Note: This article was first published in Mandarin for Taiwan’s CommonWealth Magazine in May 2022.
The word “decentralization” comes from “centralization” and is the spirit of blockchain technology. However, as decentralization has evolved, many question how decentralized can blockchain be when many of its applications such as stablecoins and exchanges are fundamentally centralized.
We would like to share how we define decentralization, using some of the USD stablecoins with the largest market capitalization as examples.
Decentralization is a spectrum of practical applications that can be roughly divided into three dimensions: ledgers, operations, and decision-making.
In this article, we will use some of the largest US-based stablecoins in terms of market capitalization to explore how decentralization will be defined in 2022 in ledgers, operations, and decision-making. How should individuals, institutions, and governments maintain a balance between centralization and decentralization?
I. Decentralized ledger
Pros: Unalterable, traceable
Cons: Low efficiency
Blockchain is also known as “decentralized ledger” technology, where one ledger is copied to a large number of verifiers (miners); they all participate in the ledger (mining). Every time a transaction occurs, these bookkeepers (verifiers or miners) must keep a ledger and receive a fee for doing so.
Decentralizing and deconcentrating the ledgers and bookkeeping responsibilities reduces the efficiency of the information system but increases the trust level because:
- Becoming a bookkeeper does not require licensing authority; anyone can inspect the ledgers so transparency is high.
- No entity can modify the ledgers.
From this perspective, the US dollar, or any fiat currency, has a centralized ledger. The US Federal Reserve and the US government dictate the amount of US dollars issued, and the ledger is not transparent, so it is difficult for the general public to know how many dollars are printed by the Federal Reserve each time it eases and where they go.
In contrast to USD, both centralized stablecoins such as USDT, USDC, USDP, BUSD and decentralized stablecoins such as Dai, UST, and Frax are issued using decentralized blockchain ledger technology, which is relatively more transparent. In addition to that, the Russian-Ukrainian war is an example where everyone can analyze and see that Russian exchanges are significantly increasing the use of certain USD stablecoins.
We can also compare the difference in the transparency of stablecoin issuers with the payment vendors we are familiar with.
Take Taiwan’s EasyCard (a payments card for public transit and retail) as an example; the general public cannot easily know how much money all users have deposited in EasyCard. However, without special permission, everyone can know the amount of each stablecoin issued from the chain data, and know the total amount and money flow in the chain.
II. Decentralized operation
Pros: High transparency, easier to gain trust
Cons: Easy to be hacked due to program vulnerabilities
Take the operation of Taiwan’s EasyCard as an example:
- What is the total amount of user deposits?
- How much is the company’s reserve?
- Is there a capital shortfall?
- How are these reserves allocated?
- What is the percentage of demand deposits and time deposits?
- In which banks are they placed?
- Are there any national bonds and commercial bonds in the reserves?
- What are the deployment rules?
- What is the average amount of money saved by users every day?
- What is the total amount of user spending?
- How much is the daily handling fee?
- How much revenue is generated?
Since the operation of EasyCard is centralized, the above questions are not transparent to the general public.
Although the books are decentralized with the centralized USDT and USDC, operations are centralized. Issuers are required to maintain a 1:1 USD reserve and are required to issue as many USD stablecoins as they have in reserves, which are regularly checked and made public by an external audit firm.
However, there is no way to know when an issuer is going to exchange its reserves for bank deposits. When must issuers allocate the ratio of bank deposits to short-term U.S. bonds? When do they lose money on commercial bonds? How much is the daily handling fee and how much is the revenue?
We even have to blindly trust audit reports issued by their external audit firm.
Therefore, EasyCard is a case where both the ledger and operation are not decentralized; USDT and USDC are cases where the ledger is decentralized, but the operation is not.
In contrast, the operations of a decentralized stablecoin (Dai, Frax, UST) are highly transparent and can be analyzed by anyone. The decentralization of the operation is, in short, the mechanism of blockchain smart contract implementation, which automatically triggers the agreement to be enforced without any obstruction or human intervention. This ensures transparency and eliminates reliance upon intermediaries such as external auditors.
The decentralization of ledgers and operations can be exemplified by Dai, a stablecoin issued by MakerDAO, which is primarily on the Ethereum blockchain. Each Dai is guaranteed by Ether, USDC, and other cryptocurrencies.
When the market price of Ether falls, the holder of the collateral must add Ether collateral, otherwise, MakerDAO’s smart contract will automatically auction and liquidate its position to ensure that the entire MakerDAO system is over-collateralized.
Since its launch at the end of 2017, Dai has experienced the collapse of the cryptocurrency market due to the COVID-19 pandemic, a more than 50% drop in Ether on March 12, 2020, and several bigger drops in quick succession, during which all of MakerDAO’s mechanism operations have been analyzed in depth by many blockchain experts and made into a real-time chart.
More charts are attached at the end of this article to show Dai’s supply, burning volume, net circulation, changes in positions, changes in collateral asset classes, etc. As we can see, the decentralized operation is to implement a set of financial services through blockchain smart contracts, which on one hand greatly enhances public trust and transparency, and on the other hand significantly reduces operation costs, including manpower, accounting, external auditing, etc.
The operation that relies solely on fully automated smart contracts also has its own risks. A stablecoin could collapse in value instantly if hacked. The lightning attack on Beanstalk Farms, an algorithmic stablecoin on Polygon, and the illegal minting of Safedollar, an algorithmic stablecoin protocol due to a vulnerability in the protocol, all cost hundreds of millions of dollars.
III. Decentralization of decision-making
Pros: Community sharing and governance
Cons: Lack of efficiency
As mentioned above, USD is centralized in terms of ledger, operation, and decision-making, USDT and USDC are decentralized in terms of ledger, and the rest are centralized, while Dai, Frax, and UST are decentralized in terms of ledger and operation to a considerable extent.
Now, let’s talk about the third dimension of the spectrum: decentralization of decision-making. Which coins have achieved this?
The rise of the Decentralized Autonomous Organization (DAO) has opened up new possibilities for communities to share power and decentralize decision-making.
By using tokens to calculate each person’s contribution and ownership, a new democratic voting mechanism is formed, overturning the traditional top-down structure of organizations where a few specific people hold the power to make decisions behind closed doors.
We can also understand DAO as a voting monitoring mechanism with high transparency (on-chain voting), high efficiency (low-priced), and high execution (automatic execution of voting results by the program).
The biggest prerequisite for a DAO to work well is that the operation must be decentralized, that is, built on top of a smart contract. Therefore, in terms of stablecoins, a decentralized stablecoin has a better chance to further decentralize the decision-making process by using a DAO.
Although the mechanism exists, it is up to organizations whether or not to implement it. “Decentralization of decision-making” is a political and philosophical issue with advantages and disadvantages.
Although decentralization has advantages of democracy, equality, and community governance, it is difficult to avoid problems such as too many opinions, inefficiency, and even community confrontation. Moreover, whether the majority opinion is the best opinion is another debate.
As of now, not many stablecoin issuers are interested in decentralizing their decisions. Perhaps the only one that has made progress is MakerDAO, the first financial mechanism to issue a decentralized stablecoin (Dai), whose governance currency (MKR) represents Maker’s governance rights. Having MKR is the same as having the right to participate in setting transaction policies, including changing lending rates, collateral types, minimum over-collateralization rates, Dai deposit rates, and so on.
As we increasingly decentralize decision-making through DAO, we also observe that MakerDAO has been slow to innovate in recent years compared to its competitors. It is not easy for any new proposal to pass a community vote, and forums are divided. This is the price of democracy.
The once-popular STEPN, has also issued a governance token, GMT, and many people had looked forward to its governance rules and to participate in the project that has sparked the Move-To-Earn model. Some of the NFTs that have made it out of the ring have had the same effect, moving toward decentralization of decision-making through community building and actual empowerment.
Imagine a completely decentralized society. When someone holds a gun and forces you to hand over your digital assets, no law enforcement agency can help you. This kind of Wild West society is not suitable for the general public.
Increasing the public’s familiarity with decentralized systems is an important task to enhance people’s financial autonomy. However, just as not everyone can learn to carry a gun to protect themselves, not everyone will be able to harness decentralized financial tools in a short period of time.
Decentralization is a spectrum with multiple dimensions. When we think about the degree of decentralization of an organization or a financial service, we can look at the three dimensions explored in this article: decentralization of ledgers, operations, and decision-making.
At XREX, our operations and decisions are centralized, but the ledger of our digital assets is decentralized. The main reason for this design is that we focus on serving newcomers to digital assets.
If we were to design in a highly decentralized model, it would be too difficult for users to back up their private keys and resist fraud and hackers. Also, as a highly regulated exchange, our decision-making process has to comply with national regulations and require those involved in the decision-making process to take legal responsibility. As a result, it is difficult to decentralize the decision-making process.
Similarly, even though many organizations such as MakerDAO are moving toward using DAO to decentralize decision-making, they still rely heavily on centralized tools such as Discord, an instant messaging platform, and Discourse, an online forum platform, which is also a kind of hybrid system in operation.
However, decentralization does not mean that it is unmanageable, nor is it without accountability. Since the birth of the blockchain industry more than a decade ago, many tools have matured to achieve different dimensions of decentralization in ledgers, operations, and decision-making, and to calculate the contributions, returns, and rights of stakeholders such as teams, investors, community contributors, liquidity providers, and bookkeepers.
Financial organizations can mix and match dimensions of decentralization according to user attributes to achieve the most equitable economic game model for all stakeholders with the best hybrid system and to build a sustainable community organization that can benefit everyone.