The Importance of Decentralization and Privacy After 2022

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The Decentralized Roots of Web3

Satoshi Nakamoto intended to create a financial system that would prevent a 2008-style bailout — one that left the little guy holding the bag for the big guy. As Amanda Cassatt, the founder, and CEO of Serotonin, notes: “When the [Bitcoin] network launched, they inscribed these words in its genesis block, ‘The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.’”

How deeply ironic then that by 2022, many in Web3 were calling for bailouts. Centralized entities like Celsius and FTX used customer deposits as an exit strategy. Once again, the little guy was left picking up the multi-billion dollar tab; millions lost everything, just like in 2008.

It turned out that several centralized exchanges were just fractional reserve banking with extra steps. It was traditional finance with a blockchain facade.

What was the cause of this crypto carnage? While regulators target DeFi, the true cause clearly lies at the feet of centralization. As we take a quick look back at the destruction, let’s hope that this is the beginning of the end of the “Centralization Era” for Web3.

The Epicenter of Every 2022 Implosion was Centralization

The FTX implosion is fresh, but it is far from the only example of the failure of centralization in 2022. Every single major hack, implosion, and explosion that rocked Web3 happened due to centralization. Let’s take a fond look back at those who went out “deploying more capital:”

After December 17th, node operators will also need to update the fn CLI tool to work with the v0.3.35 upgrade. Though not necessary to participate in consensus, updating the CLI tool is necessary to make sure CLI wallet operations are successful.

• Voyager Digital
• 3AC
• Terra/Luna
• Celsius Network
• FTX and Alameda
• Genesis

This doesn’t include the record number of hacks from centralized bridges, like the Wormhole Bridge hack, BSC Bridge hack, Harmony’s Horizon Bridge hack, Nomad Bridge, Ronin Bridge, and Chain Swap — to name just a few. Over the course of 2022, more than $2 billion have been stolen from bridge hacks.

Centralized meltdowns, along with worsening macro trends, have sent the crypto markets spiraling in 2022. Interestingly, however, in the wake of the FTX implosion, decentralized exchanges were up against centralized exchanges:

The Centralized — and Vulnerable — Nature of Bridges and Stablecoins

But are the examples listed above truly examples of centralization? After all, the Terra ecosystem system was ostensibly decentralized, and several bridges mentioned above classify themselves as DeFi.

However they may classify themselves, bridges are centralized by nature because they need large liquidity pools to power cross-chain transfers. These liquidity pools, combined with the absence of on-chain privacy, make them prime targets for hackers who have grown adept at exploiting this point of centralization. The problem is so serious that Vitalik Buterin has expressed doubt they will play a large role in the future.

Perhaps privacy protections that allow them to shield their address of liquidity pools will reduce the liability that results from centralization. But without on-chain protection, their natural centralization is a huge liability for Web3.

Stablecoins, like Terra/Luna’s UST, are also centralized by nature. Every stablecoin needs a mechanism to protect its peg, and those mechanisms must be governed by an individual, group, or DAO. Some stables are less centralized, like MakerDAO, and some more, like Circle’s USDC. But they all, algorithmic or not, depend on groups of humans to take non-automated actions to defend their pegs.

Because these mechanisms need to be actively governed, the market tends to trust centralized stablecoins as they are capable of taking quick action. That’s why the three biggest stablecoins by market cap are the most centralized ones: BUSD, USDC, and USDT. UST was vulnerable because it was centralized, and it failed because its centralized Luna Foundation Guard could not defend it.

Centralization has some advantages, providing convenient financial rails and necessary fiat on-ramps and off-ramps to Web3. But the goal should be to make centralization a stepping stone to a more decentralized future because, after 2022, centralization is clearly a liability, not an asset.

Defining the Decentralization vs. Centralization Spectrum

Defining centralization and decentralization is difficult, and there is no consensus on broad definitions. But, much like a bad haircut, you know it when you see it.

It’s best to think of them as on a spectrum, with key attributes on both sides. Key qualities of centralization in Web3 include:

• Large amounts of capital are controlled by a single or just a few addresses (like bridges)
• Offering under collateralized loans (like Genesis)
• Opaque institutions (think FTX especially)
• Permissioned or KYC’d Access (think all CEXs)
• Multiple single points of failure or control.

On the other hand, here are the qualities you should see in truly decentralized entities:

• Transactions are traceable and accountable (on-chain transactions)
• Loans are over-collateralized (trustless systems that don’t need central control)
• Minimizes human control in favor of code (automated vs. manual processes)
• A distributed network of nodes and capital (schools of fish vs. a small whale pod)

Because DeFi is an innovation native to blockchain, all movements are public and traceable. Access is free and open, not permissioned — and this means systems end up being trustless and anti-fragile. For example, loans must be over-collateralized, a system that would prevent meltdowns like Celsius Network and FTX.

As a Web3 invention, smart contracts ensure actions are taken in a truly neutral way and without room to pay for favoritism. It keeps organizations transparent, accountable, and solvent. It’s not perfect — but it’s a vision worth incarnating. It is the true roots of Web3 that we as an industry need to rediscover.

Decentralization Is Safer Than Centralization

Decentralization didn’t sink the life savings of millions of people — robbing many of the only capital they will ever be able to invest. It didn’t tank Web3 markets. That was the failure of centralized entities like FTX operating with little to no transparency.

Decentralization is the key innovation of Web3. Digital technology has served as a huge centralizing force, caging the internet behind walled gardens. Money and capital also tend to be centralized: that’s why national banks slowly replaced regional banks and why currency in the US eventually consolidated behind the “greenback.”

DeFi was the first application of digital and online technology to reverse those trends; blockchain gives us the chance to make a more equitable and antifragile system.

Yet, despite the harm clearly done by centralized institutions, regulators are going after DeFi introducing bills to enforce the KYC of self-custody bitcoin wallets and other restrictions.

Adding Privacy to Decentralization

DeFi succeeds where CeFi fails because it is transparent. There’s accountability and collateral. Everyone can see for themselves if the emperor is wearing no clothes — or if he’s wearing his royal robes purchased with customer deposits.

But that same transparency comes at the cost of privacy. Privacy is built into Web2, and it is necessary for business and payroll: no one wants to give away sensitive business information to competitors or make themselves targets for hackers who can see the balances in their accounts. Because DeFi cannot facilitate this privacy, it cannot currently replace many centralized financial functions.

One response is to say privacy isn’t possible in the digital age anyway, and we need to shift our expectations of privacy rather than innovate to protect it. Their thinking is, “If you are innocent, you shouldn’t have anything to hide.”

That response isn’t really the right one, either. Wanting privacy isn’t an admission of guilt; there’s a reason why we use sealed envelopes and don’t build houses out of glass, and it’s not because we’re black-hat hackers. Businesses do need privacy and confidentiality to operate optimally, and competition breeds progress and advancement.

Building Back Strong in 2023

The Web3 community fell off a crypto cliff in 2022. As we climb our way back up the cliffside, it’s critical that we reflect back with a clearer perspective and learn why we ended up face-down against the rocks. Rebuilding with more decentralization, paired with confidentiality and auditability, is a non-negotiable for the Web3 community in 2023.

For now, stay safe, stay humble, keep building, and let’s climb back up together.