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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.
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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.
Fast Facts:
- 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.
Decentralization
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 and your investment could be in a similar system that cryptocurrency sought to solve in the first place.
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 compared to another.
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
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 so this is not necessarily an issue.
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
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
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 (centralized finance) 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
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 their 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
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 with a small number of validators with faster hardware. In its current state, this is certainly a centralization concern but, as mentioned with Solana, this concern will likely fade as the network scales out of its initial stages.
Accessibility & Network Participation
The next question to ask is how accessible and democratized it is to run be a node, miner or validator. Bitcoin’s initial aim was to make it so anyone could run a node and mine with basic home computer hardware.
Some projects require expensive hardware, huge annual fees or even an application to participate in the network. This can be detrimental to the decentralization of a network because having a system that is accessible to a broader range of participants other than the wealthy or team approved helps to propagate the network further.
Ethereum
The requirements to participate in Ethereum are relatively low. To run a basic node with your own hardware on the Ethereum network would require a minimum of a 2 core CPU, 4GBs of RAM, an SSD or HDD with around 8GBs and 8MBits/s of internet bandwidth.
In other words, you could run a node with just about the cheapest of today’s computers so long as you have a steady internet connection. Ethereum mining, on the other hand, requires far more power. Unfortunately, the cost of hardware has skyrocketed during the pandemic. A 980 Ti graphics card from 2015 can still cost as much as $800 on some markets.
Ethereum is soon moving over to Proof-of-Stake. To become a validator on Ethereum’s new Proof-of-Stake chain requires a minimum of 32 Ethereum or $116,181 at today’s price.
Cardano
Running a stake pool on Cardano requires a 2 core CPU, 8 GB of RAM, 30 GBs of storage, a Linux operating system and a 10Mbps network connection. While the hardware requirements are negligible, operating a Cardano stake pool requires knowledge in developer operations, server operation and maintenance skills and Prometheus or Grafana knowledge for alerts and monitoring. There is no minimum amount of ADA for creating a stake pool though a pool may not be productive with a small amount of ADA.
Binance Coin
As mentioned, the Binance Smart Chain uses the Proof-of-Authority consensus mechanism. In this system, there are 21 validators that all must be approved by Binance.
To become a validator you must apply and in doing so you must prove your identity. If chosen, 10,000 BNB, or $4.4 million at today’s prices, are required to begin your validator. Validators also require the purchase of a hosting server or a fast computer with an 8 core CPU, 16GB of RAM and an SSD with at least 500GBs of storage.
Solana
Running a Solana node requires either the purchase of a high-powered server through a provider like Amazon or Google or an extremely powerful personal server or computer. The recommended system includes a 12 core CPU, 128 GBs of RAM and a PCIe NVME SSD with a terabyte or more of storage. A system like this is essentially a very expensive home server that would cost several thousand dollars to build.
On top of that, operating a node requires sending a vote transaction for each block the validator agrees with. This can add up to 1.1 SOL a day or about $56,000 dollars a year at the current price of SOL. Validators are of course earning rewards for their commitment, but there is a rather large barrier to entry. It would not be surprising if a sizable portion of the validators were run by the Solana Foundation or that most of the network exists on a centralized web services platform like AWS.
As with Cardano, a degree of know-how is also required to run a Solana validator as well. Understanding networking, server maintenance, virtual machines and more are all necessary to run your own Solana validator.
Polkadot
Polkadot currently has a cap of 297 validators so it is impossible to become one now. This will soon be increased to 1,000 validator slots and will give additional validator hopefuls a chance to become one.
To become a validator you must indicate that you wish to be a candidate. Nominators, or DOT holders, then submit (nominate) DOT to the validator candidate they wish to elect. Candidates with the most DOT backing their candidacy then become active validators.
Regardless, the requirements for a validator include a minimum amount of DOT that changes dynamically based on a number of factors. Right now that number is around 5,500 DOT or $184,140 at today’s price. Validators can choose to use their own hardware or server service. Those running their own hardware will need an Intel i7-7700k CPU or higher, an NVMe SSD with at least 80GBs and 64 GBs of RAM running a Linux operating system. Polkadot does say that these are the recommended specifications and that validators could be run with less after some optimization.
With just 297 validators it is relatively safe to assume that a high portion of the network is federated and run by Polkadot’s Web3 Foundation and that many are being run on centralized servers owned by Amazon or others.
Coin Distribution
One of the most important aspects to look at when determining how genuine a project is is how the coins were distributed when they were created. When Satoshi Nakamoto created Bitcoin he simply released the software for anyone to be able to mine rewards. Many coins that followed Bitcoin mined thousands if not millions of coins before releasing the code to the public. Most of these coins died off shortly after release as they were totally manipulated by their creators.
This method is generally regarded as a disingenuous way of going about the creation of a new cryptocurrency. Some even give Ethereum a hard time as its founders generated tokens for the co-founders and the Ethereum Foundation before the Ethereum software was available to the public. While this is true, the Ethereum team created a small amount of Ether relative to the money raised during the initial sale of the coin and far less than what some more current projects are doing.
Some of these more recent projects create a coin and then spread its supply among the creators and investors before making it publicly available to buy or generate through staking. This creates not only obvious conflicts of interest but also breeds centralization as Venture Capital investors and coin creators control nearly half or more of token supplies.
https://messari.io/research
As shown above, more recent projects like Solana, Polkadot, Binance, Flow and Avalanche have given massive amounts of their token supplies to founders and investors prior to public availability. Others, like Ethereum, Cardano, Tezos and even Eos gave a far more equitable opportunity to all investors instead of prioritizing venture capital firms and other private investors.
While coin distribution alone does not indicate the quality of a project it, along with other aspects like accessibility and node distribution, gives insight into the intent of its creators. It leads one to question whether the creators are in it to create wealth for themselves or if they genuinely would like to advance decentralized technology for the benefit of many.
Development Distribution & Control
Another important aspect is how the project’s development is distributed. Can only the project’s founding company or foundation make updates? Or can anyone submit an update proposal? This is a bit harder to determine for a number of reasons.
If a solid portion of the validators and nodes of a blockchain network are controlled by the creators of the coin then whenever new code is proposed they have a heavy influence on whether that code actually gets implemented rather than the public making the decision.
In this instance, the updates that occur to a network are generally only ones that are proposed by developers within the coins foundation or even its company as opposed to the community proposing updates that they would like to see.
This of course does not mean that the updates that are done are not in the best interest of the community at large, but rather that there is a greater possibility for conflicts of interest when systems are not as decentralized as they could be.
Lack of validator distribution throughout the public can certainly pose a threat to decentralization, but so can powerful, near celebrity-like leaders. The creators of Cardano and Polkadot, Charles Hoskinson and Gavin Wood, were both co-founders of Ethereum along with Vitalik Buterin.
Within crypto communities, they are extremely well-known figures who carry a high degree of authority in the space. Part of the issue with cryptocurrency is that it is still a highly confusing and complicated subject for many. For that reason, many investors take the word of some of these more well-known figures.
In these cases, projects can take the direction of whatever the figurehead deems best, rather than what may actually be in the best interest of the broader community. While the best interest of the community has rarely if ever, deviated from what the figurehead pushes for it still puts a whole cryptocurrency ecosystem at the whim of an individual.
For this reason, Bitcoin benefits greatly from the absence of Satoshi Nakamoto. So many people have yet to fully grasp the concept of decentralization and the purpose of Bitcoin that if Satoshi were to appear today and say that KYC (know your customer) should be integrated into Bitcoin many would likely agree.
Other Aspects To Consider
The above aspects of a blockchain are arguably the most important when considering where to invest and what to use for transactions or decentralized finance products, but other things, like the Dapps that exist in its ecosystem, a chain’s cost and speed and the background of a coin’s creators are definitely worth considering.
Dapp Decentralization
Understanding how a decentralized application is developed and how decentralized it actually is is something that may be worth the research prior to its use. Many currently popular Dapps were created by small teams. While the smart contract for the Dapp may run on a blockchain like Ethereum’s, the front end, or user interface, is controlled in-house and sometimes is not open-source code.
There are some coming out that are more decentralized where its development was done by a decentralized autonomous organization (DAO) and where the front end is stored on the InterPlanetary File System (IPFS), a decentralized file storage system.
In the event of a total regulatory ban on DeFi, Dapps that have central control where its front end is run on an in-house server may be shut down, whereas one created by a DAO with a front end stored in a decentralized way would likely be fine.
Cost
Some blockchains have become expensive to use. Ethereum, for example, has become so congested that the cost of transactions has made the network nearly unusable for anyone other than those with larger funds. This is one of the reasons Ethereum plans to scale with Proof-of-Stake and methods like sharding in its Ethereum 2.0 update.
While Ethereum is the most decentralized network of the ones above, it certainly has some drawbacks in its current state. This is why choosing a system that is decentralized while maintaining low costs is ideal. Ironically, Bitcoin hits many of these marks via its lightning network though it has yet to build as robust of a decentralized ecosystem.
Speed
One sign that a network is not decentralized is when it has remarkably high throughput (transactions per second) while having a small validator count and no chain sharding or side chains. This generally means that the network is dependent on large block sizes and expensive hardware or centralized web services like Amazon’s.
Chain sharding is when a blockchain is split into different shards allowing it to handle more transactions. Side chains or channels is when another chain or payments channel is built on top of the existing chain to increase speeds
With current technology, it is impossible to have such high speeds without having sharded chains, side chains or side payments channels. So far the only successful large-scale implementation of such a system is Bitcoin’s lightning network that uses payment channels that exist outside of the blockchain itself. The transactions that occur within these channels are permanently added to the blockchain once the channel is closed. Bitcoin’s lightning network allows for nearly free and instant Bitcoin transactions.
Other than Bitcoin, there are no chains that have fully implemented these scaling solutions outside of a testnet. This means that chains with extremely high throughputs are reliant on very powerful hardware that very few are able to run.
While it is less of a concern than the costs of using a network, the speed at which it operates may be worth considering when choosing a network. It is important to note that most of the chains mentioned in this are in development phases plan to implement such scaling solutions as mentioned above.
Team Background
It can also be insightful to look at who exactly is behind the coin that was created. What is their background? Are they qualified? What are their motives?
Many of these projects are created by extremely passionate people. Others, less so, and may be more of a tool for wealth creation than they are a means for technological advancement. When evaluating a cryptocurrency for investment or use as a tool for transactions, understanding who it is that made it can go a long way and may help you avoid coins that have little longevity or even blatant scams.
Choosing an Ecosystem
Everyone has different priorities when entering the cryptocurrency space. Some are more focused on technology and what it could theoretically do to the way society functions. Others have entered with more of an economic incentive.
The former would likely be more concerned with decentralization and that all demographics have the ability to participate. The latter may be more concerned with transaction speed and cost.
If you are someone more interested in speed, transactions costs and trading, it may be wise to first understand the purpose of decentralization and the problems it aims to solve. It also may be beneficial to question the legitimacy of projects that are more centralized and what their motives are.
Considering the middle ground of these tradeoffs and asking yourself which chain has relatively high decentralization, high accessibility, fair coin distribution, low transaction costs and moderately fast speeds is a good way of researching. Taking all these factors into account before making an investment may help you to avoid scams, hacks or other issues.
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