Why Decentralization Matters

Date
October 25, 2023
Tags
Research
Author
Ikuma Mutobe

Decentralization is a prevalent term within the realms of Crypto/Web3 and Blockchain. Despite its ubiquity, it remains a concept shrouded in ambiguity.

In truth, decentralization is actualized at a significant cost and sacrifice. Miners and validators, tasked with the role of verifying blocks, dedicate immense resources to this daily undertaking.

My (ikuma) attraction to Crypto/Web3 was primarily fueled by the empowerment of individuals through decentralization.

Through the technologies underpinning blockchain, which are fundamentally decentralized, networks and ecosystems are collaboratively forged by participants rather than being monopolistically controlled by singular entities like corporations or governments. There’s an absence of a centralized authoritative figure or entity. This framework fosters the potential emergence of more efficient and equitable systems.

This article aims to elucidate the essence of decentralization in Crypto/Web3 and why it holds paramount significance, enriched with insights from experts. Furthermore, it seeks to share reflections on engaging constructively with decentralization. The discourse aims to offer valuable insights that can guide developers, Web3 projects, and enterprises in their contemplation of decentralization.

TL;DR

  • Decentralization is a cardinal concept sustaining blockchain technology.
  • Decentralization manifests across diverse facets and layers.
    • From broader perspectives such as technology, economics, and politics to finer nuances like node clients and deployment of new features, decentralization pervades various aspects.
    • It’s conducive to perceive not merely a binary opposition between decentralization and centralization but rather a gradation between the two.
  • Decentralization is pivotal in establishing essential principles of Web3.
    • Ensuring decentralization across all aspects facilitates the realization of core Web3 principles such as Credible Neutrality (an unbiased, permissionless utilization by individuals or groups), Composability (an amalgamation of software components akin to Lego blocks), and Trustlessness (operation through economic mechanisms and incentives without necessitating trust in third parties).
    • In Web3 protocols where these essential principles are affirmed, a paradigm shift is witnessed, diverging from traditional Web2 frameworks, promoting competitive proliferation, safeguarding freedom, and rewarding stakeholders.
  • Engaging with Decentralization
    • The quintessence of Crypto/Web3 resides in decentralization. In progressing projects and enterprises, maintaining fidelity to the principles of decentralization is imperative. This is fundamental because, without actualizing decentralization, leveraging the innovative attributes and paradigm shifts intrinsic to Crypto/Web3 remains unattainable.

What is Decentralization?

I want to elucidate the concept of decentralization.

The dictionary definition of decentralization is "the condition of not being concentrated in one place but being spread out moderately."

Three Types of Decentralization

Vitalik Buterin, in his blog dated February 6, 2017, "The Meaning of Decentralization," categorizes the definition of decentralization from a software perspective into three types.

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When people talk about software decentralization, there are actually three separate axes of centralization/decentralization that they may be talking about. While in some cases it is difficult to see how you can have one without the other, in general, they are quite independent of each other. The axes are as follows: Architectural (de)centralization — how many physical computers is a system made up of? How many of those computers can it tolerate breaking down at any single time? Political (de)centralization — how many individuals or organizations ultimately control the computers that the system is made up of? Logical (de)centralization — does the interface and data structures that the system presents and maintains look more like a single monolithic object, or an amorphous swarm? One simple heuristic is: if you cut the system in half, including both providers and users, will both halves continue to fully operate as independent units?
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Source: The Meaning of Decentralization

Various real-world examples are explicated employing these three axes:

  • Corporations: Traditional corporations are politically centralized (single CEO), architecturally centralized (single headquarters), and logically centralized (cannot be practically halved).
  • Civil Law: Contrastingly reliant on centralized legislative bodies, Common Law is constructed through precedents set by numerous individual judges. Nevertheless, as many courts wield substantial discretion, civil law retains some architectural decentralization, with more found in Common Law. Both are logically centralized ("The law is the law").
  • English Language: The English spoken between Alice and Bob need not concur with that between Charlie and David. No centralized infrastructure requisite for language existence prevails, nor are the grammatical rules of English established or administered by any single individual.
  • BitTorrent: Similarly logically decentralized as English. Content Delivery Networks also share this attribute but are controlled by a single corporation.

As for the pivotal blockchain, it’s organized as follows:

  • Blockchain: When examined against the blockchain, it manifests as politically decentralized (controlled by no one) and architecturally decentralized (lacks centralized failure points), albeit logically centralized (a single agreed-upon state exists, and the system operates akin to a single computer).

a16z’s Definition of Decentralization

a16z expounded on the definition of decentralization in their blog dated May 31, 2023, "Factors of decentralization of web3 protocols: Tools for planning greater decentralization."

This discourse, mindful of U.S. regulatory trends, aims explicitly to accurately evaluate and compare the decentralization of Web3 protocols, distinguishing between blockchain and smart contracts, thereby elucidating the definition and nuances of decentralization.

They proclaim three types of decentralization:

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Technical decentralization (T): Programmable blockchains and autonomous smart contract protocols can facilitate technical decentralization by offering an autonomous, permissionless, trustless, and verifiable ecosystem. Products and services can be deployed and executed without necessitating a trustworthy centralized intermediary, thereby unveiling a vast realm of possibilities. Economic decentralization (E): Employing unique native tokens, open-source, and decentralized systems foster distinct economic spheres, encouraging widespread participation and the equitable distribution of benefits. Legal decentralization (L): Legal decentralization pertains to whether specific regulations intended risks are obviated by system decentralization. Technically and economically decentralized systems can mitigate additional risks, inclusive of those related to the tokens of Web3 systems and their underlying values, thereby negating the necessity to apply U.S. securities laws to token transactions, which could otherwise considerably limit the extensive circulation of tokens.

In addition to these perspectives, a table defining degrees of decentralization across various elements has been released, promising to be a valuable reference for measuring future protocol decentralization degrees.

Every meticulous aspect of Web3 protocols’ decentralization is comprehensively covered, encapsulating aspects like node client decentralization, development entity decentralization, voting power decentralization, and the number of tokens in circulation, each delineated across four stages: Centralized, Partially decentralized, Significantly decentralized, and Decentralized.

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Note:　Excerpt from Source.

Source:　a16z & LATHAM&WATKINS, Decentralization Factors for Tokenized Consensus Protocols (Layer 1s and Layer 2s)

Summary

We have explored the various facets and layers of "decentralization."

Decentralization exists at various levels, ranging from broad categories such as technology, economy, and politics, down to finer points like node clients and deployment of new features.

Moreover, as seen in a16z’s illustration, decentralization is not a simple binary opposition against centralization (Decentralization vs Centralization), but rather possesses various gradations.

Why is Decentralization Important?

We have looked into the definition of decentralization. Next, let’s contemplate why decentralization is important.

This debate has been carried out extensively by many people. I hope to present some examples and provide a basis for contemplating its importance.

Vitalik’s Reasons for Decentralization

Vitalik Buterin articulated the reasons for decentralization in his blog dated February 6, 2017, titled "The Meaning of Decentralization" as follows:

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Fault tolerance - decentralized systems are less likely to fail accidentally because they rely on many separate components that are not likely. Attack resistance - decentralized systems are more expensive to attack and destroy or manipulate because they lack sensitive central points that can be attacked at much lower cost than the economic size of the surrounding system. Collusion resistance - it is much harder for participants in decentralized systems to collude to act in ways that benefit them at the expense of other participants, whereas the leaderships of corporations and governments collude in ways that benefit themselves but harm less well-coordinated citizens, customers, employees and the general public all the time.

Fault Tolerance

Vitalik discusses the importance of decentralization at detailed implementation and operation levels, providing examples for fault tolerance such as:

  • All nodes of a blockchain running the same client software, which is discovered to have a bug.
  • Development teams of the software being socially corrupt.
  • The team proposing protocol upgrades being socially compromised.
  • And several more instances involving hardware, geographic locations, and token holders.

Attack Resistance

Vitalik elaborates on attack resistance by stating, for instance, that Proof of Stake is superior to Proof of Work as tokens are more resistant to regulation and attacks than hardware.

Collusion Resistance

For collusion resistance, Vitalik introduces three points, such as building protocols that can withstand undesirable collusion, finding a happy medium that allows sufficient collaboration without enabling attacks, and distinguishing between beneficial and harmful collusion, making the former easier and the latter harder. He also suggests several strategies to mitigate undesirable collusive behaviors.

a16z’s Perspective on the Importance of Decentralization

a16z, in their blog post dated May 31, 2023, "Factors of decentralization of web3 protocols: Tools for planning greater decentralization," discusses the importance of decentralization as:

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Decentralization is the critical feature of web3 protocols that enables this paradigm shift. Decentralization will drive the creation of a democratized internet and will enable three important shifts:

promoting competition, safeguarding freedoms, and rewarding stakeholders.

Promoting Competition

The blog mentions that decentralization enables Credibly Neutrality and Composability, fostering enhanced competition.

In the Web2 era, centralized platforms like Twitter, Facebook, Google, Amazon, and YouTube wielded significant authority, monopolizing data and abruptly changing policies as they offered APIs.

However, with Web3, Credibly Neutrality and Composability have been established through decentralization. These two concepts are quite crucial, explained as follows:

  • Credibly Neutrality: It signifies that "Web3 protocols cannot discriminate against any individual or group stakeholders." This aspect is vital for motivating developers in building services.
  • Composability: This entails "combining software components similar to Lego blocks."

These established principles enable Web3 protocols to function like public infrastructure, allowing anyone to freely build apps and services.

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Source: Factors of decentralization of web3 protocols: Tools for planning greater decentralization

Recently, protocols like Lens and Farcaster, Web3 Social, have emerged. A comparison with Twitter in the Web2 space clarifies this. Web3 Social Protocol provides an underlying architecture designed for social media, controlled by token holders rather than corporations or organizations. It allows everyone to build unique applications or clients on this protocol, accessing users.

In Web2, dominant centralized platforms stifled competition. However, Web3 has transformed this scenario, promoting competition, as articulated in the a16z blog.

Safeguarding Freedoms

In Web3 protocols, utilizing tokens to encourage a wide range of user participation in the ecosystem is crucial to prevent power concentration in a handful of individuals or corporations.

Rewarding Stakeholders

Traditional capitalism has prioritized certain stakeholders (shareholders). However, decentralization enables equitable profit distribution among all stakeholders.

For instance, platforms like Twitter and Facebook didn’t reward users for their contributions despite their role in platform growth. Web3 protocols, however, potentially allow rewarding ecosystem contributors with tokens, offering flexibility in reward design based on various business endeavors, objectives, and philosophies.

Conclusion

I believe decentralization is essential for individual empowerment and promoting personal freedom. Considering this, I will elucidate the significance of decentralization mechanisms below:

  • Maintaining decentralization ensures the establishment of vital Web3 principles:
  • Credible Neutrality: Allowing everyone to use protocols without discrimination or favoritism.
  • Composability: Combining software components as Lego blocks.
  • Trustless: Operating through economic mechanisms and incentives without trusting third parties.
  • Essential Web3 principles promoting competition, freedom protection, and stakeholder rewards:
  • Establishing these principles triggers paradigm shifts, such as competition enhancement, freedom protection, and stakeholder rewards, as mentioned in the a16z article.
  • Utilizing these features allows for the construction of distinctive services and ecosystems.

Recently, entities claiming to embrace Web3 and blockchain, yet retaining strong centralized tendencies may struggle to acquire these characteristics, hindering their ability to differentiate their services and construct robust offerings.

How much decentralization do we need?

We’ve outlined the definition and significance of decentralization. Though a gradation exists in decentralization, this section aims to explore "to what extent decentralization is necessary."

Nakamoto Coefficient

First proposed by Balaji Srinavasan and Leland Lee and named in honor of Bitcoin's creator, Satoshi Nakamoto, the Nakamoto Coefficient indicates the minimum number of independent entities that can shut down a blockchain collaboratively.

In typical Proof-of-Stake networks, the Nakamoto Coefficient is defined by the number of node operators controlling more than one-third (33.33%) of all stakes on the network. (For Proof-of-Work, it is 51%.)

Simply put, the higher the Nakamoto Coefficient of a network, the more resilient it is against these attacks. A network resilient against such attacks is more decentralized and resistant to censorship.

Ethereum's Nakamoto Coefficient is 2

Ethereum's Nakamoto Coefficient is 2. This implies that collusion between two organizations can shut down Ethereum.

The active validator count for Ethereum, as per beaconscan.com, is around 860,000—a substantial number. At face value, it appears considerably decentralized, but why is the Nakamoto Coefficient low?

Examining the distribution of Ethereum validators reveals that the largest Liquid Staking Protocol (LSP), Lido, holds about 31%. With one more entity, surpassing 33% would allow them to shut down the network.

The presence of LSPs (also known as staking pools) contributes to this. LSPs allow individuals holding fewer than 32 ETH to participate in staking and earn returns. Stakers receive stETH, usable in other services like DeFi. The dominant share of Lido within LSPs ultimately weakens the network's level of decentralization.

Various Perspectives on Decentralization

Decentralization can be assessed through various lenses: geographical distribution, consensus mechanisms, execution clients, non-data center validators, staking pools, etc. Monitoring these metrics closely is crucial to prevent centralization, ensuring the network’s resistance to censorship and attacks.

For instance, websites evaluating Ethereum’s decentralization indicate that diversity amongst staking pools/entities is a red flag. Additionally, there seems to be a challenge in the geographical diversity of validators (e.g., 30-40% in the USA, 10-20% in Germany).

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Source:　ethsunshine.com

Centralization in Ethereum's Block Building Infrastructure

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Various actors exist in the value chain until transactions are incorporated into blocks. Centralization among these actors is progressing and becoming problematic.

Centralization in MEV Boost

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The software MEV Boost, provided by Flashbots, boasts a 90% share. It’s an early off-chain implementation of the Proposers Builders scheduled to be incorporated at Ethereum’s protocol level.

Centralization in Block Builders

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Block Builders, too, are near a 90% share held by six entities. A monopoly by a few players raises concerns, such as the selective inclusion or exclusion of specific blocks and adherence to OFAC regulations.

Centralization in Relays

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Relays are dominated by four entities holding a 90% share. Despite their crucial role in Ethereum's operation, there is no current profitable model, and they operate at a loss. A limited number of operators and a lack of geographical diversity weaken the network's resistance to faults and censorship.

Ongoing discussions surround the distribution of profits to validators and Block Builders, but no conclusion has been reached. Recently, Blocknative discontinued its Relay operations due to a focus on selection and concentration.

Conclusion

The "extent of necessary decentralization" varies based on individual projects, personal views, positions, and business stages. Different perspectives exist depending on whether it concerns blockchain protocols like L1, L2, or decentralized applications at the smart contract level. Maintaining high levels of decentralization at various angles, layers, and functionalities of the value chain is challenging and costly.

It is essential to gradually move towards decentralization, considering variables such as the business realms of Web3 protocols, capital capabilities, and business stages.

How Should We Engage with Decentralization?

Through this article, we have delved deeply into the definition and importance of decentralization. Many developers, entrepreneurs, investors, and corporate leaders might wonder, “What exactly should we do?”

The essence of Crypto/Web3 lies in ‘decentralization’. When advancing projects and businesses, it is essential to uphold the principles of decentralization. This is because, without achieving decentralization, one cannot experience the innovative characteristics and paradigm shifts of Crypto/Web3.

As discussed in this article, the characteristics obtained through decentralization include fault tolerance, attack resistance, and collusion resistance. The paradigm shifts involve promoting competition, safeguarding freedoms, and rewarding stakeholders. In cases where a centralized approach is adopted, using the existing databases is often sufficient.

So far, there have been numerous projects that have prioritized speed and low costs by sacrificing decentralization. Also, amidst the excitement of 2021, the concept of 'Web2.5' emerged. However, there have been no projects that surrendered decentralization or embraced Web2.5 that have had a significant impact on society and achieved success.

Furthermore, numerous blockchains, dubbed Ethereum killers, claiming to solve Ethereum’s scalability issues and high gas fees, have also emerged. Nevertheless, Ethereum still boasts the second-largest market capitalization next to Bitcoin, and most of the innovative projects are born from the Ethereum ecosystem, providing the highest liquidity in the blockchain ecosystem.

Naturally, how one should engage with decentralization varies depending on the area of focus. We look forward to seeing many examples in the future and hope to contribute our own.

If you are interested in Tané's focus areas (investment, validators, DAO governance) or are from a Web3 project or company, don't hesitate to get in touch with us here.

Disclaimer: This post is for general information purposes only. It does not constitute investment advice or a recommendation or solicitation to buy or sell any investment. It should not be used to evaluate the merits of making any investment decision. It should not be relied upon for accounting, legal or tax advice or investment recommendations. This post reflects the current opinions of the authors. It is not made on behalf of Tané or its affiliates and does not necessarily reflect the opinions of Tané, its affiliates or individuals associated with Tané. The opinions reflected herein are subject to change without being updated.