The Crypto Industry’s Growing Dependency on Centralization

The viability of cryptocurrency and blockchain centers on their capacity to deliver what conventional systems lack. These technologies have earned their statuses as disruptive innovations because they offer a distributed and transparent way of creating new assets, storing information, verifying the validity of data, and much more. In other words, cryptocurrency and its underlying technology owe their burgeoning popularity to the elements of decentralization that govern their operations. However, this notion is increasingly becoming redundant even as both technologies push towards mainstream adoption.

In this article, I will explore the gradual relegation of decentralization and how many elements of centralization the crypto landscape can adopt before it loses its essence.

How Centralized Is the Crypto Industry?

The crypto space prides itself as being disconnected from some factors prevalent in traditional industries. We believe that our understanding of blockchain technology and the diverse ways it could be put to good use make us impervious to the oversight of entities governing the inflow and outflow of traditional systems. Cryptocurrency offers us a means to negate censorship and establish a world where financial freedom was no longer a myth. It also had real-world use cases in the energy sector to fast-track the implementation of a distributed marketplace for renewable energy. In the legal scene, crypto and blockchain hold the key to the eradication of contract disputes and the establishment of a distributed source of truth that might come in handy in courtrooms.

At one point, the media was in full gear, reiterating the innovative power of both technologies and how they could easily relieve central authorities of their influences on the proceedings of established sectors. While this was going on, the crypto space found a way to bypass restrictions in existing fundraising mechanisms by introducing Initial Coin Offering ICO, a far less restrictive mechanism, which possesses the level of global reach alien to the traditional investment landscape. As a result of the promising nature of cryptocurrency and the uncensored state of ICO, the crypto market surged to unprecedented heights that brought about a bull run.

However, just as the crypto space was winning its external battles, the decentralization concept that was once the foundation of the industry was slowly losing its potency. At this point, some centralized crypto exchanges had grown so big that it was only a matter of time before they started wielding their authority on the proceedings of the crypto market. Before long, we began to hear rumors of price manipulations attributed to these entities. Also, they had become the de facto gatekeepers of the crypto market. Therefore, new projects that wish to join the hallowed ranks of cryptocurrencies listed on top exchanges had to part with a large chunk of money.

Following these events, regulators around the globe saw a need to curtail the excesses of the crypto industry by imposing KYC requirements on centralized exchanges. This development came as no surprise as centralized exchanges were the major link between the conventional financial system and the decentralized economy. It only made sense that regulators would look to have regulatory oversight on the crypto economy by targeting the sector that embodies the middleman factor.

If we choose to look at it from another angle, this development was justified. The prevailing perception that crypto allowed you to do whatever you want had begun to dent the viability of crypto in mainstream industries. News of crypto’s insecurity and the influx of scam projects were becoming the order of the day and had devastating effects on crypto’s budding reputation.

While crypto participants were reeling from the effects of negative press and a bear market, countries and enterprises began to put plans into motion to establish centralized digital currencies and ensure that they excelled where decentralized blockchains had failed. What this short analysis tells us is that the crypto industry is not completely free from the influence of centralized entities. At different stages of its short existence, the industry has been pressured into taking up more centralized components. And at each instance, it has shed a bit of decentralization to boost its appeal to conventional entities.

How Devastating Is the Situation?

Even though the core proponents of crypto’s decentralization foundations believe that centralization will eliminate digital currency’s potency, there are cases where the decision to accept more regulatory oversight has helped the industry escape murky situations. For one, the emergence of crypto regulations has reduced the cases of scams related to ICOs and other unregulated fundraising mechanisms. Startups have begun to put more effort into ascertaining the true nature of their investment assets and the right method of protecting themselves and investors. It has forced these entities to do more when it comes to the development of their crypto products because they are required to develop results or returns to investors.

This notion also applies to the emerging crypto custody market. The incessant attacks on the crypto security systems and the frailties of decentralized crypto storages have led to the introduction of institutional-grade infrastructures, which offer to hold large holdings in insured cold storage facilities on behalf of their clients. Without this solution, individuals and enterprises holding large amounts of digital assets will remain susceptible to common security threats. Furthermore, the introduction of KYC/AML requirements for crypto exchanges has helped security experts find new ways to trace and track the activities of nefarious entities using crypto as an instrument to fund or execute illegal acts.

While these points are valid, it does not erase the apparent risks and downsides of centralization. Centralization concentrates power on a select few. And from what we have learned so far from human history, the powerful tend to oppress the helpless. In other words, it’s only a matter of time before we start to see how centralization will erode trust and transparency that crypto embodies. To ensure that crypto finds acceptance in the mainstream financial landscape, we are slowly eliminating vital components that make it unique. In no time, crypto will eventually become what it was designed to replace – fiat currency.

China’s CBDC And What It Means for The Crypto Market

It is safe to say that China’s proposed central bank-backed cryptocurrency is designed to evade the backlash previous state-backed cryptos had generated. To this end, China is looking to take advantage of the current health and economic crises as suitable springboards for its digital currency. Marion Laboure, a macro strategist at Deutsche Bank, captures this sentiment when he explained that the concerns that physical cash could spread pathogens will serve as a valid argument for the fast implementation of a CBDC. Laboure stated:

“A once-in-a-century pathogen demands once-in-a-century solutions. An obvious place to start is to accelerate the inevitable shift toward [digital cash].”

In agreement, Bank of International Settlements’ researchers argued in a report that concerns over the viability of such projects are irrelevant in a time like this. The document reads:

“Irrespective of whether concerns are justified or not, perceptions that cash could spread pathogens may change payment behavior by users and firms… The pandemic may hence put calls for CBDCs into sharper focus, highlighting the value of having access to diverse means of payments, and the need for any means of payments to be resilient against a broad range of threats.”

Experts also believe that China could use this financial instrument to fast-track the distribution of stimulus packages promised to its citizens. The founder of Schnapper-Casteras PLLC, John Paul Schnapper-Casteras, attest to this sentiment when he commented that digital currencies will eliminate certain middleman entities that currently impede instant payments. Schnapper-Casteras explained:

“Two core features make CBDCs efficient and comparatively attractive as a policy tool: payment speed and helicopter money. Those would be especially useful in the current crisis, since a government could rapidly send direct payments to citizens (compared to the long delays in check issuance, tax refunds, etc.) and could also provide geographically and temporally targeted relief/stimulus.”

On the contrary, there is no guarantee that the reservations that had discouraged the idea of a national digital currency will suddenly disappear. Konstantinos Stylianou, an associate professor of competition law and regulation at the University of Leeds, suggested that concerns over CBDCs will rebound once the health and financial crises are no more immediate threats. He argued:

“The primary drive behind CBDC’s was never to create a more hygienic form of payment, nor were they primarily considered as financial stability or liquidity enhancing mechanisms, which is what the world needs now. Once the pandemic conditions are longer an urgent concern, the usual reservations that held CBDCs back will take hold again… The financial system is in such disarray at the moment that introducing an untested unprecedented financial instrument that was risky even during normal times would be neither prudent nor representative.”

After analyzing both sides of the divide, I concluded that the introduction of CBDCs is inevitable, considering the failing state of the global financial market. For what is worth, the pandemic and the global recession will force governments to try new ways of establishing their currencies as a means of facilitating direct trades and cutting off middlemen costs. However, this does not mean that the risk that governments, with successful CBDCs, will consolidate their censorship and surveillance schemes. It does not also erase the fact that poor financial policies still threaten the economic well-being of nations. Last year, Wulf A. Kaal discussed the precarious state of decentralization in China’s proposed national digital currency. He believes that autonomy has no place in China’s plans. Kaal stated:

“It is hard to see that the Chinese government would seriously consider a truly decentralized token. We would be able to debate what “decentralized” will mean in the case of China. If we agree that “decentralized” would mean, at a minimum, a token that is censorship-resistant, autonomous, and anonymous, it is hard to see the Chinese government facilitating that.”

The Push for Circuit Breakers

Conversations for and against the implementation of circuit breakers at the exchange and token levels have reinforced my belief that the crypto space will continue to take on more centralized components. Most of the people supporting the introduction of circuit breakers in the crypto space argue that it will protect investors and open more avenues for crypto to showcase its investment viability to traditional investors.

Jake Stott, the founder of dGen, believes that the unavailability of circuit breakers in the crypto market is detrimental to the approval of a Bitcoin ETF. Stott explained:

“Without circuit breakers, we may never see products such as a Bitcoin ETF, due to the huge price variations that could occur between the 24 hour and traditional exchange-traded product. I’m personally in favor of the circuit breakers because it appears much of the recent problems were caused by margin traders’ uncovered shorts and subsequent clogs in the Bitcoin and Ethereum networks. Price crashes were much more extreme for those reasons.”

Unfortunately, the current framework of the crypto exchange market is disadvantageous to the establishment of circuit breakers. Currently, crypto exchanges have autonomy over several key decisions, including those regarding the activation of circuit breakers. Hence, for this concept to become effective in the crypto space, we might need to impose a centralized governing council on the crypto exchange market that will issue directives like when to activate circuit breakers across all crypto exchanges.

A partner at Kairon Labs Market Making, Jens Willemen, discussed the strain decentralization will have on the concept of crypto circuit breakers. He explained:

“Circuit breakers do make sense for the larger, more liquid tokens to add in a bit more stability to the markets. In practice, we believe this will be very hard to implement in the crypto space. Most tokens are listed on a number of different (unregulated) exchanges, getting all these exchanges to agree on when and how to implement these circuit breakers will be very difficult to say the least.”

In a statement that supports this sentiment, Michael Creadon suggested that circuit breakers are not suited for the crypto market. Creadon explained:

“Circuit breakers won’t work because there are too many exchanges and no centralized rule-making body. If Coinbase freezes up but the market moves another 50% on Binance, you won’t be able to get out. So, you’re damned if you do, damned if you don’t. For long term hodlers, I think this is less important. For day traders, this is very important. Circuit breakers are a good thing, but hard to deploy when there are hundreds, if not thousands, of trading venues.”

Final thought

Centralization has become an unmistakable component of the crypto industry. And from what I have learned so far, this will continue to be a trend. Therefore, I can’t help but wonder whether decentralization was never designed to become mainstream.