As tempting as it is to uphold the mantle of decentralization, the best businesses in crypto began as centralized entities. Only after finding market-fit, did they then began distributing the protocol.
- Decentralization often prevents projects from attaining maximum efficiency in their early stages.
- More protocols and companies may start to gradually shift from centralized to decentralized governance structures.
- Weak projects are being shaken out by the market, while worthy projects continue to grow as the global economy contracts.
- Web 3.0 will only take off if tokens are able to capture value from their underlying protocols.
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The need for a decentralized world has been emphasized time and time again. And as the cracks of centralized finance begin to show, is the rise of Web 3.0 and distributed protocols imminent?
The Trade-Off of Decentralization
Decentralization has long been the crypto market’s favorite buzzword. As a result, companies in this budding ecosystem are expected to fulfill this ethos from day one.
Unfortunately, this can cause problems for early-stage startups due to the severe trade-offs that come with creating a truly distributed network.
Until the technology advances, crypto startups are stuck facing the infamous scalability trilemma. This problem states that of scalability, security, and decentralization, founders and developers can only have two of the three.
What’s more, failing to achieve all three characteristics sufficiently can earn the ire of the crypto community.
Michael Anderson, a co-founder at Framework Ventures, a new age VC fund focused on DeFi, is preaching a contrarian way of thinking about how crypto businesses should grow.
A rationalist, Anderson believes that starting centralized is beneficial for new protocols.
“Build a great product and user base first, then decentralize,” he told Crypto Briefing in an interview.
Cosmos, for example, had a critical vulnerability that allowed validators to vote on essential governance proposals without taking on any financial risk. This would have allowed malicious validators to join the community, vote, and leave with no punishment.
Thankfully, this was identified and fixed within 24 hours because protocol changes weren’t subject to a decentralized governance model. The developer team was able to rectify the error quickly.
Even in Bitcoin’s early days, one could say power was centralized with the network’s anonymous creator, Satoshi Nakamoto. When the value overflow bug hit, printing 184 billion BTC, Satoshi was able to fix the Bitcoin Core bug in roughly four hours and get the then-tiny community to upgrade.
Such a bug would take much longer to resolve these days, as no single developer can force every node to update.
Synthetix, which is part of Framework Ventures’ portfolio, began similarly, with the Synthetix Foundation holding the keys to every contract. The Foundation has also been the sole entity that can execute protocol upgrades.
But as the protocol has grown, Synthetix has begun a shift to a DAO governance model, where the “ProtocolDAO” performs all major governance decisions.
Likewise, MakerDAO has existed for years, but its community of MKR token holders has never had full control over the protocol. Maker finally conceded to truly decentralized governance after being eviscerated on Black Thursday.
This move may, however, prove to be too little, too late.
DeFi Will Eat CeFi’s Lunch
Moving from centralized to decentralized is underrated. And for companies that can withstand the criticism, it may be a network’s only chance.
Consider the steady rise of the lending platform, Celsius.
Unlike Compound, Celsius is not permissionless as the company can freeze user funds at will, and there is no proof that borrowers are collateralized. Since it is not a protocol deployed on a smart contract, users have to believe what the company tells them.
Many in the DeFi community have even criticized those who group the company with other decentralized platforms.
We delisted Celsius Network.
Non transparent company, with crazy CEO – it’s big red flag, so we can’t recommend this product any more.
— defiprime (@defiprime) October 23, 2019
Still, Celsius has enjoyed staggering success. According to reports from CoinDesk in 2019, BitGo, the company’s crypto custodian, held over $1 billion in Celsius holdings. For reference, the entire DeFi sector boasts $765 million locked in value at the time of press.
Now it looks as though the firm is turning towards decentralizing the platform.
Celsius has integrated ChainLink for data feeds, so users have an extra layer of certainty that fair pricing data is used to compute their interest.
While this doesn’t make Celsius fully distributed yet, it is a sign of things to come.
As companies begin to see the advantage of decentralization, and users demand permissionless protocols, the DeFi space will likely enjoy further growth.
“We’re starting to see some cracks in the walls of centralized finance,” said Anderson. “Open interest on BitMEX dropping 50% in a month and Binance frequently going down for maintenance is starting to cause users to question the transparency of unregulated, centralized trading venues as opposed to something that is decentralized and open”
Such a shift won’t happen overnight, of course.
User safety has been a key theme throughout the short life of the DeFi industry. Fortunately, protocols that lack robust security mechanisms are being shaken out of the market.
bZx, which was exploited twice in the same week, saw a momentous drop in user confidence and has failed to recover since.
On the other hand, protocols with unshakeable moats such as Set Protocol and Aave have grown even as the market crashed over the last month.
But for DeFi to truly take market share away from centralized alternatives, it needs to be able to execute successful value capture mechanisms. Money is the most crucial element, and price plays a significant role.
Synthetix, for example, is building a bridge between investing in crypto and investing in legacy assets.
With the addition of the FTSE 100 and NIKKEI 225 indexes, along with Brent crude, Synthetix has created digital-equivalents of these traditional assets. This way, crypto-native investors can gain exposure to equities without leaving crypto.
This bridge is being built in a permissionless manner, with the ethos of decentralization in mind, and all synthetic assets are collateralized by the network’s native token, SNX.
To be clear, Synthetix has had its fair share of struggles, such as traders frontrunning its oracle and the exploitation of low liquidity assets.
It has, however, managed to overcome these issues through community-driven proposals.
From Web 2.0 to Web 3.0
Behemoths of the dot com era like Facebook, Google, and Twitter all cut their teeth through a similar value capture mechanism: build a product people want, attract a large user base, then monetize them.
This strategy still applies to Web 3.0 companies, but this time with tokens. Anderson theorizes that users aren’t the product, but rather the beneficiary of monetization, as value accrues to the tokens they hold.
Similar to how equity shares democratized ownership of companies, tokens can democratize platforms far more transparently.
But first an attractive product. And often this means beginning with a centralized model to iterate and find product-market fit rapidly.
Then, to attract crypto enthusiasts, a shift to decentralization is mandatory.