Centralized Versus Decentralized Platforms
“Not your keys, not your crypto!”
We have all encountered this aphorism regarding being safe in the crypto industry, especially given the recent catastrophic events in centralized platforms such as Celsius and Voyager, which led the bearish downslide across the entire cryptocurrency market and created a wave of panic amongst investors. This saying warns that investors should reconsider putting their life savings in centralized platforms where they are not in control of their crypto assets.
DISCLAIMER: NOTHING IN THIS ARTICLE CONSTITUTES INVESTMENT ADVICE. MAKE SURE YOU DO YOUR OWN RESEARCH BEFORE MAKING ANY DECISIONS.
Before we dive deeper into the difference between centralized and decentralized platforms, let’s talk about what happened in recent months.
In June of 2022, we saw the popular lending platform Celsius file for Chapter 11 bankruptcy. The company has over $8 billion lent out to clients and $12 billion in assets under management (AUM) as of May 2022. On June 12, in a surprising announcement, the centralized platform stated that it would stop all withdrawals from its platform due to “extreme market conditions”, thus locking its users out of their money. Rather than operating as a bank, Celsius acted like a hedge fund using its user’s money in high-risk investments. And within weeks, we saw another high-profile centralized crypto platform, Voyager Digital, file for bankruptcy — suspending withdrawals, deposits and trading on its platform. Essentially both the platforms locked their user’s out of their funds! At the centre of these insolvencies is their exposure to the now notorious Three Arrows Capital, a massive crypto hedge fund founded by Credit Suisse traders Zhu Su and Kyle Davies, which managed an estimated $10 billion in assets and went bankrupt.
These recent events bring us to a common argument of centralization versus decentralization. A thorough understanding of the pros and cons when choosing platforms can go a long way in mitigating risk and keeping your crypto investments safe.
Let us start with a generalized table which outlines the fundamental concepts of centralized and decentralized platforms.
Centralization: What is it, and how does it work?
Examples of centralized platforms are all around us, from social media apps such as Facebook and Twitter to video apps such as YouTube. In crypto, we have examples such as Voyager and Celsius or other popular platforms such as Binance or FTX. These platforms have a centralized model, meaning that a central authority controls the data, functions and algorithms that constitute it. In the generic case of Facebook, the company has complete control over all the platform aspects and the ability to decide who can or cannot join the platform as a user. In the case of a crypto platform such as Voyager, the company similarly has control over every aspect of the platform, even the right to stop you from accessing your money stored on its platform, as we recently saw.
Technically, centralized systems need third-party intermediaries to verify their data. When you send a message to your friend on Facebook, the data will be stored and verified first and then transferred to your friend. Sending an email is another example where the moment an email is sent to another person, the service provider knows what is being sent and when it is being sent.
In summary, centralized systems have complete authority and control over user data and accessibility. Furthermore, a single point of failure adds additional risks of data mismanagement and abuse.
Advantages of Centralization
- Higher efficiency
Most centralized systems have a well-defined hierarchy with a transparent chain of command, and this reduces redundancy and enables centralized systems to perform efficiently.
- Rapid decision making
A small set of people within the organization are responsible for decision-making, such as the CEO and the board of directors, which quickens the decision-making process.
Disadvantages of Centralization
- Misaligned interests lead to a lack of trust
Most often, the primary goal of a centralized organization is to generate the maximum profits for its shareholders, which leads to a misalignment of user and company interests. As in the case of Voyager and Celsius, their greed to generate higher company profits led to them abusing their user’s funds.
- Single point of failure
Most organizations are prone to a single point of failure, such as all user data being stored in a centralized server, which is at a high risk of being hacked or leaked if the company does not follow the highest security protocols.
Decentralization: What is it, and how does it work?
Although decentralized technology has existed for a while, it became more mainstream with the release of Bitcoin in 2009. Understanding the use of blockchain technology in Bitcoin opened up a whole new set of possibilities, making decentralization genuinely possible. For example, when one user sends bitcoin to another, the transaction does not go through a centralized intermediary. Instead, it is verified using consensus algorithms where the network is open, can be connected by anyone and is transparent where anyone can verify the transactions if needed.
A recent example of such a decentralized system is the Compound platform which enables users to deposit/lend, and borrow assets using a set of algorithms operating on the Ethereum blockchain called smart contracts. These smart contracts autonomously allow lenders to earn interest based on the interest rates paid by the borrowers. The decision-making of this entire platform is governed not through a central authority but by a decentralized community of COMP token holders and their delegates who can propose and vote on upgrades/changes to be implemented on the platform.
In summary, a decentralized system is an interconnected system where no single entity has sole authority. The decision-making is distributed between the network participants, reducing any single point of failure. With context to the blockchain, consensus algorithms remove the need for trust between two entities interacting on a centralized blockchain.
Advantages of Decentralization
- Total control
In decentralized platforms, users have full control of their activity, and thus they can initiate and complete a transaction without the need for a central authority to verify it. For, e.g. user’s can securely store and transfer a cryptocurrency asset with total control over it.
- Immutable data and records
Blockchain technology enables data structure to be immutable and append-only. Once data is recorded on a blockchain, it cannot be modified or altered by anyone.
Decentralized platforms operating on a blockchain are secure as they use cryptography to manage data ledgers.
- Censorship resistant
Reduced censorship is another advantage of decentralized platforms. As no central authority controls the data and access, a decentralized network is less prone to censorship as peers within the platform can interact directly.
- Open sourced development
Decentralization platforms are a proponent of open source development. An open development environment encourages collaborative participation, rapid prototyping, transparency, meritocracy, and community-oriented development.
Disadvantages of Decentralization
- Governance conflict
Decentralized platforms may sometimes face decision-making conflict, as a wider group of participants with varying interests are involved in proposing and voting on governance decisions.
- Code is law
Decentralized platforms operating on a blockchain enable all activities through complex codes. These codes are not legible to all its participants, which introduces risks where a code may have a logical flaw, or a honeypot may exist by a rogue developer that the users are unaware of.
- Crime and corruption
Anonymity comes at a cost, as it also attracts corrupt participants.
Crime is a significant disadvantage of decentralized networks mainly because all activity is anonymous, and it incentivizes rogue developers to create faulty systems that take advantage of unaware users.
To further summarize this article, we have covered an example of the functionality of centralized and decentralized platforms, which are relevant to the current times.
Celsius (Centralized Platform)
Celsius was an example of a popular centralized platform. The platform offered high yields on various cryptocurrencies and digital assets, such as Bitcoin, Ethereum and stablecoins. The platform functioned like a bank. Here, crypto lending is similar to a savings account offered by traditional banks. Users can deposit their assets and earn a stable interest on them. The platform further allowed users to borrow other crypto assets against their existing deposited assets or collateral.
Celsius and other similar platforms have used the centralized finance (CeFi) model as an alternative to decentralized finance (DeFi), where users work with a centralized intermediary. Over the years, the platform attracted massive interest in the crypto community and did exceptionally well. At the peak of the recent bull run, the company’s valuation was a whopping $3.25 billion. But as mentioned in the introduction, Celsius abused its authority and invested users’ funds in high-risk investments without their consent, leading to them losing their user’s funds and eventually the company filing for bankruptcy.
Waterfall DeFi (Decentralized Platform)
Waterfall is a decentralized financial platform that offers true risk diversification to its users through smart contracts. Waterfall DeFi Tranches are structured investment products that segment a pool of yield-generating DeFi assets into different categories known as “tranches”. Each tranche is classified based on its seniority and has a unique expected yield, risk and maturity set.
In simple terms, the profits generated from the underlying DeFi assets are paid out sequentially, first to senior tranche users and then to junior tranche users. Thus, this forms a waterfall-like payment structure.
The mechanism of Waterfall DeFi tranches provides key advantages. Firstly, it provides diversification, where users can invest in a portfolio of DeFi assets instead of just one, which diversifies the risk and reward for the user. With the leveraged yield feature, the lower tranches allow risk-tolerant users to earn a leveraged return on their existing investment strategies, such as providing liquidity to DEXs. While in the higher fixed-APR products, by tranching a pool of riskier DeFi assets, our platform offers users a safer fixed-yield product that pays a higher yield than traditional vanilla products. The senior tranches are specifically attractive to such risk-averse users.