What is decentralization in cryptocurrencies?

What is decentralization in cryptocurrencies?

You’ve probably heard often that Bitcoin works in a decentralized way. What does this mean, and why is it crucial in cryptocurrency? Is only Bitcoin decentralized? How do we recognize decentralization or lack thereof? We will try to find the answers!

For many people, the word decentralization means nothing more than an empty advertising slogan that can be used to create a project to get rich through the cryptocurrency market. However, it is worth knowing that the lack of decentralization calls into question the whole point of the existence of cryptocurrencies, both in the sense of the blockchain network and in the sense of tokens. It calls into question the existence of this market, unlike the imaginary tirades about “lack of value.”

This article will discuss what decentralization is, what it consists of, why it is important, and how to recognize and evaluate it.

What is decentralization in cryptocurrencies?

In the case of cryptocurrencies, decentralization is the lack of a central authority that makes all decisions regarding the operation of the network and controls the network at its discretion. Bitcoin and other cryptocurrencies are decentralized and distributed networks, i.e., they have nodes worldwide.

Whether a system is decentralized consists of many elements that are often not discussed. From typical decision-making regarding network changes, through how many consensus participants there are, to the technical requirements. The multitude of factors makes it difficult to clearly define the decentralization of projects and establish any single determinant. There are attempts to show decentralization in numbers, such as Nakamoto Coefficient, but none are perfect.

Decentralization is important for any cryptocurrency network. There’s a reason why one of the first words you’ll find on the first page of any project will be “decentralized.” In many cases, it is just advertising, which does not change the fact that many networks start in a centralized way but strive for decentralization.

What is decentralization for?

Decentralization is needed so everyone can use the network on their terms and clearly defined rules, verify it, and retain the full right to use their funds as they see fit without asking for permissions or worrying about bans and blocks. Additionally, leaving such a network is as easy as joining it, and no one can forbid one or the other.

Slightly decentralized ecosystems can easily be shaped under a few people’s or organizations’ dictation and censored. The ability to join the validation process (i.e., your node) increases the security of the entire network and the user’s security because the full node independently verifies the state of the blockchain.

This increases resistance to tampering, single points of failure, and censorship and keeps the network transparent and honest. Decentralization minimizes the element of trust in the system. You can check everything and manage your funds without waiting for intermediaries’ approval or worrying about blockages.

Who decides on decentralization and how?

The fact that no entity is making decisions does not mean that no one has the right to make these decisions. Decentralization is democratic. This means that if in the voting system, which is, for example, programmed in the protocol, the majority makes a decision, it will be implemented, even if some do not agree to it.

Voting implemented in the protocols is, in many cases, only the official part. The entire discussion occurs offline, e.g., on forums, conferences, social media, blogs describing the need for changes and their impact, etc.

Then, depending on the model in which a given network operates, voting takes place directly on the chain, or participants of a given network decide which side they will choose during the software update in the case of controversial ideas or radical changes (or simply someone’s whim), can lead to a fork in the chain known as a hard fork. This means that some nodes support the “original” chain, and some (or most) switch to an alternative version with changes.

In the case of Bitcoin, such a system works, and the effects of its operation were most noticeable in 2017 when Bitcoin Cash was created. In a newer update called Taproot, this has been slightly changed to “signalling” miners.

Therefore, decentralization does not mean the absence of changes and updates. It does not mean that no one can work on the project; on the contrary, everyone can work on it and take part in votes.

The more people work on or engage in developing a given network through on-chain voting, the more decentralized the network is.

Bitcoin is an excellent example of software changes that split the network, but other projects can improve or change through on-chain voting.

Voting and elections are an element of social consensus regarding a given network, i.e., recognizing and following changes that we consider appropriate or acknowledging that most people want (or do not want) such changes.

Foundations?

Blockchain must function without a CEO. This is the basis of decentralization and an increasingly important point in understanding law. Each project has a founder/originator, and at the beginning of its operation, it must have some permanent programming and development support. After all, cryptocurrencies are nothing more than software.

Foundations or research and development companies are established for this very purpose, and there is nothing wrong with them as long as they do not have the only voice in the network, which they maintain for too long.

Unfortunately, this “initial” stage often takes a very long time, and foundations award themselves vast amounts of tokens, which in many cases means complete control, mainly since the networks use the Proof of Stake mechanism and on-chain management, in which the number of tokens determines the impact on the network and her safety.

So, how can you tell if a project is decentralized in decision-making?

It must have well-implemented management, whether it is on-chain or off-chain. It must have a large community of users involved in development, work, and votes, especially in crucial votes, and a large developer base.

The project may have a foundation, but its influence should be as small as possible, as should its power.

Remembering that anyone can set up a company and support a given project or use an existing company, fund, or bank is worth remembering. This does not mean that it is centralized; quite the opposite. The more organizations that support, educate, and encourage construction, including financially, the better for the project.

However, the community should always be able to reject the foundation’s proposal, which is often not the case because interest in the network and its development is only ensured by the steps taken by one company.

So you can claim that the project is centralized because one team is responsible for the development, or you can assume that the best people do it and their ideas are suitable for the network, so they are not questioned. The point of view will probably depend on what we think about a given project.

Regardless of all the details, the foundation and no other company (not necessarily the founding team) or even person can control most tokens, nodes, or power in the case of POW systems. This risks not only attacks but also legal consequences for the entire network that may be targeted. In such a case, the government can force specific action (e.g. censorship).

Decisions are not everything.

Okay, but the decisions made by most network participants are only one of the variables that make up decentralization.

Network participants are node operators, miners, and speakers who give their votes to one or more participants. A user who only sends a transaction and buys an NFT does not influence whether the network is decentralized.

As we already know, the majority makes decisions in decentralized networks. However, a lot also depends on how many participants there are. In the case of Bitcoin, we do not know the exact number of nodes because they do not have to disclose themselves and can freely leave and join the network. Data shows that we know and see over 16,000 nodes in BTC.

As for Ethereum, it has over 7,000 nodes, which is two times less than Bitcoin, but does less mean little? We will get to the answer to this question later.

It is essential to know that not every node is a POW miner or POS validator directly participating in the consensus.

Consensus

The network of each cryptocurrency consists of nodes, i.e., computers that must agree on what is correct and what is not. Since no institution oversees the operation of cryptocurrencies, these nodes must know in advance what is right and operate, even if some of them (usually a maximum of 33%) cheat.

Consensus and its mechanisms define the rules. If they are missing or defective, network attacks and fraud may occur. The laws that govern each cryptocurrency are fundamental because they also determine the degree of decentralization. The more miners or active validators, the greater the level of decentralization. If blocks are added or verified by a handful, and the network is already so extensive that it is impossible to participate in consensus without huge investments, decentralization decreases and is limited. Sometimes, it is also the case that only selected people can join in the consensus, which is a clear manifestation of centralization.

Creating and adding blocks is one process. Very important, but not the only one. Verifying these blocks is equally essential and rests with nodes not participating in the consensus.

In PoW networks, security depends not on the number of miners but on their power. In PoS networks, it depends on the number of blocked tokens. Decentralization depends on the even distribution of this power/stake among multiple entities.

Entry threshold

Imagine a project that announces itself as decentralized and available to everyone. The problem is that you must actively participate in the consensus, for example, to invest in tokens worth $200… million.

The absurdly high entry threshold limits network users to the “grace” of the richest. On the other hand, you cannot accept the rule: “Either I can run the node on a refrigerator processor, or there is no decentralization.” Decentralization should allow anyone who wants to participate actively in the network, but the $5,000 entry threshold, although less decentralized than $200, is still accessible to millions of people.

The higher the cost, the less decentralization. In systems where delegation occurs, decentralization may still be increased due to network settings such as limiting the maximum token limit per node (although this tends to lead to more nodes being set up by the same participants), increasing user awareness through delegation to smaller nodes and no restrictions on the number of active consensus participants (or high limits).

Let us also remember that validators are not the only nodes in the network, just as miners are the only nodes in PoW networks, although they may adversely affect security.

However, the entry threshold is not limited to the initial investment but to subsequent investments.

High decentralization and a low investment threshold should also have a low threshold for maintaining the node and allow for a relatively quick connection to the network. The size of the Bitcoin chain is approximately 550 GB. This site is constantly growing and will continue to grow. New network participants must download 550 GB of data to their computers.

With the increasing speed of the Internet, this is not a big problem today. However, it is essential to remember that different blockchains generate different amounts of data that must be physically downloaded and sent if you want to verify the network from A to Z yourself or participate in the consensus.

However, downloading the blockchain itself is just the beginning. Each BTC block has a 4MB data limit and appears approximately every 10 minutes. In faster networks, it may be, for example, 4 MB, but every 10 seconds or even more and much faster. Such a block must be downloaded and forwarded; at low speeds or increasing sizes, problems may begin to appear, not with the transaction throughput but with the physical throughput of the network. Large sizes may lead to hard forks, consensus problems, or more “Orphan” blocks.

Large blocks require higher Internet speeds and more powerful hardware to store and process this data, leading to less decentralization.

Some equipment and Internet connection will always be required; the smaller, the greater the decentralization possible. However, this does not mean that more expensive equipment and higher Internet transfer values ​​eliminate decentralization.

Suppose there are 2,000 different validators in a network that requires powerful hardware, good Internet, and the additional purchase of a certain number of tokens (POS). In that case, it can be considered “sufficiently” decentralized—probably about 2,000 times more decentralized than any company, bank, or service provider.

The situation is similar to Bitcoin mining, which is becoming less and less decentralized every day. You can either mine in a pool or invest tens of millions. Even mining in a pool requires tens of thousands of dollars of investment, which is unattainable for many people, but that does not mean that thousands of miners worldwide are not enough. There is no decentralization in BTC, and such voices appear…

In an era where access to technology and the technology itself is developing and becoming cheaper, requirements can be increased over time because the cost of storing 1 GB of data is constantly decreasing, as are the costs and access to the Internet and better quality equipment. You can always join the pool too.

The operation and impact of pools on decentralization is an exciting but extensive issue. However, we must touch on it briefly. The pool comprises many participants, and although they decide in the short term what they do and how, and it is clear that too much power (or stake) should be avoided in one pool, it is still a “pool.” The combined resources of many participants can change the delegation of their power or stake at any time.

Liquid staking is a slightly different story, as it depends on exactly how the solution works and how many tokens have been donated to a given project. However, it centralizes more than delegations.

Software

Software is often ignored, or users are unaware of its importance, yet all cryptocurrencies are software. In this case, it is about what the network nodes use clients and how many different clients there are (the client, i.e., the version of the Bitcoin, Ethereum, etc. application installed on the computer).

Using one client is very risky because a possible error in its code may end badly for the network, causing downtime or even mass slashing. Situations of errors and downtime, and even block reorganizations, have already occurred in Ethereum, or even… Bitcoin (not reorg, but mistakes, yes).

Ethereum is doing quite well in terms of software diversity. It’s still far from perfect, but awareness is growing. The Bitcoin Core software almost entirely dominates Bitcoin.

Impact of Token Distribution

Investors, funds, VCs, and finally, the project team itself. A considerable amount of tokens can end up in the hands of a small number of people. But does this have an impact on decentralization?

Here, a lot depends on the distribution of these tokens and their impact on the network. The most significant effect of poor token allocation may be on the price. Still, suppose many of them immediately go to these entities. In that case, it also affects decentralization, mainly since tokens are used to vote on changes to the protocol and participate in the consensus.

Even a relatively small number of tokens can affect the voting results for one simple reason – most users are not interested in managing and participating in voting. This is quite natural, and the same situation applies to the stock market, but some crypto projects and proposals for changes can involve a large part of the community.

Initially, allocating too many tokens is a big problem for new POS networks.

Decentralization in cryptocurrencies is not one-and-done

Someone may say that there is or is not decentralization, but (in my understanding) it is entirely different.

Decentralization can come in various sizes. It may be small, medium, large, or absent at all. No project is entirely decentralized and never will be because that would mean that every person on the planet has their node through which they communicate with the network and preferably participate in the consensus…

If a project has, for example, 10,000 nodes worldwide that work according to consensus, it is less decentralized than a project with 15,000 nodes but more than one with a thousand. Contrary to what you often hear, this does not mean that 1,000 validators mean no decentralization. Such decentralization is less than it could be. Just because X isn’t as decentralized as Y doesn’t mean it isn’t at all.

Some projects are more and less but still decentralized. However, there is also a limit. Theoretically, we can say that a project with seven nodes, one on each continent, is decentralized, but is it? Even if it exists, such low decentralization is too tiny to be said to be occurring at all, at least in the understanding and scale of cryptocurrencies.

Decentralization must be measured, taking into account many factors. There is no perfect indicator, but some helpful indicators allow you to assess the security of a given system, assuming certain things. One of them is the Nakamoto Coefficient I have already mentioned.

Is decentralization the most essential thing in cryptocurrencies, and does anyone care?

How much someone cares is subjective, but decentralization is crucial for cryptocurrencies. Without it, there is virtually no point in this entire market because it would be no different from existing “ordinary” databases that do not require tokens, rewards, incentives, fees, or consensuses.

Decentralization and what it offers (no permissions, censorship, access, openness, verifiability) is the main reason for the existence of cryptocurrencies, so if a project does not meet too many points of decentralization, its sense is and should be questioned. It does not have to be written off immediately as long as it strives for devolution.

Fortunately, many of the most significant projects are decentralized to varying degrees, and you should judge whether it bothers you that X has fewer nodes than Y.

Bitcoin nodes check transactions and the correctness of blocks miners send, but miners actively participate in the consensus. Both miners and nodes are needed because nodes will not accept an incorrect block, but when comparing the amount of decentralization, it is worth paying attention to what we are reaching and to what. Sometimes, full BTC nodes are compared to validators actively participating in the consensus and earning rewards, which are two different things.

Talking about delegation as a system without decentralization is also very common. While decentralization in such systems can be much smaller, it depends on the project. Is the ability to delegate and arbitrarily re-delegate to 130 validators centralized by different system members? No, it is less decentralized than 400, which does not change the fact that decentralization is still high in such a system.

The truth is that most people don’t care about decentralization. This is best seen by participating in votes or delegations. When delegating or mining, most people focus on short-term profits, not on participating in decentralization and its development, which is understandable.

Ultimately, cryptocurrencies are a financial market, and, like all other activities in this market, at the very end, the goal of each participant (or the vast majority) is to make money, sometimes to minimize operating costs, and, therefore, make money.

Summary

I hope you learned more about decentralization from this article. It is influenced by many factors, not only the number of nodes, token distribution, entry threshold, or consensus.

Evaluating the project in this respect requires analyzing many things, including the impact of the consensus mechanism, the operation of each consensus itself, and the number of copies of the chain, which are not described in more detail in this article. Multiple duplications are also very important.

Whether decentralization is essential to us depends only on us. Many cryptocurrencies approach decentralization in a “fairly loose” way, but just because a project isn’t as decentralized as some other project doesn’t mean it isn’t at all.

However, an individual approach does not change the fact that decentralization is a crucial aspect of the operation of cryptocurrencies and the foundation of their offer. It may also be so in the assessment of governments and courts when various decisions regarding this market and individual projects will be made.

Decentralization is irrelevant to most. Until suddenly, in a particular situation, it turns out that it was necessary after all…

FAQ: Understanding Decentralization in Cryptocurrencies