directly with each other without the need for a trusted third party

The downside of this system was that it was extremely technical for casual users. There was no simple and smooth user interface allowing people to transact on the network. This led us to the creation of cryptocurrency exchanges and the so-called decentralized system took its first turn to the centralized nature at the very beginning of its life.

Age of Cryptoexchanges

Now, exchanges are the main platforms for trading cryptocurrencies. Indeed, there might be traders out there circulating cryptocurrencies mined by individual miners but it is not unreasonable to assume that those cryptocurrencies will end up in an exchange at some point due to the wide coverage of these platforms.

To provide an insight, let’s take a look at Bitcoin exchanges. Bitcoin has the biggest market cap in all cryptocurrencies and almost the half (approx 48%) of all cryptocurrency transactions involve Bitcoin. The 24h volume distribution of Bitcoin transactions among exchanges is as follows (at the time of this writing):

Bitcoin Exchange Distribution (Source: CoinMarketCap)

What is the meaning of this chart? Two big platforms, BitMEX and BitForex have significant dominance over others and there is a certain level of concentration in the rest of top ten exchanges. Major cryptocurrency exchanges having a certain concentration might be problematic for two main reasons.

First of all, these exchanges are subject to KYC/AML regulations. It means that they have to collect detailed personal information from and verify identities of their customers. It means that that the anonymity, or pseudo-anonymity for the most of cryptocurrencies, is mostly not available due to the dominance of exchanges and these exchanges have huge amount of personal data. How this data can be used depends on the jurisdiction these exchanges are based and there is an ongoing tension between the protection of personal information and attraction of cryptoinvestments worldwide.

Secondly, as it can be seen from the chart, most of these exchanges charge fees. BitMEX is different in the sense that it does not charge fees for standart withdrawal/deposits but it does for derivative transactions. Charges are almost always arbitrarily determined. Of course there will be a pressure arisen from the competition with other exchanges but this does not remove the possibility of major exchanges with simple user interfaces to abuse the average customers’ lack of technical and financial knowledge and to apply hidden charges. A calculation published on Bloomberg website estimates some major exchanges make daily profit of more than $3 Million. Binance and Coinbase expect yearly profits very close to $1 Billion.

The only question left here is the following: What difference has left between cryptoexchanges and traditional banks at this point? Well, with regards to the regulation and portfolio of services, there is still a huge difference. However, from the daily internet users’ perspective, both charge significant fees — cryptocurrencies are still better than banks for international payments but there are startups doing a very good job in this field — and both have online platforms. But at least, traditional banking feels more secure and instant for daily purchases and the value of the fiat currency is not as volatile as that of cryptocurrencies.

In short, my point here is that the operation of major exchanges might amount to kill most benefits of cryptocurrencies and their decentralized nature.

Mining

There is one more point that must be clarified. In mining-based cryptocurrencies, there are miners ‘mining’ the cryptocurrency and collecting the rewards as compensation. There is also possibility to pay miners a small amount of fee to incentivize them. However, I believe this does not make them intermediaries in the traditional sense since, firstly, the miner fee is not mandatory for all transactions and its value is proportionally low compared to the value of transaction and, secondly, miners are individual players meaning that they do not have power to control the transaction flow. However this second part is also under the challenge due to the foundation of big mining pools.

At the time of this writing, the hashrate distributions of Bitcoin and Ethereum (ETH) are as follows:

Hashrate Distribution for ETH (Image Source: Etherchain.org)
Hashrate Distribution of BTC (Image Source: Blockchain.com)

What is the meaning of these graphics? It is possible that mining pools gather enough computing power to overtake the consensus mechanism and decide the future of a mining-based blockchain. Concentration is lower at Bitcoin compared to Ethereum (ETH). But the risk is very real for both.

History repeating itself?

Decentralized systems being centralized is not something new. Both internet and e-mail started the same and found their way somehow. Now we cannot live without either of them. Internet is a decentralized work but there are different centralized actors with different powers from governmental authorities to large-scale internet service providers. It is the same for the e-mail. E-mail protocols are decentralized but it is very rare to come across mail addresses other than the ones provided by huge firms like Google and Hotmail. Even business operations are using their infrastructure.

It must also be mentioned that this is not necessarily a bad thing. Maybe there is a justifiable reason behind this centralization of initially-decentralized systems. They become much more effective and widely-recognized, there is no doubt. The initial problems of cost and infrastructure are solved significantly when there are central operations. It becomes much easier to regulate for regulators when there are concentration points in the network. Hence, this is a trade-off between being mainstream and efficient on the one hand, privacy and control on the other. And it does not seem to be finalized for cryptocurrencies anytime soon.

Lawyer | IP&IT&Blockchain Law| PhD Candidate in Law & Computer Science| Self-taught Coder | LL.B. (Galatasaray) - LL.M. (LSE) - M.A. (Ankara) - MJur (Oxon)

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