Not "Suffficiently Decentralized"

Mining power 25 June 2018

Perhaps the most consequential result of the tsunami of Blockchain Gaslighting ocurred on 14^th June 2018 when William Hinman, the Director of the SEC's Division of Corporate Finance gave a speech to the Yahoo Finance All Markets Summit: Crypto entitled Digital Asset Transactions: When Howey Met Gary (Plastic). In it he hamstrung his own agency's ability to regulate the two most important cryptocurrencies by saying (my emphasis):

when I look at Bitcoin today, I do not see a central third party whose efforts are a key determining factor in the enterprise. The network on which Bitcoin functions is operational and appears to have been decentralized for some time, perhaps from inception. Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value.[9] And putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions. And, as with Bitcoin, applying the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value. Over time, there may be other sufficiently decentralized networks and systems where regulating the tokens or coins that function on them as securities may not be required.

Follow me below the fold for both the evidence that Hinman was talking though his hat, and also yet another update on the theme of my Brief Remarks to IOSCO DeFi WG, that successful systems claiming to be decentralized, like Bitcoin and Ethereum, aren't.

Hinman's speech was, as we shall see, ill-informed to say the least. The consequence of his abdication of responsibility was to provide an opening for the much smaller and much less powerful CFTC, which already approved trading in futures contracts on the notoriously manipulated cryptocurrency spot markets. Grabbing the chance to expand her agency's mandate, CFTC chair Rostin Banham later asserted that "Bitcoin might double in price if there’s a CFTC-regulated market”. It isn't clear how the CFTC's mission migrated from protecting investors to pumping cryptocurrencies.

Ether Miners 10/10/18

It so happens that, eleven days after Hinman spoke, in Special Report on Decentralizing the Internet, I included a pie chart of the distribution of Bitcoin mining power showing that three mining pools controlled the Bitcoin blockchain. In a later post, Blockchain: What's Not To Like?, I included a pie chart showing that on 10^th October that year three mining pools controlled the Ethereum blockchain.

Not that in 2018 the centralization of these blockchains was news or hard to understand. That successful permissionless peer-to-peer systems inevitably centralize is a consequence of two observations, one from computer science and one from economics:

1. The security of these systems depends upon defending against Sybil attacks by making participation more expensive than the reward from an attack. This had been well-known in computer science since well before the attack was named in 2002.
2. Technologies in general, and these systems in particular, have very strong economies of scale. This had been well-known in economics since well before W. Brian Arthur's 1994 book Increasing Returns and Path Dependence in the Economy

Thus participation in these systems will have strong economies of scale, which will drive oligopoly, in other words centralization. I first detailed the process on 7^th October 2014 in Economies of Scale in Peer-to-Peer Networks. It wasn't a prophesy; four months earlier Dan Goodin's Bitcoin security guarantee shattered by anonymous miner with 51% network power reported that:

on June 12, GHash produced a majority of the power for 12 hours straight,
...
GHash's ascendency to a majority miner comes even as its operators pledged never to cross the 51-percent threshold. It also comes less than a year after GHash was accused of using its considerable hashing power to attack a gambling site.

Thus four years and two days before Hinman spoke, the centralization of the Bitcoin blockchain had become obvious even to the crypto-bros. The fact that the Ethereum blockchain had, by the time Hinman spoke, suffered at least as much centralization as Bitcoin's was by then equally well-known. Indeed, 17 months before Hinman spoke, Vitalik Buterin, co-founder of Ethereum stressed the fragility of decentralization in The Meaning of Decentralization:

In the case of blockchain protocols, the mathematical and economic reasoning behind the safety of the consensus often relies crucially on the uncoordinated choice model, or the assumption that the game consists of many small actors that make decisions independently.

and pointed out the lack of it in practice:

can we really say that the uncoordinated choice model is realistic when 90% of the Bitcoin network’s mining power is well-coordinated enough to show up together at the same conference?

Saying that Hinman was ill-informed about the technology he was refusing to regulate is an understatement.

Why am I bringing up this history now, more than 5 years later? To point out that there has been no progress on resolving either the regulatory or the centralization problems.

Nine-digit political contributions and lobbying from Sam Bankman-Fried and Ryan Salame failed to get regulatory authority assigned to the CFTC before the collapse of FTX made the idea radioactive. The SEC's enforcement actions have steered clear of Bitcoin and Ethereum, and now face incompatible rulings from Judge Analisa Torres in the Ripple case versus Judge Jed Rakoff in the Terra case.

But the proximate cause of this post was Olga Kharif's Ethereum Is Becoming More Concentrated After a Key Infrastructure Provider Dropped Out:

On Sept. 27, blockchain infrastructure provider Blocknative said it will stop operating as a so-called relay, a key participant in adding blocks of transactions to the Ethereum blockchain. Its exit leaves only four other major relay players to handle most Ethereum blocks and raises concern of potential problems, ranging from the censorship of transactions to stealing of other key operators’ profits.

The relay issue comes as Ethereum already faces concentration concerns in other parts of its operations. The network is run jointly by relays as well as parties called builders, which compile most transactions into blocks, and validators, which order blocks into a blockchain. Both builder and validator functions are dominated by a handful of participants. The relay decline is especially worrisome.
...
The situation goes against the decentralized ethos of crypto, which was born in the fallout of the Global Financial Crisis as a reaction against powers that be: corporate and government control.

Kharif notes that:

The builder category is highly centralized, also. While a year ago one builder — Flashbots — controlled the market, nowadays four builders, including one run by crypto market maker Wintermute, account for the majority of blocks built, according to Relayscan.io.

And:

To add to the problems, a pool called Lido currently controls 32.3% of total validator power. A validator controlling 34% could potentially falsify transactions.

It is worth repeating that, just like Bitcoin's, Ethereum's blockchain has never been really decentralized. Even more "against the decentralized ethos of crypto" is the fact that, as Moxie Marlinspike documented, most "smart contracts" on Ethereum use one of two services, Infura and Alchemy. On the 1^st January 2019 The Block published The Burden of Infura, which started:

Infura (hosted on AWS) is positioned as a potential single central point of failure for a significant portion of the Ethereum network in its current form, as its infrastructure dependence is widely pervasive within the dapp ecosystem

Ethereum's switch from Proof-of-Work to Proof-of-Stake clearly hasn't reduced centralization, because the fundamental problem isn't technical, it is economic. Kharif writes:

Currently, relays have little financial incentives to act, and many are simply there because they want to support the network or have side businesses that can benefit from offering the function. It costs $500,000 to $1 million a year to operate a relay, Klarman said, and relays don’t get paid. While several ways to compensate relays have been considered in the past year — since Ethereum moved to its new proof-of-stake system of ordering transactions that uses relays, builders and validators — none has taken off.

I have often complimented the Ethereum team's technical and operational skills; the Merge was an extraordinary success along both axes. But their devotion to Austrian economics means that they aren't good at designing economic systems. Here, for example, they designed a clever piece of technical infrastructure that needed many instances if the system were to be "sufficiently decentralized". Running an instance cost "$500,000 to $1 million a year", so there were never going to be that many of them, and the designers forgot to provide the few instances that there were with any, let alone a viable, business model. It is really amazing that, after 8 years running a system in which economics forced centralization of its infrastructure, Ethereum failed to address the economic problems of its infrastructure.

The failure is actually quite understandable because the problem is fundamental. As I wrote in More Cryptocurrency Gaslighting what investors need is an investment:

Proof-of-Stake has the same fundamental problem of gambling vs. investment. As I write 17.6M ETH have been staked. With a block time of 12s, each ETH can expect a reward on average once in 6.7 years (gambling). So the "nodes" in the Ethereum network are not individuals running their own validators, but staking services such as Lido, and exchanges staking their customers' coins such as Coinbase and Kraken. Each of these nodes stakes millions of ETH (investment).

It seems the crypto-bros don't need decentralization and trustlessness in practice, they only need it in Prof Angela Walch's words as "a veil that covers over and prevents many from seeing the actions of key actors within the system".