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Decentralization typically has some tradeoffs such as lower transaction throughput, but ideally, the tradeoffs are worth the improved stability and service levels they produce. Benefits of decentralization Provides a trustless environment In a decentralized blockchain network, no one has to know or trust anyone else. Each member in the network has a copy of the exact same data in the form of a distributed ledger.
Improves data reconciliation Companies often exchange data with their partners. Each time the data is transformed, it opens up opportunities for data loss or incorrect data to enter the workstream. By having a decentralized data store, every entity has access to a real-time, shared view of the data.
Reduces points of weakness Decentralization can reduce points of weakness in systems where there may be too much reliance on specific actors. These weak points could lead to systemic failures, including failure to provide promised services or inefficient service due to the exhaustion of resources, periodic outages, bottlenecks, lack of sufficient incentives for good service, or corruption.
Optimizes resource distribution Decentralization can also help optimize the distribution of resources so that promised services are provided with better performance and consistency, as well as a reduced likelihood of catastrophic failure.
How decentralization compares Decentralization should be applied where it makes sense. The main distinguishing feature is that these services are provided without central intermediaries. In addition, there are a number of auxiliary services that are needed for the decentralised platforms to run and that result from having no central intermediaries.
Examples include the storage and transfer of crypto-assets through platform interfaces, the provision of informational resources through so-called oracle services[ 12 ], and blockchain bridges that aim to solve interoperability issues by bridging crypto-assets from one network to another e. While these services are not directly needed in traditional finance, some of them are akin to functions provided by market infrastructure, such as custody or clearing and settlement activity.
Instead of relying on a centralised and regulated intermediary to generate trust in the system, this is automated by code governed by predefined rules. Through these smart contracts, transactions are executed in a peer-to-peer manner based on predetermined rules that require little or no human oversight. For example, over-collateralisation and the enforcement of required margins through smart contracts are substituted for a credit risk assessment of the borrower.
DeFi applications use open-source technology, allowing a high level of composability. The different applications can then be combined to create new applications though mainly when using the same blockchain , akin to using Lego bricks. However, this also increases the complexity of the system due to the recycling of digital assets within different applications. DeFi protocols or platforms claim to have a decentralised governance structure, although in reality governance is often concentrated.
Decentralised governance relies on voting rights via governance tokens and decentralised autonomous organisation. As such, while purportedly claimed to be decentralised, DeFi applications retain a high level of centralisation. Like its traditional counterpart, DeFi lending is subject to market, liquidity and credit risk and, as a result of leverage, can exacerbate procyclicality.
For example, the strong use of stablecoins and unbacked crypto-assets can make DeFi susceptible to spillovers from the materialisation of stablecoin risks or strong price movements of unbacked crypto-assets. The recent developments related to the crash of the stablecoin TerraUSD exemplify these vulnerabilities, as the related DeFi protocol Anchor essentially collapsed Chart A. Smart contracts automatically execute if predetermined conditions are met, even if in certain market conditions it would be better not to.
Hence, as smart contracts take on the role of traditional market infrastructures such as exchanges or central counterparties, there could be strong ripple effects across the DeFi system as smart contracts continue to execute and cannot be stopped.
Technical and operational risks can originate from the immature and decentralised technology, in particular pertaining to the smart contracts that enable automation. Bugs within the codes whether erroneous or intentional can also be exploited to steal funds from participants. Alongside the recent growth of DeFi, the scale and frequency of attacks have also increased.
Notes: Panel a: data as of 12 April Panel b: funds stolen by DeFi attackers reflect cumulative amounts. Regulation The lack of traditional centralised entry points for regulation and its opaque and anonymous nature pose challenges for policymakers in terms of enforcement and effective regulation and supervision. The nature of DeFi may facilitate regulatory arbitrage and, despite providing existing financial services, it may fall outside the regulatory perimeter.
If DeFi protocols are not controlled by a central entity or such entities cannot be identified, it is not clear to whom regulations should apply. As some DeFi activities may already fall under current EU financial legislation, further steps will require a careful analysis to better disentangle actual regulatory gaps from lack of enforcement and DeFi trying to escape financial regulation through decentralisation and opaqueness.
Where regulatory gaps exist, the innovative ways in which DeFi provides financial services will require innovative ways of regulation to close regulatory loopholes. As a consequence, holders of governance tokens, decentralised autonomous organisation and platform developers could be brought into the regulatory perimeter.
To date, interlinkages with the traditional financial sector have been limited, but they have the potential to grow rapidly given institutional interest.
As stated in a previous point, the system of trust-less connection inherent in most cryptocurrencies disallows for the possibility of a single bad actor forging a transaction and corrupting the system; instead, more than 50 percent of the nodes in the network would need to cooperate unanimously to gain influence over the system. The larger the system, the smaller this possibility becomes. The distributed network model also minimizes potential threats.
Resource distribution improvements. Distribution has the potential to improve resource allocation within the system as well. Distributed networks can engage nodes, as needed, to produce the most consistent performance. Financial independence. People also like the appeal of total financial independence.
Individuals within the network can exercise much more independent decision-making. Possibility for competition. Decentralization also introduces more possibilities for financial competition. Appeal to investors skeptical of centralized authorities. The decentralization of cryptocurrency is also appealing to investors interested in removing themselves from the influence of centralized authorities. In our current financial system, centralized authorities are almost impossible to avoid.
For example, the Federal Reserve System has generated significant criticism in recent years. This is because it was making questionable decisions regarding interest rate adjustment, quantitative easing, and monetary policy overall. Cryptocurrency gives investors a way to opt-out of the current system.
How Decentralization is Also a Threat That said, decentralization can also pose some threats to your financial system and the individuals within it, such as: Lack of authoritative direction. Cryptocurrencies lack any sort of authoritative direction. Crypto developers spend a lot of time developing the product from the ground up before releasing it. And, you could argue that they still retain at least some control over the product, even after it they distribute it and it begins operations.
Still, a decentralized system neither monitors nor evaluates Bitcoin transactions in the same way authoritative control monitors transactions. Having this authoritative direction potentially leads to more significant insights, more robust security , and other advantages. Difficult maintenance. Most cryptocurrencies are designed to be autonomous and mostly maintenance-free; Bitcoin transaction processes today are nearly identical to Bitcoin transaction processes several years ago.
However, if maintenance ever does need to be performed, it can be difficult to impossible in a decentralized system. Suppose it follows the tenets of true decentralization. In that case, no single person will have total control over the system, which means any changes, updates, or modifications will need to be introduced with every individual node in mind.
Reduced performance and higher costs. We see this demonstrated by the fact that cryptocurrency uses more electricity than some entire countries ; every transaction needs a review and verification by a network of different individual computers, each processing very complex cryptographic problems, thereby spiking energy consumption. In cryptocurrency, this can be its own strength; the high-demand transactions serve as an added security feature.
These systems are decentralized because the data isn't in a single location but also centralized because a single company owns them. For instance, centralized systems are faster and more scalable, while decentralized systems are more secure and anonymous. Ultimately, the right network architecture decision comes down to the use case—there is no single solution that's best for every problem. How to Measure Decentralization You can measure decentralization by looking at the number of nodes and the distribution of responsibilities across nodes.
The process of measuring decentralization differs between consensus mechanisms: Proof-of-Work - The decentralization of proof-of-work blockchains depends on the number of nodes, hash rate, and the hash rate distribution among the nodes. As more nodes join and the hash rate increases, the network becomes more decentralized and harder for any single participant to disrupt. Proof-of-Stake - The decentralization of proof-of-stake blockchains depends on the number of stake pools or validators, the distribution of supply tokens across them, and the staked token supply percentage.
As the percentage of staked tokens increases, the network becomes more decentralized and difficult to disrupt. Of course, there are limits to decentralization with both approaches. Proof-of-work consensus mechanisms require more and more computational power over time, which becomes less and less affordable to maintain for individuals.
The result is more centralization over time as only larger entities can afford the rising computational power requirements. Proof-of-stake consensus mechanisms don't cost more as they scale, but forgers receive rewards proportional to their staked value. As a result, influential participants on the blockchain will become even more significant contributors over time.
Like with PoW blockchains, this can lead to lower levels of decentralization as time progresses. Trends Toward Decentralization The crypto community continues to push decentralization into new and exciting use cases. Beyond cryptocurrencies, the community hopes to apply decentralized blockchain and smart contract concepts across financial services and even governance.
As with Bitcoin's original intent, the goal is to democratize these services. The two most significant innovations include: Decentralized Exchanges DEX - DEXs are peer-to-peer marketplaces where transactions occur directly between traders rather than through a centralized intermediary. Using smart contracts, they algorithmically establish prices based on supply and demand and use "liquidity pools" to facilitate trades.
Instead, they use smart contracts and governance tokens to vote on decisions. They're often used to decide on project infrastructure or determine how token supplies are managed and spent. Cryptocurrencies are also exploring ways to become more decentralized by looking beyond proof-of-work and proof-of-stake consensus mechanisms.
For example, an extended proof-of-stake mechanism could replace actual stakes with a percentage stake to mitigate the centralization of forgers while improving security and efficiency.
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