Guide to Centralized Cryptocurrencies: Impacts of Centralization

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This article takes a look at the impacts of centralization in centralized cryptocurrencies, weighing both the positive and negative aspects. Is centralization all bad?

In the decentralized world of cryptocurrencies, the idea of centralization is an insult to any project associated with it. In the minds of the larger cryptocurrency community, centralization paints a negative picture of elites (especially in the form of government and banks) that possess too much power for our liking. In our previous article, we have identified several features that make a cryptocurrency coin centralized. Here are the types of centralization for centralized coins:

Centralization in the context of cryptocurrencies can come in various forms, as illustrated in the diagram above. Let’s explore the negative and positive impacts of cryptocurrency centralization.

Negative Impact of Centralization

Centralization in the cryptocurrency space has a negative connotation. Let’s take a look at the negative side of centralized coins:

Bad Image

Let's face it, whenever a coin is branded or referred to as ‘centralized', it's not good publicity. People tend to shy away from centralized coins. The most pressing justification is that centralization goes against the ideology and philosophy of cryptocurrencies itself. The first and largest Cryptocurrency – Bitcoin – was created as a decentralized system to address the issues of our centralized monetary system controlled by governments and banks. A decentralized structure allows for an equal playing field for all participants within the network. A centralized coin on the other hand, goes against all that good stuff.

Having a negative image within the community would deter support and investments toward the project and its native tokens. This is never healthy and could compromise the long-term viability of the project.

(See more: Evolution of Cryptocurrency: The Problem With Money Today)

Power Concentration

It must be pointed out that cryptocurrencies were created to break away from the traditional powers of centralized institutions. History has shown that entities with too much power and little oversight leads to disastrous results. The most compelling example is the financial crisis in 2008, in which the catastrophic effects led to the creation of Bitcoin.

The root causes of the subprime mortgage crisis can be attributed to the abysmal monetary policies undertaken by the government and the horrendous practices of big banks that exploited the masses for profits. In both these cases, a centralized and hierarchical power structure enabled huge decisions to be made with little to no oversight and accountability.

The financial crisis was a huge reminder on the importance of open-sourced decentralization in being an alternative paradigm for a fully-functioning and fair system. Instead of relying on the decisions made by a single authority, a decentralized network empowers anyone to contribute to the entire system. The structure of a centralized cryptocurrency exhibits the same characteristics and power structure of traditional entities, which defeats the point of creating them in the first place.

A greater degree of power and control goes against the empowerment of a decentralized system. Unsurprisingly, centralized cryptocurrencies do not fare well with the larger cryptocurrency community.

Price Manipulation

Given the unregulated nature of cryptocurrencies, price manipulation is rife in the cryptocurrency markets. This is especially relevant in coins that have a centralized token structure, in which the founding company or team holds a majority of pre-mined tokens.

Pre-mined coins are cryptocurrencies or tokens that have been created before it is launched to the public.

The issue of the core team or entity having majority ownership of the token supply is troubling, since they possess the power to easily manipulate prices. They can liquidate a portion of the token supply at their own discretion, which leads to greater selling pressure in the open market and will result in decreased token prices. The greater cryptocurrency community usually tend to stay away from such coins.

An example is Ripple (XRP), where the founding company (Ripple Labs) and its CEO holds over 60% of XRP’s coin supply. As we speak, Ripple is facing multiple lawsuits that allege that its Ripple Labs and its CEO have been illegally profited from price increases.

Security Issues

A major weakness of a centralized network is that it more susceptible to hacking since it has a single point of data collection. That is why a decentralized, peer-to-peer system is extremely secure; in order for hackers to infiltrate the system, they have to hack every single database or node in the network, which is an improbable scenario.

Another crucial risk in a centralized system is network failure, which occurs when the centralized nodes in the system freezes and shutdown. A total network shutdown will compromise the functionality of the system and will harm the prospects of the project. An example of this is when the NEO network (also known as the ‘Chinese’ Ethereum) suffered from a total network shutdown due to the failure of a single node. At that time, NEO had a centralized blockchain architecture with only 13 initial consensus nodes that were fully controlled by them. Expectedly, the community reacted negatively towards this and NEO’s price suffered as a result of the network shutdown.

(See also: Guide on Identifying Scam Coins)

Positive Impact of Centralization

However, it is important to understand that centralization may not be generally a bad thing. There are merits to a centralization, which include:

Efficiency

The core limitation within blockchain technology is scalability; decentralized systems are by nature much slower than traditional, centralized systems. This makes them inefficient as compared to centralized databases.

For instance, VISA processes an average of 1,700 transactions per second (TPS) while Bitcoin (BTC) is capable of 7 TPS and Ethereum (ETH) at 20 TPS.

* (The metric used to measure scalability is Transactions Per Second [TPS])

Due to its limited capacity, a decentralized network will be congested with increasing mainstream usage. This would lead to various issues that will hinder user experience such as increasing fees and longer confirmation times. That is why there are some projects – such as NANO and Solana – that are focused on creating high-throughput (high TPS) blockchain solutions, which inevitable requires giving up a degree of decentralization.

Having a high-throughput solution greatly enhance scalability and opens up the wide range of applications that can be developed on blockchain technology, enabling real businesses to leverage on the technology without compromising on speed and performance. In fact, some projects – such as Dispatch Labs – are engineering mechanisms to preserve the integrity of decentralization while focusing on enterprise-grade blockchain solutions with high-throughput.

Network Stability

There are projects that are initially centralized in the early stages of development. Usually, this is publicly stated in the project roadmap since the start, so that the community is aware of the plan. The main reason for doing so is to provide stability to the infant network, with continual developments to further enhance and secure the network. Over time, the project will progress towards decentralization. Once the project is completely tested and ready, the project will be fully decentralised by allowing anyone to participate in the network as nodes or users. This is a practical way to allow for the maturity of the project and it's ecosystem, allowing for a more stable developmental progress.

An example is Factom, a distributed record-keeping system that employ an initial centralized structure. Factom has 3 milestones (stage) that progresses towards decentralization. The first milestone runs on only one, centralized server so as to establish the infrastructure and data structure. The second milestone entails increasing the number of servers to 8, allowing for greater (but not optimal) decentralization. The Factom Protocol will be fully decentralized and trustless on the third milestone, with a total of 64 Federated Servers and an election process for maintaining the servers.

Price Stability

It is important to understand that this is only one of the ways to stabilize price in the early stages of the entire cryptocurrency market and of the specific cryptocurrency itself. Thought some might argue there are better ways to stabilize prices, it still qualifies as a positive impact on the cryptocurrency project. An analogy to this is when the founders of a traditional company assumes majority ownership (51% or more) of their business; they have a greater degree of control and decision-making power to steer the business to greater heights. This includes managing the token supply to ensure price stability in the infant and highly volatile lo.

It is no surprise that the crazy volatility and risks associated with cryptocurrency prices negatively affects the operational and financial processes of projects. Therefore, it could be in the best interest of the project to assume responsibility in managing the token supply – through acquiring a majority stake of tokens – so that they can better control prices of their native tokens, instead of fully relying on the highly speculative open markets. Their incentives are naturally aligned with the success of the project, since they would in turn benefit financially with the its success.

(See more: Guide to Cryptocurrency Liquidity: Understanding Liquidity & Its Importance)

Potential Solution: Hybrid of Centralization & Decentralization?

In a bid to bring out the best from both worlds, some projects are working towards a hybrid model that uses a decentralized structure combined with centralized elements. They would argue that a hybrid model would benefit from the security and transparency of a decentralized structure, whilst facilitating scalability and efficiency to compete with conventional systems in the real-world.

Of course, the long-term goal is to achieve pure decentralization without compromising on scalability. However, a purely decentralized framework is too unrealistic at the moment due to the relative infancy of blockchain technology. At this current stage, elements of centralization could be integrated as a pragmatic approach for real-world applications. Perhaps this will take us closer into realizing the end goal of a decentralized ecosystem.

(You might also be interested in: Crypto Trading Guide: 4 Common Pitfalls Every Crypto Trader Will Experience)

Beneficial Resources To Get You Started

If you're starting your journey into the complex world of cryptocurrencies, here's a list of useful resources and guides that will get you on your way:

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Aziz, Master the Crypto Founder

I'm Aziz, a seasoned cryptocurrency trader who's really passionate about 2 things; #1) the awesome-revolutionary blockchain technology underlying crypto and #2) helping make bitcoin great ‘again'!

Guide to Centralized Cryptocurrencies: Impacts of Centralization