As crypto markets rise newcomers enter the market. While many may not be new to investing in general, most are unaware of the complexity and potential for scams in the crypto markets. There are now well over 10,000 cryptocurrencies. How can one determine which are legitimate and actually safe to invest in?
Mike Tyson recently asked Twitter if he should use or invest in Solana or Ethereum.
This sparked much debate in the comments with people spamming what they think are the best DeFi options for Mike to begin using. Some said Solana and others said Ethereum, but there were several other platforms mentioned.
Learn how smart money is playing the crypto game. Subscribe to our premium newsletter – Crypto Investor.
The debate does raise the question, how do you evaluate an altcoin? Or, more specifically, how do you evaluate the quality of a DeFi ecosystem?
There are many things to consider when trying to determine what a good DeFi ecosystem is. Much of this is also dependent on each individual’s preference. For example, some people care less about decentralization and more about fees. And some people are all about the highest yields.
But sometimes users don’t understand the tradeoffs that occur when you have these types of preferences and even why decentralization is important in the first place.
- Not all blockchains are decentralized by default.
- Decentralization is essential to avoid conflicts of interest and ensure accessibility for all parties.
- The distribution of coins to insiders and investors prior to public availability can greatly harm decentralization, especially when this portion makes up nearly half of the supply.
- Other factors, like update proposals, speed and costs should be considered when choosing a DeFi platform.
The common misconception among newcomers to the cryptocurrency space is that blockchains are decentralized by default. Or, once they have learned that perhaps not all blockchain platforms are decentralized, believing that decentralization is not really that important.
Why is Decentralization Important?
The answer to this question is deeply rooted in why Bitcoin was invented in the first place. Bitcoin was created following the 2008 financial collapse. During that time banks took on enormous risk by being over-exposed to poorly assembled mortgage-backed securities (MBS) and collateralized debt obligations (CDOs).
The banks were then bailed out with taxpayer money and the Federal Reserve began adding more dollars to circulation in an attempt to help the economy. This resulted in inflation and a weaker dollar with dwindling purchasing power
Bitcoin was born out of this moment as a new form of money that no singular entity could control or inflate. The only way to change anything about Bitcoin is if the majority of its users decide to change it. That means the amount of Bitcoin and how fast new Bitcoin is issued can only be altered if the majority of its users wish to. This is a drastically different system than having the Federal Reserve, a partially private banking institution, control a global currency.
The decentralized nature of Bitcoin also meant that the unbanked people of the world could access a monetary system for free. In some third-world countries, many people do not have official identification and cannot access the banking systems of the world. Either that or they live in authoritarian regimes that may siphon citizens’ money kept in a bank the regime controls. With KYC (know your customer) and AML (anti-money laundering) laws, billions of people in the world are closed out of the basic economic infrastructure and further disenfranchised.
While these laws may have good intentions, they seem to create more of an inequality problem than they do at stopping money laundering and other illegal activities. This seems evident when looking into how much money gets laundered through banks regardless of these laws.
Decentralization also means that you do not need to trust one entity to do right by its users. Everyone is aware of how many times companies like Visa, Mastercard, banks and other institutions have been hacked, revealing people’s personal information or even banking credentials.
Decentralization means that the collective users of such a system have control instead of relying on one central company to behave in an ethical and moral way. This is especially important when dealing with people’s money and livelihoods.
This decentralization becomes even more important when you have a private group of individuals minting and controlling a completely unregulated digital asset. This is why it is important to make sure you are investing in something that doesn’t have central control and is instead controlled by the collective of its users. Otherwise, whatever group has central control could be using the currency for its own wealth generation.
How To Measure Decentralization
Decentralization of a platform can be a tough thing to measure sometimes. This is because different platforms have different structures so it can be hard to find equivalent statistics on two different blockchain protocols.
That said, there are generally enough commonalities across blockchains to give an indication of how decentralized or centralized a platform is.
We’ll compare the decentralization of the top five DeFi cryptocurrencies by market capitalization based on their network size and distribution, accessibility, initial coin distribution, cost and speed.
*Note: All statistics are based on applicable block explorers and may not be exact.*
Hashrates, Stake Pools & Validators
Measuring decentralization requires you to look at the mining hashrate a network has and how many nodes, stake pools or validators there are.
*Note: Mining and hashrate are specific to Proof-of-Work while stake pools and validators are specific to Proof-of-Stake. Both systems have nodes. Hashrate is a unit of measurement for the cumulative processing power of a Proof-of-Work cryptocurrency.*
It is also important to check how distributed these aspects are among different parties. The stake pools, validators and miners find a new group of transactions and then the nodes audit them against the previous transactions on the ledger. If everything adds up, then that new group of transactions is added to the chain. Generally, multiple validators, stake pools or miners can be connected to one node.
To measure the decentralization of a Proof-of-Work system you would need to check how much hashrate its miners produce and how many groups that hashrate is divided amongst.
For a Proof-of-Stake system, you would need to check how many stake pools or validators exist on the network, how much of the coins circulating supply is staked and what portion of the validators or stake pools are run by the founders of the coin, rather than public entities and individuals.
The higher the percentage of the coin that is staked to the network, rather than simply held or traded, the greater security the network has.
Ethereum has a node count of nearly 3,500 and a hashrate of over 736 terahashes. To put that into perspective, Bitcoin has a hashrate of 6.18 petahashes of power. In the scale of hashrates it goes kilohash, megahash, gigahash, terahash, petahash and exahash.
Just under 70% of Ethereum’s hashrate is divided among four different mining pools but pools can be comprised of thousands of different miners, both public and private.
Ethereum is soon merging with its Proof-of-Stake “beacon chain” that has roughly 243,000 validators running on the network. This switch to Proof-of-Stake may benefit Ethereum in terms of decentralization, efficiency and speed.
Cardano currently has 2,924 validators, also known as stake pools, that are responsible for finding blocks. In late March, the developer teams of Cardano switched off their stake pools and turned the network over to the public. 72% of circulating Cardano are staked to the network, giving it relatively robust security and decentralization compared to other leading altcoins.
Binance Coin utilizes what is called the Proof-of-Authority consensus mechanism. With this system, Binance uses just 21 validators to find blocks. On top of that, each of these validators must be approved by Binance itself.
The Binance Smart Chain that the Binance Coin runs on could be considered a federated blockchain. This means that the majority of control is centralized under its creators. While it is still “permissionless” in the sense that anyone can use the chain (mint tokens, make transactions, etc.), It is a centralized blockchain.
In a since-deleted tweet, the founder and CEO of Binance said, “DeFi is great. I love it. But CeFi is about to give it a run for its money.” He then went on to say that the benefits to a “centralized finance” system are that the exchange (Binance) would be able to vet projects and that Binance has the “right of first refusal” for almost all new projects.
Of course, there would come to be a number of exit scams that would happen on the Binance Smart Chain even after the CEO’s promise of vetted projects.
Solana has over 1,000 validators with almost 77% of its supply staked to the network. While its stake is high, there are concerns over the number of validators, how many are run by the Solana Foundation and how many of them are dependent on service providers like Amazon Web Services (AWS) or Google Cloud.
Right now it is not possible to tell what percentage of the network is operated by the founding team. It is generally safe to assume that young and budding networks like this may depend on its creators in the beginning. This does not mean in any way that it will not become more and more decentralized over time. Every network, including Bitcoin’s, was operated by a small group of people in the beginning.
Polkadot currently has a cap of 297 validators and plans to increase this to 1,000 or more. Its reasoning is to maintain high performance…