Have you ever wondered who controls Bitcoin or decides the price of a cryptocurrency? Do you know how important decisions about digital assets are made and who is responsible? Have you ever heard that cryptocurrencies are better than fiat currencies because they aren’t controlled by anyone but the code? Well, then you are in the right place! You are already thinking about cryptocurrency centralization and decentralization.
Centralization and decentralization essentially represent two opposite ways of organizing a structure. Centralization implies that the power to manage, control, and oversee a certain entity, like a state or a currency, is concentrated around a position of authority. Decentralization is the opposite process, where the powers that organize a certain structure are distributed so that no one position controls the entire structure.
If you want to understand what all of these have to do with cryptocurrencies, we prepared a guide to explain the cryptocurrency centralization vs decentralization debate and answer all your burning questions.
What Are Decentralized Cryptocurrencies?
While not all cryptocurrencies are decentralized, some of the most famous and popular ones like Bitcoin and Ethereum are, at least in theory. But what does it mean to be a decentralized currency?
Unlike centralized currencies like the Euro and the US Dollar that are regulated by central banks, decentralized currencies are regulated by their codes. What’s more, the monetary policies of centralized currencies lie at the hands of central banks, whereas cryptocurrencies are regulated by their communities.
For example, we know that there can only be 21 million BTC in existence because that is in Bitcoin’s code. But who is allowed to make changes to a digital currency code? Who makes these decisions?
Bitcoin actually set an example for many digital currencies that came after it in terms of decentralization. According to the Bitcoin protocol, decisions regarding Bitcoin can be made by the users of Bitcoin. This means there is no single governing body that makes decisions on behalf of users – or at least that is the theory. This facet of decentralized governance is actually challenged by the popularity of mining pools that control most of Bitcoin’s hash rate, but we will come to that later.
However, Bitcoin is not just decentralized when it comes to governance. Another dimension of decentralization that Bitcoin popularized among cryptocurrencies is the independence from central authorities when it comes to managing security.
How Do Blockchains Help Decentralization?
As you may already know, blockchain technology lies at the foundation of cryptocurrencies. While it is not necessary to employ a blockchain to make a digital currency, a blockchain is a preferred method because it allows for decentralization and a trustless system without authorities.
In a decentralized system, the power to regulate the currency and check the books can’t belong to one single authority. But how can a cryptocurrency without a governing authority make sure people are not spending more than what they have without someone checking the books? Bitcoin’s peer-to-peer public blockchain offered a solution to this problem by employing a cryptographic protocol known as proof-of-work. This is essentially a consensus mechanism for the user community to decide and control which transactions on the blockchain are valid.
A blockchain consists of blocks of data, arranged in a way that each block is tied to one another in a single unbroken chain. Each block contains information about transactions that is used to prove the validity of the next block so that no single actor can add a block that contains false information.
For example, Bitcoin users can add blocks to the blockchain only if they satisfy the proof-of-work algorithm. Since the blockchain is public, it can be accessed by everyone, allowing all the users to check the validity of the dataset for themselves. This is how a cryptocurrency can function securely without a central authority.
Most digital currencies employ a consensus mechanism similar to the proof-of-work algorithm, but not all of them. There are also cryptocurrencies that use private blockchains. Private blockchains have centralized systems, with only a select few having the power to add new blocks and check the validity of transactions. This option requires users to put their faith in a managing authority. We will explore why some cryptocurrencies prefer centralized solutions in the next section.
How Does Cryptocurrency Decentralization Work?
Imagine decentralization and centralization as two ends of a wide spectrum. When we say a currency is centralized or decentralized, we are actually determining which end of the spectrum it is closer to. There are several factors that should be taken into account in determining where the cryptocurrency exists on the centralization-decentralization spectrum. Let’s have a look at these factors one by one.
Private or Public Blockchain
Anyone can plug into a public blockchain in order to add blocks and validate transactions. Here, the community of users monitors the safety of the blockchain by complying with the consensus mechanism of the blockchain. The power to run the blockchain is dispersed among a decentralized network of users.
However, a decentralized blockchain is only as strong as its community, and that can be problematic for smaller communities. One way to manipulate the blockchain data is to accomplish something that is known as a 51% attack. If an individual or a group manages to control more than 51% of the mining power of the network, they can alter the whole blockchain, and manipulate it for their own gain. While a cryptocurrency like Bitcoin that has a wide user base can protect itself, a blockchain with a smaller community is vulnerable to such attacks.
A private blockchain, on the other hand, introduces other measures of control alongside cryptography in order to regulate the blockchain and its community. There is a third party that decides who can interact with the blockchain, and defines the conditions of doing so. However, a centralized cryptocurrency has to depend on private servers. This, in return, can create a single point of failure for a security breach.
Decision Making Powers
Governance is another important aspect of decentralization. Remember how we asked who is making the important decisions about cryptocurrencies in the beginning? Well, that depends on how the governing power is distributed across the cryptocurrency network.
While it is true that cryptocurrencies are governed by their codes first and foremost, those codes can be amended by developers of the cryptocurrency. In most cases, the user community needs to approve such changes, because cryptocurrencies are worth only as much as they are used and approved by their communities. However, that doesn’t mean everyone automatically gets a vote on how things are decided.
Different cryptocurrencies employ different government methods, but it is common for public blockchains like Bitcoin and Ethereum to give voting powers to miners. That brings us to another important factor on the list: who are the miners?
In the first years following the launch of Bitcoin, Bitcoin mining could be accomplished by individuals with computers. However, as the network grew in numbers and computing power, so did the difficulty of solo mining.
These days, cryptocurrency mining is mostly done through mining pools, where users combine their computing power in order to mine coins successfully. Mining pools run protocols that manage the mining process and share mining rewards among users. However, they also receive governance and voting rights based on their combined hash rate, which effectively gives them decision making powers. Bitcoin and Ethereum mining is accomplished mostly through a couple of major mining pools, and their owners get to make decisions regarding cryptocurrency governance.
As a result, cryptocurrency governance is becoming more and more centralized as mining pools grow. For example, Bitmain, a private ASIC producer company that owns several large mining pools including Antpool, came dangerously close to controlling 51% of the Bitcoin network back in 2018. Bitmain’s years-long resistance to implementing the SegWit protocol resulted in a Bitcoin hard fork, creating Bitcoin Cash.
Decentralization essentially means no single authority wields power over a structure. Our modern world, however, is full of centralized authorities, such as nation-states. While cryptocurrencies might have more decentralized structures compared to fiat currencies, they are not completely exempt from government regulation.
Some cryptocurrency enthusiasts like to overemphasize how cryptocurrency decentralization allows digital assets to eschew traditional governance mechanisms, but that seems to change as governments begin to introduce plans to regulate certain facets of cryptocurrency trading, such as implementing taxes or identity verification standards for buying and selling digital assets or limiting such services.
Internet providers and private companies like Google and Amazon that provide cloud services limit how decentralized digital assets can be, in terms of their dependence on such services.
Another important infrastructure limit is exchange markets. Digital assets are mostly exchanged on cryptocurrency exchanges that are run by private companies, though there are also decentralized exchanges.
We will take a more detailed look at crypto exchanges in the next section because they are actually one of the most important factors when it comes to cryptocurrency decentralization.
Centralized vs Decentralized Cryptocurrency Exchange?
A digital currency exchange (DCE) is a market for buying and trading digital assets. They are also known as cryptocurrency exchanges.
There are two types of crypto exchange platforms. The first and most common type is centralized exchanges (CEXs). Centralized exchanges are owned by third-party companies that act as middlemen between cryptocurrency traders. Coinbase, Gemini and Binance are all centralized cryptocurrency exchanges.
A decentralized cryptocurrency exchange (DEX), on the other hand, allows users to trade digital assets without middlemen. Decentralized platforms use smart contracts, like atomic swaps, that allow traders to exchange one digital currency for another.
There are many differences between these two types of exchanges but perhaps the most important difference is that you can’t exchange digital assets for fiat currencies through decentralized exchanges. Anti-money laundering (AML) regulations require all fiat currency exchanges to be documented, so centralized crypto exchanges comply with Know Your Customer (KYC) regulations and perform identity checks for buyers and sellers on their platforms.
Cryptocurrency exchanges are an important part of the cryptocurrency ecosystem. Regardless of how decentralized a digital currency is, if users have to depend on centralized crypto exchanges to buy and sell their cryptocurrency, that means complete decentralization is not possible.
A Few Words Before You Go…
We often think of centralization and decentralization in absolute terms, but real-world applications of such concepts are often more complex than the words imply. Most cryptocurrencies employ a mix of centralized and decentralized procedures to function. As a result, there is not a single correct formula applicable to all digital assets when it comes to decentralization.
Functionality, security, governance, and trading are major areas in which cryptocurrency centralization and decentralization have real-world consequences. For example, centralization of the mining power in large mining pools could harm community decision-making processes, while decentralization of crypto markets could lead to easier money laundering activities. It is important that cryptocurrency users inform themselves on such issues and take an active role in determining the future of digital asset markets.