What is decentralization in blockchain
A blockchain is a distributed database that is shared among the nodes of a computer network. As a database, a blockchain stores information electronically in digital format. Blockchains are best known for their crucial role in cryptocurrency systems, such as Bitcoin , for maintaining a secure and decentralized record of transactions. The innovation with a blockchain is that it guarantees the fidelity and security of a record of data and generates trust without the need for a trusted third party. One key difference between a typical database and a blockchain is how the data is structured. A blockchain collects information together in groups, known as blocks , that hold sets of information.
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- Decentralization is a Cost-Benefit-Risk Tradeoff
- What is Decentralization?
- Bitcoin’s Decentralized Decision Structure
- What You Need to Know About Decentralized Social Networks
- DeFi risks and the decentralisation illusion
- It's Time to Walk-the-Talk on Decentralized Governance
- The Blockchain Trilemma: Fast, Secure, and Scalable Networks
Decentralization is a Cost-Benefit-Risk Tradeoff
The BIS hosts nine international organisations engaged in standard setting and the pursuit of financial stability through the Basel Process. Decentralised finance DeFi is touted as a new form of intermediation in crypto markets. The key elements of this ecosystem are novel automated protocols on blockchains — to support trading, lending and investment of cryptoassets — and stablecoins that facilitate fund transfers. There is a "decentralisation illusion" in DeFi since the need for governance makes some level of centralisation inevitable and structural aspects of the system lead to a concentration of power.
If DeFi were to become widespread, its vulnerabilities might undermine financial stability. These can be severe because of high leverage, liquidity mismatches, built-in interconnectedness and the lack of shock absorbers such as banks. Existing governance mechanisms in DeFi would provide natural reference points for authorities in addressing issues related to financial stability, investor protection and illicit activities. Crypto markets are underpinned by various forms of intermediation.
While some forms of crypto intermediation have direct analogues in traditional finance, others — known as decentralised finance, or "DeFi" — are fundamentally new and have recently gained more traction.
DeFi provides financial services without centralised intermediaries, by operating through automated protocols on blockchains. While the main vision of DeFi's proponents is intermediation without centralised entities, we argue that some form of centralisation is inevitable. As such, there is a "decentralisation illusion". First and foremost, centralised governance is needed to take strategic and operational decisions.
In addition, some features in DeFi, notably the consensus mechanism, favour a concentration of power. In principle, DeFi has the potential to complement traditional financial activities.
At present, however, it has few real-economy uses and, for the most part, supports speculation and arbitrage across multiple cryptoassets. Given this self-contained nature, the potential for DeFi-driven disruptions in the broader financial system and the real economy seems limited for now. DeFi would need to satisfy a number of conditions if it is to become a widely used form of financial intermediation. For one, blockchain scalability and large-scale tokenisation of traditional securities would need to be improved.
No less importantly, DeFi will need to be properly regulated. Public authorities would need to interface with DeFi's inherent governance structures, so as to ensure sufficient financial stability safeguards as well as to enhance trust by addressing investor protection issues and illegal activities. This special feature examines DeFi mainly from a financial stability perspective, drawing attention to vulnerabilities that stem from leverage and liquidity mismatches. As a key attribute of crypto markets, leverage amplifies their volatility and procyclicality.
In addition, the crypto ecosystem lacks internal shock absorbers, such as banks, that can provide liquidity at times of stress. This increases the potential for stablecoin runs that could sever links across investors and platforms, eroding the "networked liquidity" that is a defining feature of DeFi. The rest of this special feature is organised as follows. The first section provides an overview, focusing on the building blocks of the DeFi ecosystem.
The second outlines the decentralisation illusion. The third discusses key vulnerabilities from a financial stability perspective. The final section concludes with policy considerations. Decentralised finance DeFi is a fast-growing part of the crypto financial system. The rise of cryptoassets can be traced back to a whitepaper Nakamoto outlining a peer-to-peer transaction mechanism — blockchain — and the creation in of the first consequential cryptoasset — Bitcoin BTC.
Numerous blockchain technologies, as well as the respective cryptoassets that serve as mediums of exchange, have mushroomed since then. This technology supports automated contracts with pre-defined protocols hosted on blockchains, commonly referred to as "smart contracts", 2 and was instrumental to spurring on the DeFi ecosystem. The term DeFi refers to the financial applications run by smart contracts on a blockchain, typically a permissionless ie public chain.
The key difference between DeFi and CeFi lies in whether the financial service is automated via smart contracts on a blockchain or is provided by centralised intermediaries.
While DeFi records all the contractual and transaction details on the blockchain ie on-chain , CeFi relies on the private records of intermediaries, such as centralised exchanges and other platforms ie off-chain. DeFi aims to provide financial services without using centralised entities. Namely, it digitises and automates the contracting processes, which — according to its proponents — could in the future improve efficiency by reducing intermediation layers.
Importantly, it also provides users with much greater anonymity than transactions in CeFi or traditional finance. Such propositions have been key drivers of the heightened interest in DeFi platforms and the strong price rises of the attendant cryptoassets Graph 1 left-hand panel.
The expansion of DeFi in turn has hastened the emergence of alternative blockchain designs that host smart contracts and seek to rival Ethereum. DeFi differs from traditional finance not so much in terms of the types of service it seeks to provide, but rather in how it performs them.
Each row in Table 1 represents a specific service, grouped under three broad functions: trading, lending and investment. This section analyses the main building blocks of these services, and how the underlying mechanisms compare with those in CeFi and traditional finance. Stablecoins are cryptoassets that strive to tie their values to fiat currencies, such as the US dollar. They play an important role in the DeFi ecosystem, facilitating fund transfers across platforms and between users.
Stablecoins allow DeFi market participants to avoid converting to and from fiat money at every turn. They also act as a bridge between the crypto and the traditional financial systems, which share a common numeraire — ie fiat currencies.
The growth of stablecoins has been exponential since mid, when DeFi activities started to take off. In particular, USD Tether has gained substantial scale as a "vehicle currency" for investors who seek to trade in and out of cryptoassets right-hand panel. Being the first stablecoin, its growth has benefited from a user base built up early on, which has attracted new adopters seeking ease of trading network externalities.
The mechanism for assuring a stable value varies across different designs. In the case of CeFi stablecoins, a designated intermediary manages issuance and redemption as well as the reserve assets backing the stablecoins.
Some of these assets are bank deposits or their close substitutes. Other assets may comprise short-term securities — such as Treasury bills, certificates of deposit and commercial paper — as well as cryptoassets themselves.
To the extent that DeFi relies on such stablecoins, it remains dependent on CeFi and traditional finance. DeFi stablecoins record all transacting histories directly on-chain, without the involvement of centralised intermediaries. They rely on an overcollateralised pool of cryptoassets, ie the underlying assets are worth more than the stablecoins in circulation.
Since crypto collateral has a very high price volatility, as measured in the reference fiat currency, DeFi stablecoins incentivise users to actively monitor the collateralisation ratio. They do so by adjusting the supply of stablecoins to match their demand. So far, no purely algorithmic stablecoin has been widely adopted. In sum, stablecoin issuers receive assets collateral in exchange for their own liabilities stablecoins.
While this mechanism looks superficially similar to how banks operate, there are fundamental differences. Issuers lack public backstops, such as deposit insurance, and rely on private backstops collateral to ensure that stablecoins maintain a steady value and are suitable as mediums of exchange.
As such, the expansion of the balance sheets of stablecoin issuers, at least currently, is driven more by the appetite of investors to hold the stablecoins than by any desire of the issuers to acquire more assets.
In other words, this growth is liability-driven, while the expansion of bank balance sheets is commonly asset-driven McLeay et al The former are structured around the same principles as their conventional counterparts.
CEXs maintain off-chain records of outstanding orders posted by traders — known as limit order books. By contrast, DEXs work in substantially different ways, by matching the counterparties in a transaction through so-called automated market-maker AMM protocols. AMMs follow mathematical formulas to determine prices based on transaction volumes. Box A discusses how AMMs incentivise liquidity provision; it also looks at their susceptibility to market manipulation.
In addition, trading on DEXs incurs execution costs when transactions are validated on the blockchain. These stem from so-called gas fees, which are designed to compensate validators. Gas fees increased markedly as cryptoassets gained popularity and blockchains such as Ethereum became more congested compare left- and right-hand panels. Although transaction costs are higher in DEXs, some traders still prefer these platforms, in part due to their greater anonymity and interoperability with other DeFi applications the so-called "DeFi Lego".
Lending in DeFi tends to be overcollateralised. The reason is similar to that underpinning the overcollateralisation of DeFi stablecoins — the inherent lack of trust in anonymous transactions, together with the high volatility of the cryptoassets used as collateral. To protect the lender, loans can be automatically liquidated when the collateralisation ratio falls below a threshold. At present, the need for crypto collateral stands in the way of lending to households and businesses, eg for house purchases or productive investment.
Rudimentary forms of unsecured lending, known as "credit delegation", are available on some platforms. This often involves entities with established off-blockchain relationships, making collateral unnecessary.
DeFi lending platforms also offer a unique financial instrument, typically referred to as flash loans. These allow arbitrageurs to act without their own capital by taking out a loan for the entire arbitrage trade and then repaying the loan.
Such loans are of zero duration and are essentially risk-free requiring no collateral , as they are granted only if the arbitrage trade ensures the repayment of both principal and interest. Crucially, this is possible as all legs of the transaction can be attached to the same block ie settled simultaneously on the blockchain.
The growth of DeFi lending platforms has also encouraged the development of applications similar to investment funds in traditional finance. These decentralised portfolios follow pre-determined investing strategies, eg aggregating funds from investors and automatically shifting them across crypto lending platforms to profit from the best yields.
DeFi purports to be decentralised. This is the case for both blockchains and the applications they support, which are designed to run autonomously — to the extent that outcomes cannot be altered, even if erroneous. But full decentralisation in DeFi is illusory.
A key tenet of economic analysis is that enterprises are unable to devise contracts that cover all possible eventualities, eg in terms of interactions with staff or suppliers. Centralisation allows firms to deal with this "contract incompleteness" Coase and Grossman and Hart In DeFi, the equivalent concept is "algorithm incompleteness", whereby it is impossible to write code spelling out what actions to take in all contingencies.
This first-principles argument has crucial practical implications. All DeFi platforms have central governance frameworks outlining how to set strategic and operational priorities, eg as regards new business lines. This element of centralisation can serve as the basis for recognising DeFi platforms as legal entities similar to corporations.
While legal systems are in the early stages of adapting, decentralised autonomous organisations DAOs , which govern many DeFi applications, have been allowed to register as limited liability companies in the US state of Wyoming since mid In addition, certain features of DeFi blockchains favour the concentration of decision power in the hands of large coin-holders.
What is Decentralization?
Blockchain technology is most simply defined as a decentralized, distributed ledger that records the provenance of a digital asset. By inherent design, the data on a blockchain is unable to be modified, which makes it a legitimate disruptor for industries like payments, cybersecurity and healthcare. Our guide will walk you through what it is, how it's used and its history. Blockchain, sometimes referred to as Distributed Ledger Technology DLT , makes the history of any digital asset unalterable and transparent through the use of decentralization and cryptographic hashing. A simple analogy for understanding blockchain technology is a Google Doc. When we create a document and share it with a group of people, the document is distributed instead of copied or transferred. This creates a decentralized distribution chain that gives everyone access to the document at the same time.
Bitcoin’s Decentralized Decision Structure
For the sake of this article, we will skip the part on explaining the technology. If you need some catching up, check our explanatory piece on the topic. A successful governance model is usually what makes an organization click. While a participative democracy could work for some, having powers vested in a central authority may be preferable for others. Though as diverse as they may be, exemplary governance models are often centered around a set of qualities: transparency , integrity , effective performance and collaboration. In the context of blockchain, the discussion on governance currently revolves around two sets of models: centralized vs. The first duel is the classic blockchain paradox which calls into question contemporary authority structures. The second refers to human involvement and the extent to which decision making processes are automated. Regardless of the governance structure, matters at stake typically involve network access, funding allocation, block size, reward systems, voting and decision making e. On a large scale, this effectively means the removal of centers of authority such as governments and their institutions, central banks, etc.
What You Need to Know About Decentralized Social Networks
The Future of Money. From blockchain and bitcoin to NFTs and the metaverse, how fintech innovation is changing the future of money. Read More. Decentralized finance, or 'DeFi', is an emerging digital financial infrastructure that theoretically eliminates the need for a central bank or government agency to approve financial transactions. Regarded by many as an umbrella term for a new wave of financial services innovation, DeFi is deeply connected with blockchain -- the decentralized, immutable, public ledger on which Bitcoin is based -- that enables all computers or nodes on a network to hold a copy of the history of transactions.
DeFi risks and the decentralisation illusion
Decentralized networks are made up of computers, also known as nodes, that interact on a direct, peer-to-peer basis, without the need for third parties. Each node has an updated copy of all recorded data. Decentralized networks can also distribute data so that certain private information can be validated without that information being transferred to a third party. Data is validated by using an agreed-upon consensus mechanism, which often involves the other computers on the network checking the validity of the data before it becomes permanently imprinted onto a blockchain. In a decentralized network, each participating node is independent of the others. Rather than following the instructions of a central authority, decentralized nodes connect using common rules, but maintain their sovereignty and manage their own privacy.
It's Time to Walk-the-Talk on Decentralized Governance
The decentralised web, or DWeb, could be a chance to take control of our data back from the big tech firms. So how does it work and when will it be here? T he story that broke early last month that Google would again cooperate with Chinese authorities to run a censored version of its search engine , something the tech giant has neither confirmed nor denied, had ironic timing. The same day, a group of web builders and others — among them Tim Berners-Lee, who created the world wide web — were meeting in San Francisco to discuss a grand idea to circumvent internet gatekeepers like Google and Facebook. And its proponents have got projects and apps that are beginning to function, funding that is flowing and social momentum behind them. In light of the Snowden revelations and Cambridge Analytica scandal, public concerns around spying and privacy have grown. What is the decentrali sed web? It is supposed to be like the web you know but without relying on centralised operators.
The Blockchain Trilemma: Fast, Secure, and Scalable Networks
Are blockchain and distributed ledger technology the same? This is a common misconception that many people have. We are living in a digital age of sound bites and buzzwords. An age where even complex technological solutions are reduced to five words or less.
The Internet of Things IoT has provided many services in the fields of intelligent transportation, smart cities, medical treatment, and military. With the development of the IoT, it is expected that 50 billion devices will be connected to the IoT by Security, privacy, and data storage issues have become key issues in IoT systems. The current centralized architecture model in IoT systems is difficult to scale to meet the needs of future IoT systems.
The BIS hosts nine international organisations engaged in standard setting and the pursuit of financial stability through the Basel Process. Decentralised finance DeFi is touted as a new form of intermediation in crypto markets. The key elements of this ecosystem are novel automated protocols on blockchains — to support trading, lending and investment of cryptoassets — and stablecoins that facilitate fund transfers. There is a "decentralisation illusion" in DeFi since the need for governance makes some level of centralisation inevitable and structural aspects of the system lead to a concentration of power. If DeFi were to become widespread, its vulnerabilities might undermine financial stability. These can be severe because of high leverage, liquidity mismatches, built-in interconnectedness and the lack of shock absorbers such as banks.
The promise of blockchain is decentralized governance. However, managers need to carefully consider two things. First, decentralized governance is not a necessary feature of blockchain; it needs to be enacted.