By Arjun Goswami & Praveen Singh
The illusion of decentralisation in crypto has been one of its major criticisms in recent times. The criticism is based on the fact that decentralisation, i.e. the elimination of a central authority and intermediaries in executing a transaction, was initially the main promise of crypto assets. The Bitcoin white paper highlighted that one of the key shortcomings of traditional financial systems was the ‘trust’ factor, i.e. the need to trust an intermediary in every transaction. Accordingly, Bitcoin was supposed to be a trustless and decentralised system of transactions. However, in the 16 years since the launch of Bitcoin, the crypto ecosystem has been largely centralised. Most transactions in crypto today are executed through centralised exchanges, and assets are managed by trusted third-party custodians. This dominance of intermediaries in the crypto ecosystem is sometimes referred to as the decentralisation illusion or the decentralisation paradox.
On the face of it, it does appear counterintuitive that a technology that grew with the promise of decentralisation has effectively acquired the same centralising traits it set out to challenge. However, it is worth considering the reasons for this centralisation in the crypto ecosystem.
Driving Force Behind Centralisation in Crypto
Centralisation is a phenomenon that happens automatically in any disciplined and organised ecosystem. Crypto is no different. Centralisation in the crypto ecosystem can be attributed to many technical factors. These include contract incompleteness, i.e. the inability to write contracts that can cover all future possibilities; congestion in proof-of-work systems and concentration of power and coins in proof-of-stake systems; and the inherent need of decentralised finance to obtain information from the real world through a trusted third-party intermediary. Beyond these technical factors, there is also a human element in crypto that needs to be accounted for if it is to be truly inclusive and democratic.
One thing about crypto that everyone agrees on is that it is a complex technology, and even the most sophisticated customers don’t fully understand it. It is therefore hard to imagine that the average reader here would exchange crypto assets through a peer-to-peer transaction, using complex wallet codes that are more difficult than the strongest passwords you’d have seen, where the slightest error may result in the crypto assets being sent irretrievably to an unknown person whose identity may not be found. Most users, therefore, use centralised exchanges and third-party wallets to execute transactions, which makes it possible and reasonable for an ordinary person to engage with crypto. Without them, the number of users would likely drop immediately. For context, the trading volume on decentralised exchanges, which use automated protocols on blockchain to facilitate a transaction and reduce the role of intermediaries and human intervention, remains less than 10% of the global crypto trading volume. The low trading volume on decentralised exchanges shows the limitations of decentralised systems in meeting human needs and the relevance of centralisation and intermediation. Perhaps centralisation in crypto democratises things that may be too complex for the ordinary public.
Role of Centralised Intermediaries
We are humans, and we can make mistakes. We can forget our passwords, enter the wrong wallet code, or make any number of other inadvertent errors. Given the irreversible nature of crypto transactions, it is crucial to minimise the potential losses from such mistakes. One argument might be that only the most sophisticated investors should engage with crypto. But it’s not good for anyone if complex things don’t get simplified for everyone over time. Remember that crypto remains daunting and complex despite the intermediaries. Imagine how much more complex it could be without them. Centralisation, therefore, is crucial to ensure a minimum degree of consumer protection and to assure a minimum degree of security and stability.
The presence of centralised intermediaries is particularly comforting for regulators, for it provides them with an identifiable person to be held accountable in case things go wrong in a faceless ecosystem. So, whether you want to ensure robust governance, protect vulnerable consumers, prevent fraud, ensure minimum standards of security, or address any other policy imperative, you need an identifiable accountable person to be held liable. These crypto intermediaries provide regulators with such an identifiable entity. In some cases, the collaboration of intermediaries like Binance has also helped law enforcement agencies trace and recover assets lost in hacks and thefts.
Future of Crypto Industry
The crypto industry has a long way to go before it can become mainstream, and there will be evolutions and changes in the sector depending on multiple factors. The tension between the promise of decentralisation and the reality of centralisation will challenge us to think more deeply and reimagine the decentralisation of finance in the coming years. However, the decentralisation paradox, by itself, is not reason enough to dismiss the industry. There are very good reasons why crypto has moved towards centralisation, and the centralisation of a decentralised technology may give us the best of both worlds. In fact, centralisation may be exactly what facilitates the mainstream adoption of crypto assets.
(Arjun Goswami, Director – Public Policy and Praveen Singh, Senior Associate at Cyril Amarchand Mangaldas.)
Views are personal, and do not represent the stand of this publication.
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