Decentralization in Cryptocurrency
Since the Bitcoin genesis block was mined in 2009, much has happened in the cryptocurrency space. Businesses have begun embracing blockchain technology. Until recently, you could buy a Tesla with Bitcoin. J.P. Morgan, whose CEO had previously labelled Bitcoin a fraud worse than tulip bulbs, now has its own cryptocurrency and blockchain-based network. At the time of writing, CoinMarketCap indicates the market capitalization of cryptocurrency as 2 trillion US dollars.
With such developments in the corporate space and the meteoric rise of cryptocurrency’s popularity amongst retail and institutional investors alike (Ark Invest’s Cathie Wood believes cryptocurrencies could eventually become part of the recommended portfolio for everyday investors), the spotlights are truly shining.
A fundamental draw of cryptocurrency is that of decentralization — where no single entity or authority exercises control. After all, Satoshi Nakamoto’s Bitcoin White Paper was couched on the need for a payment system that would allow “any two willing parties to transact directly with each other without the need for a trusted third party”.
Attractiveness of decentralization and the power of the blockchain has also seen the rapid rise of decentralized finance and decentralized applications. However, amidst the current climate of laws and regulations which seem to curtail true decentralization, will we ever see its purest form?
Cryptocurrency and Decentralization
Cryptocurrency has allowed us to digitally make financial transactions without relying on third parties (like banks or PayPal) to enable them, preside over them, or keep things in check. By definition it is censorship-resistant:
The idea is that no nation-state, corporation, or third party has the power to control who can transact or store their wealth on the network. Censorship-resistance ensures that the laws that govern the network are set in advance and can’t be retroactively altered to fit a specific agenda.
Apart from the technical and operational benefits of blockchain technology, what else makes decentralization attractive as an overarching concept? To quote Binance CEO Changpeng Zhao:
Today, our world is on the more centralized side with some governments having too much power, and they control everything from what you can say to how you can spend your money. That’s why many people demand more decentralization, and why cryptocurrency is popular.
Of course, the power imbalance is not limited to citizen-government relationships. There is increasing desire from individuals to wrestle back some control, whether in the context of how they are governed or how commercial entities interact with them. Globally, we have seen an uptrend in the focus on data privacy with increased consumer awareness on their rights regarding the same. Over on Wall Street, the recent Gamestop episode¹ saw retail investors worldwide rally against hedge funds over a short squeeze, and the brokers who suspended trading of the company’s stock now face class action lawsuits for illegal market manipulation.
In this context the appeal is apparent. As lawyers in the space have noted, the “Bitcoin ethos enshrines the concept of decentralized governance, designed to bypass regulated, established systems”. Nevertheless, a quick look at prevailing regulations reveals we are some way off true decentralization.
The Current State of Decentralization and its Limits
Whilst cryptocurrencies are not exactly new, jurisdictions are still coming to terms with how to deal with them. Regulatory response has been “inconsistent, and relatively schizophrenic”:
On one side of the coin, scarcely a week passes without a regulator taking enforcement action against a cryptocurrency exchange or issuing warnings against cryptocurrencies and ICOs. However, alongside this regulatory concern, governments from Sweden to China are embracing digital currencies at a national level, to give them more power and greater control over monetary policy.
Even with perceived statutory gaps, much centralization exists in terms of being subject to national law. For one, cryptocurrency companies launching Initial Coin Offerings in the United States have to consider, amongst other things, whether their tokens will constitute securities and in turn be subject to the relevant securities legislation².
In December 2020, the SEC filed an action against Ripple and two of its executives for having “raised over $1.3 billion through an unregistered, ongoing digital asset securities offering”. Remedies sought include injunctive relief, disgorgement, and civil penalties. The suit is still ongoing.
Like most financial institutions, cryptocurrency exchanges must also comply with Anti Money Laundering laws and Know Your Customer obligations. The Monetary Authority of Singapore announced last year its intention to implement new regulations for the financial sector. These changes would apply to cryptocurrencies and serve to “regulate virtual asset service providers created in Singapore for anti-money laundering and countering of financing of terrorism purposes”.
The cost implications and infrastructure demands of complying with such obligations are significant. Following a joint statement by US regulators in 2019 on the application of these obligations to the cryptocurrency industry, Poloniex, a major exchange founded in the US in 2013, decided it would no longer offer its services to US customers. Existing users were given a deadline to withdraw their digital assets.
Apart from being at the mercy of local regulators, it is also worth considering the power held by cryptocurrency projects and exchanges themselves. As with any technology that exists on a network, blockchains are not immune to the work of malicious hackers. If a hack results in members of the blockchain losing their valuable cryptocurrency, what actions should be taken to remedy the situation, if any? Ultimately, aren’t blockchains supposed to be immutable and censorship-resistant?
The DAO hack in 2016 brought this dilemma to life. With US$60 million in Ether stolen from The DAO (a venture capital fund), Ethereum founder Vitalik Buterin’s solution was to implement a “hard fork” which effectively restored the lost Ether to investors. As a result, today’s Ethereum blockchain is itself the deviating fork. The smaller portion of the Ethereum community which viewed the fork as incompatible with the fundamental concepts of immutability and censorship-resistance soldiered on with the “original” chain reflecting the stolen Ether. This chain, known as Ethereum Classic (ETC), remains alive and kicking, with the ETC coin still being traded today.
More recently, the KuCoin hack in September last year saw the exchange, together with several projects, freeze affected assets. KuCoin users’ wallets were also suspended. The stolen cryptocurrencies have been mostly recovered. The end results of the DAO and KuCoin hacks can be seen as ideal since order was restored with reversals of arguably ill-gotten gains. Still, the idea of third parties taking unilateral action does seem hard to reconcile with the concept of decentralization.
Can “True” Decentralization Ever Be Achieved?
European lawyers have written the following on Bitcoin and the regulation of blockchain technology³:
The aim behind this project was to create a revolution to dethrone the big intermediaries of the financial world, such as banks and other financial institutions. If regulators attempt to decouple blockchain from its intended purpose, blockchain fundamentalists will retaliate by further developing blockchain to satisfy their objective of replacing the financial system as we know it.
But perhaps blockchains and cryptocurrencies cannot be absolutely divorced from external parties that exert influence and control over them. For starters, it is difficult to imagine removal of seemingly inseverable ties these objects have with national laws and global regulations.
Additionally, there seem to be natural and inherent features of centralization that would be tough to overcome. Founders of cryptocurrency or blockchain projects are often influential. When publicly known, their views can dominate the future of the project, and avoidance of this centralization is perhaps the reason for Satoshi Nakamoto’s continued anonymity even today⁴. Indeed, Buterin himself recognizes this, and in conversations about Ethereum’s road map has stated that stepping back would be “a necessary part of the growth of the community.”
Also, effects of the degree of control by development teams over cryptocurrencies cannot be understated. Circling back to Ripple and the present SEC suit where much will turn on whether its XRP token is a centralized one, law professor Carol Goforth comments that:
If the cryptoasset is truly decentralized so that there is no ‘other’ upon whom purchasers are relying, the Howey Test is not met. That is, the coin or token would not be considered a security, as happened with Bitcoin and Ether. In the case of an asset like XRP, where the creator/issuer owns the bulk of the asset, controls its distribution, and is primarily responsible for its utility and potential profitability, it is easy to see how purchasers could be relying on the creator/issuer.
Recognition and Acceptance
As much as decentralization sounds like an ideal pursuit, it appears we have to accept that cryptocurrencies cannot exist in a vacuum. Even auditors have waded into the regulation discussion, and as a PWC representative put it:
Although Bitcoin was designed with a trustless ideology, the reality is that the industry still requires trusted entities to catalyze the development of the ecosystem.
Perhaps not having absolute decentralization can be palatable, at least in the early stages of the cryptocurrency space. After all, being tethered to some centralization would provide clarity to all parties involved (projects and exchanges included), and individuals would continue to enjoy a degree of protection in an environment not without its risks. To once more cite Binance’s Zhao:
Many people think of decentralization as absolute; you are either decentralized or not. I think that in reality, there is a gradient scale from centralization to [decentralization]. Often, a better question is: how decentralized should we (exchanges, societies) be, now and in the future? If decentralization simply increases freedom but decreases security and ease-of-use, there is a point where it becomes a net negative, and may not be worth it.
[1] Apes together strong.
[2] For example, the Securities Act of 1933, and the Securities Exchange Act of 1934.
[3] Joseph F. Borg, Tessa Schembri. The regulation of blockchain technology.
[4] Antony Lewis. The Basics of Bitcoins and Blockchains: An Introduction to Cryptocurrencies and the Technology That Powers Them. Mango Publishing, 2018.