A history of disintermediation and its cousin, decentralization
TLDR: The decision to decentralize does not necessarily lead to peer-to-peer networks — the reincarnation of decentralized intermediaries is a real threat to open, neutral, borderless, censorship-resistant networks.
Edit: Liquality Atomic Swaps are live for users to swap crypto p2p.
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The Cost of Mediation: A Loss of Freedom
Prior to the advent of Bitcoin, transactions required trusted third parties to determine their validity, due to the possibility of fraud and transaction reversals. For example, in payment processing, intermediaries like Visa, Chase, and Paypal mediate disputes and issue chargebacks, providing a useful service to victims of fraud. As such, according to the Bitcoin white paper, “completely non-reversible transactions are not really possible, since financial institutions cannot avoid mediating disputes.”
However, “the cost of mediation increases transaction costs, limiting the minimum practical transaction size and cutting off the possibility for small casual transactions,” resulting in the exclusion of populations that are deemed unworthy of transacting with.
Not only that, but also “there is a broader cost in the loss of ability to make non-reversible payments for non-reversible services. With the possibility of reversal, the need for trust spreads,” and as trust transferred over to these third parties, power consolidated in their hands.
By relinquishing control over money to authorities, single points of failure have emerged and their pitfalls, such as downtime, corruption, manipulation, and censorship, have been passed down to their subjects. In doing so, the ability to freely own, assign, and transfer value has devolved from what was once a freedom of expression into a privilege that is granted by institutions.
January 3rd, 2009: Enter Bitcoin
Satoshi’s response to these trust-maximized points of failure was an alternative, trust-minimized system: Bitcoin.
Peers in the Bitcoin network could settle transactions without the need for trusted third parties. There are five components that work together to make this system possible:
- A Proof of Work Consensus Mechanism
- A Distributed Timestamp Server on a Peer-to-Peer Network
- A Blockchain
- Cryptography
- A Native Digital Asset (bitcoins)
Peer-to-peer transaction settlement was only previously possible with in-person transactions (like cash and barter systems), requiring participants to trade in the same physical location. Bitcoin has proven that both money and transactions can be disintermediated; by solving the Byzantine Generals’ Problem, Bitcoin has not only allowed for the ownership of money and freedom to transact, but also peer-to-peer transaction finality across any space.
Bitcoin transactions are atomic and final; they either (1) happen and are non-reversible once thoroughly mined, or (2) don’t happen at all. The immutability of atomic and final transactions serves as a strong foundational component for sound, programmable money. As noted in the Bitcoin white paper, “transactions that are computationally impractical to reverse would protect sellers from fraud, and routine escrow mechanisms could easily be implemented to protect buyers.” Only with a trust-minimized foundation can there be additive layers (like the Lightning Network)and extensible functions (like HTLCs + Atomic Swaps) that are also peer-to-peer, resulting in compounding network effects, enhancement of network utility, and empowerment of network participants.
“Blockchain, not Bitcoin”
Unfortunately, the trend seems to be reversing back towards old paradigms, as demonstrated by widespread reincarnation of intermediation on decentralized networks. Whether purposefully deceitful or simply misinformed, organizations ignore the paradigm shift introduced by Bitcoin and instead cling onto and propagate the false narrative that blockchain is the real innovation underpinning Bitcoin, stealing mindshare away from what seems to be the real innovation here: empowerment of participants through disintermediation.
What these groups don’t seem to grasp is that a blockchain is just one component of what enables Bitcoin to be a practical solution to the Byzantine Generals’ Problem. Blockchains do not, by default, inherit the core characteristics brought about by Bitcoin’s consensus-based network — characteristics of being:
- Open
- Neutral
- Borderless
- Censorship-resistant
These characteristics are critical, as they catalyze permissionless participation and innovation.
As a result of this misunderstanding, the public blockchain space has been polluted by decentralized applications that place themselves at the center, rather than removing themselves out of the equation. It appears that many decentralized application developers decry institutional co-option of private blockchains as antithetical, when, in fact, they themselves are also recreating intermediary structures and institutions. This disconnect seems most apparent in the decentralized exchange (DEX) space. Rather than applying the characteristics above to the exchange of crypto assets, these “DEXs” choose to intermediate transactions between parties.
“Decentralized” Exchanges
Trading volumes on centralized exchanges have grown in lockstep with token mania. But as these honeypots proved their inability to defend themselves from attack after attack after attack, the industry seems to have gained clarity on just how vulnerable these single points of failure are. As a result, disintermediation seems to be crawling back into the picture, through the formation of decentralized exchanges.
Rather than taking custody over users’ private keys, DEXs promised that users would remain in control of their keys and allow for direct wallet-to-wallet exchange of different cryptocurrencies without the need for middlemen. Though DEXs have certainly achieved the former, the latter remains non-existent. DEXs still intermediate the exchange of value between participants through DEX-owned smart contracts, which require users to relinquish control over their value to the exchange entity for the purpose of the trade. Let’s take a look at Bancor as an example.
Whereas Bitcoin sought to distribute power over monetary policy and remove intermediaries from transactions, “the Bancor Protocol is named in honor of the Keynesian proposal to systematize international currency conversion by introducing a supranational reserve currency called Bancor” (Bancor white paper). By implementing BNT (their supranational reserve currency), Bancor advocates for a managed market economy and reincarnates a central bank monetary policy — one that Bancor controls.
Though Bancor advertises that their users can convert between any two tokens on their network without a counterparty, in truth, users don’t swap tokens with other users; users are only allowed to trade through Bancor itself. From Coindesk: “Bancor (through its smart contracts) was itself the only market maker on its decentralized platform, where it facilitated roughly 9,691 token swaps between 1,147 traders over the two-week period, Alethio found.”
In addition to Bancor-owned smart contracts’ determining who users can and can’t trade with, the contracts also allow for special functions accessible only to the Bancor team. You may have heard recently that 25,000 ETH was stolen from Bancor (equivalent to about 1,785 BTC or 13,500,000 USD at the time). To prevent further loss, Bancor called upon one of these special functions, allowing the team to freeze all movements of BNT.
Through examples like these, it is clearer that “decentralized” solutions do not necessarily cultivate disintermediation. Instead, the beneficiaries of decentralized smart contract systems are determined by the roles created by their owners, just like in the legacy financial system. Ethereum enables this by “building what is essentially the ultimate abstract foundational layer: a blockchain with a built-in Turing-complete programming language, allowing anyone to write smart contracts and decentralized applications where they can create their own arbitrary rules for ownership, transaction formats and state transition functions,” which voids the underlying benefits of a consensus-driven network (Ethereum White Paper).
When you consider that the following components:
- Blockchain database (decentralized, replicated)
- Consensus algorithm (open, decentralized, Proof of Work)
- Native intrinsic asset (reward for extrinsic energy cost, Proof of Work competition)
enable greater degrees of Bitcoin’s core characteristics, it seems that smart contracts’ owners are the direct beneficiaries of those characteristics, whereas their users are left with:
- Blockchain database → isolated state / registry manager
- Consensus algorithm → rules of the smart contract system, dictated by their owners
- Native intrinsic asset → (ERC20) token without the incentive to secure the network
In effect, users end up with software that further institutionalizes the inequities of today, through the reincarnation of intermediaries that choose to deprive users of this technology’s benefits. A follow-up blogpost will further explore the different layers of intermediation.
How to Move Forward
In the coming weeks, the core contributors of the Liquality project will release two free software projects that aim to unshackle value from their chains. Once they’re out, explore them and challenge the contributors’ assumptions. Until then, share your thoughts on the disintermediation movement.
