Decentralization — The answer to the shortcomings of traditional finance?

When making the case for whether finance should be centralized or decentralized, we’ll often find 3 kinds of people; people who front centralization, people who oppose centralization and front decentralization, and people who don’t actively participate in the discourse for whatever reason. Regardless of the nature of their alignment, the 3rd category of people will very much be part of the dominant mainstream economic framework prevalent at any given point in time. They will willingly or unwillingly participate in the system regardless of which side the scales tip towards.

What largely constitutes the nature of economic frameworks around the world is the centralization of banks and financial institutions. This framework can draw parallels to the Greek philosopher, Plato’s analysis of the various types of governments. According to Plato, Aristocracy is the best form of governance where a few key players with full knowledge of how to run a government are running the state. His analogy says that the government should be run by people who are wise and capable enough to run a government. The worst kind of system next to tyranny, according to Plato, is a democracy which rises due to the disenfranchised revolting against the oligarchy.

While governments might have been of different kinds, economic systems have largely remained centralized even in communist or socialist regimes. In traditional finance, there can never be a system where economic power and freedoms are equally distributed amongst the people in society. The financial system itself took millennia to assume the form that it has taken today.

Plato argues that democracies enable ‘equality to equal and unequal individual alike’ and that the citizens of a democracy are ‘overwhelmed by distractions which leads them to a state of overspending and never producing.’ He further said, “The state comes to be ruled by people who are unfit to rule.”

Do centralized financial institutions share the same sentiment?

Maybe not.

Does the centralized financial system have inherent loopholes that can devastate an entire economy?

Possibly.

If we go back to the subprime mortgage crisis of 2008, banks like the Lehman Brothers began offering extremely cheap credit to a large number of people (basically, anyone who wanted it), thereby putting the banks in an extremely risky position. When a large number of people failed to pay their loans back along with interest, the housing market crashed in the U.S. and parts of Europe. This caused stock prices to plummet, thereby resulting in a global financial crisis and one of the biggest economic crises’ in history.

With the digitization of banks in an increasingly digital economy, centralization can lead to a serious compromise in security for banks. If details of customer records, as well as their personal details, are stored in a centralized repository, it can be at risk of being hacked and subject to theft.

Centralization

The centralization of finance has a plethora of key bottlenecks that prove it to be an inefficient system in terms of the equitable distribution of resources and opportunities. Centralized financial institutions are not geography agnostic and therefore can only provide financial services to the geography that they operate in. It is often the case that financial institutions and banks tend to perform better in jurisdictions that are economically stable and progressive. The same institutions fail to perform well in geographies where the economic and political scenarios are relatively unstable, or in tyrant regimes and dictatorships.

In some places of Africa, the Middle East and parts of Asia, financial institutions and banks often fail to provide services at scale due to the problems associated with developing economies; low levels of income, the lack of financial literacy and a small overall market. These issues give rise to a multitude of other problems like the high fees associated with opening a bank account, inconveniently located bank branches and an inefficient bureaucratic system.

Centralized financial institutions are prone to censorship, in that they can exclude individuals from seeking out financial services. Credit scores largely determine whether a person is eligible enough to avail a loan. Furthermore, payment providers can deny services to anyone that doesn’t align with their ethos’. For example, Paypal, Mastercard, and VISA blocked WikiLeaks from receiving donations, thereby forcing them to accept Bitcoin as a form of donation.

These institutions run in conjunction with governments. If a government is efficient and recognizes fundamental human rights, then the financial institutions will be in accordance. If the government is oppressive and subjugates economic freedom and standards of living, centralized institutions will follow suit.

There is also the issue of counterparty risk with centralized financial authorities. Counterparty risk is prevalent in credit agreements where lenders have to trust that borrowers will pay the loan back after a specified duration. There is always the risk that a bank might not be able to honor a customer’s deposits. Though this risk is higher in developing economies, the 2008 subprime mortgage crisis is a clear example of how devastating counterparty risk can be at the hands of centralized financial institutions even in developed economies.

One of the biggest problems in regards to centralized financial institutions is the series of fees associated with seeking financial services. Middlemen fees are rampant in banks and centralized financial institutions and there are a host of fees associated with their services, even though banks market their services as being ‘free’. The truth is the fact that banks set minimum account balances and arbitrary requisites that let them extract fees from unknowing customers.

Decentralization

The world economy, at large, has been following the system of centralized finance since the inception of financial institutions. Whether tied to a government or not, banks and financial institutions have enjoyed sovereignty to the extent of the laws of a particular jurisdiction. This means that banks and financial institutions are free to largely set their own terms and conditions when providing financial services to their customers.

The 2008 global crisis was the tipping point for people all over the world as it exposed many of the shortcomings and pitfalls associated with centralized financial systems.

Co-incidentally, the white paper for Bitcoin and blockchain technology was revealed to the world by the mysterious Satoshi Nakamoto in the same year.

It’s only been 10 years since the first Bitcoin block was mined, but the currency and technology have taken the world by storm and are increasingly finding their way into the mainstream digital economy. For the first time, users could be self-sovereign with their finances without having to rely on governments or centralized financial institutions to store wealth. Blockchain technology enabled individuals to have full custody of their wealth.

This was also the first time users could send their funds on a peer-to-peer basis without the need for validation from a central party. The validation is done by anonymous nodes that reach a consensus before the transaction is added to the blockchain.

Decentralized systems are not owned by any single entity. The data is created and distributed by the users themselves. This means that users have full control over their own data and identity on such platforms.

Comparisons between Centralized and Decentralized networks

Permissionless

In centralized platforms, the owners of the platforms can act as gatekeepers. They can arbitrarily grant or deny access to users.

In decentralized networks, as long as all the users follow the rules for a particular decentralized network, anyone from anywhere can access those systems.

Censorship Resistant

Moderators in centralized systems can censor and shadow-ban users at will.

Most decentralized systems are censorship resistant and there is no authority that can censor users or delete their accounts.

Ownership and Sovereignty of Data

In many centralized systems, the act of collecting and selling user data is commonplace. They usually control the keys to user data which means that a user’s private messages aren’t really private.

Almost all decentralized networks use public/private key cryptography so users can have more control over who can and can’t see their data. Users alone own their keys, and only they and recipients can view private messages.

Open Source

Most centralized platforms are closed sourced. This makes it difficult to understand how they work and what’s happening behind the scenes.

Almost all decentralized projects are free and open source softwares, so users can view exactly how the protocols and the softwares work.

Data Security

In centralized companies, large amounts of data are stored in a central repository. This increases the likelihood of a major breach in data occurring. If the company providing the service goes out of business or the service goes offline, all the users lose access.

In decentralized systems, even if one user’s account is compromised, the data breach will only be limited to that user. Since a lot of the users themselves are the nodes and distribute the data amongst themselves, there’s almost no way to shut decentralized systems down. As long as a handful of nodes exist, the network will continue.

Trustless

In centralized networks, the users have to trust that the company will honor its services to or validate the users.

In decentralized networks, users don’t have to trust a central party to ensure that the transactions are validated.

Transparency

The biggest and most key defining feature of decentralized networks is that of transparency. Centralized financial systems often lack transparency with arbitrary and vague terms and conditions that have a multitude of different fees associated with their services.

Most decentralized networks are completely transparent and auditable. Anyone with an internet connection can access data on decentralized platforms.

Challenges of Decentralization:

1. Subject to user’s discretion and personal responsibility

Since the users in a decentralized network are in full control of their own data, they must exercise enough discretion to safeguard their private keys. If a user accidentally loses or misplaces their keys, their account will be inaccessible forever.

Furthermore, if fallen into the wrong hands, a user’s keys can be used to access, steal and manipulate their data by malicious third-parties in the network.

2. Issues of scalability

Decentralized networks generally have scalability issues considering the many players spread across the network, all over the world. Scalability refers to the network’s ability to process a certain amount of data within a specific time period. Since there is no central party to filter relevant data, and the members are spread across in a decentralized network, validating large chunks of data can prove to be a time-consuming process.

If you take the case of the Bitcoin blockchain, one block can carry 1 MB worth of transaction data. Auditing needs to be done by the nodes fairly often which results in the network sending the blocks to all the nodes, every 10 minutes. Due to the limited nature of each block in the network, there is a limit to the number of transactions that can be validated in a timely manner. This means that the through-put of Bitcoin transactions is limited.

Scalability has been the subject of many debates within the blockchain community, which ultimately is about how to get more transactions through the system.

3. Presence of bad actors in the network

Criminals have always been the early adopters of any new technology. Though the anonymity of users and their data might be a good thing, it also comes with the risk of increased criminal behavior.

This is, perhaps, one of the most discussed facets of any decentralized network, i.e. the presence of bad actors. Whenever a new technology or system based on decentralization is presented to the masses, it is a common occurrence that the first people to use it are, in fact, those that we would consider as society’s underbelly.

Bad actors in the system could post illegal material or spam the system itself. Since no central authority is in control, it is impossible to delete the data and ban the user.

4. High energy consumption

Most blockchains work on a ‘Proof-of-Work’ (PoW) consensus. PoW validates a blockchain by creating a random math problem which the miners on the network compete to solve. The winner is validated by other miners on the network confirming that he or she has correctly solved the math problem and has downloaded the information on the previous block.

In the Bitcoin blockchain, it is the PoW consensus that adds blocks to the chain and rewards miners with Bitcoin for adding and validating the correct blocks on the chain. In the early days, people mining Bitcoin would sell it to speculators for an amount equivalent to their electricity bills. As people found more uses for the currency with the passage of time, and realized that the amount of Bitcoin was capped at 21 million coins, the price went up.

With the price going up, miners were incentivized to generate more Bitcoin. A lot of miners tried to get an edge through more computing power and economies of scale.

The Bitcoin blockchain, alone, ranks 53rd in yearly energy consumption.

There are alternatives to PoW, like ‘sidechains’ which use a Proof-of-Authority (PoA) consensus. When blockchains use PoA, they become permissioned, meaning that not everyone can become a node. When a blockchain becomes permissioned, it no longer is decentralized.

In Conclusion

In summary, at this point, it takes a fair degree of knowledge and responsibility when it comes to operating in and using decentralized networks. Ever since humans began storing wealth, a central authority has always been acting as the guardian or custodian of that wealth, whether they are appointed by the people themselves or otherwise.

It might be a facet of human behavior that storing and monitoring one’s own wealth might work out to be tedious and time-consuming. Maybe we, as humans, don’t want to be or are not used to being responsible for our own wealth. Switching to decentralization is not just a matter of merely switching protocols, networks or platforms. Rather, it requires a shift in mindset which entails switching habits, views, and perceptions.

When blockchain technology was first revealed to the world — it wasn’t the groups of disenfranchised people hit by the global recession that understood and embraced this technology, but the experts and enthusiasts of tech that jumped on this new system. Even today, blockchain technology, in particular, is a subject of discussion among tech communities and pioneers whereas cryptocurrency is discussed by more mainstream audiences (who often use both terms interchangeably).

While blockchain technology brought the concept of decentralization to the forefront, we all know that not all blockchains are permissionless or public. Banks and financial institutions that have adopted blockchain technology mostly use private and permissioned blockchains like Corda, developed by the blockchain consortium R3 which was built specifically for businesses. The reason for this is the fact that centralized financial institutions don’t like the aspect of the lack of privacy in public, permissionless blockchains.

Public, permissionless and decentralized blockchains are perceived as being threats to the business practices and the economic influence of banks and financial institutions.

It is safe to say that no central authority wants to give up power. Assuming financial power gives you the ability to dictate people’s thoughts, emotions and behavior. We can say that not all centralized financial authorities are inherently predatory, but these institutions can go to lengths of unethical practices to protect their businesses and self-interests.

One doesn’t need to go far in order to observe the disparities in economic classes with centralized financial institutions at the top. It is quite apparent that resources in an economy aren’t equitably distributed, and that there are a few winners and a whole bunch of losers. There is an argument that people are not responsible enough if given the option to manage their own finances and data.

Indeed, Plato’s analysis of mediocrity in democracy might be true in today’s world but what if we extend that lack of efficiency to central financial authorities?

Plato championed aristocracy, where a few individuals with full knowledge of how to run things assume control. But what if the aristocrats themselves are unsure about solving the increasing scale of issues at hand? Does that model veer towards ‘aristocracy’ or ‘tyranny’? We know that the people in power aren’t willing to give up that power and control, and will go to large extents to protect their own self-interests.

When this power goes unchecked, it gives rise to a lot of disharmony in the economy. Decentralization serves to keep this power in check. It is important to realize that the world population is increasing with each passing year, with speculations of it reaching 10 billion by 2050.

Will centralization be able to solve all the problems of the ever increasing population in a world where resources are finite and continuously depleting?

The simple answer is… no.

Beyond a point, authoritarianism cannot solve for the problems of the disenfranchised masses. It is very important for people to be self-aware with their finances and data, for them to make informed decisions that will collectively have an impact on society, with productivity at the forefront. As mentioned before, switching to decentralization is a matter of switching mindsets. A person will only be able to fully utilize decentralized networks, if that person is consciously aware of what happens in a decentralized network and what it takes to survive in such a network.

Mass adoption is a matter of awareness and collective thinking. Awareness is just the first step. Participating in the network and discovering the nuances of decentralized protocols is the next and most important step.

Decentralization of systems gained prominence at the onset of blockchain technology and cryptocurrency entering the world of finance. It’s just been 10 years since the technology was revealed to the world but so significant has been its impact that it is finding its way in so many applications apart from finance itself, like in tracking food sources and voting systems.

Immediately after the 2008 financial crisis, people asked fundamentally important questions like, “What’s next?” or “Where do we go from here?”. It’s no surprise then, that this technology was revealed to the world when it was direly looking for an alternative to the existing system.

Is decentralization good for society?

Yes, because it forces the individual to take responsibility and be accountable for their own resources. A decentralized system will enable the individual to make more informed choices and not depend on an external authority for reliance and guidance in financial affairs or otherwise. Rather than look for solutions from an external central party, forming a consensus just like nodes on a blockchain can be beneficial in recognizing accountability and ensuring trust in the system.

Freedom, as much as it comes with the luxury of choice, comes with a certain degree of responsibility. This can be both terrifying and empowering. Unless individuals realize the price of that freedom, and act on it, tyrannical systems will always find a reason to assume control.

I am a blockchain entrepreneur with a very deep passion in the finance domain. This eventually led me to start Bank of Hodlers, where we focus on providing financial services to those who hold crypto assets. We have just released our first product — an asset-backed lending platform. You can visit our website here if you would like to sign up or have a look at the platform.

If you would like to know more of my work and what we are striving to achieve at Bank of Hodlers, you can read it here in ‘Inside BoH’.