January 15, 2025

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Hi readers,

In today's newsletter, Pablo Larguía of SenseiNode questions whether the industry is focused on the right incentives to drive decentralization and continue censorship resistance resilience.

Then, Andy Baehr of CoinDesk Indices offers practical solutions for those still mystified by how the crypto ecosystem outside of bitcoin works.

Thanks for joining us.

– Alexandra Levis

From the Analyst

How to Ensure Blockchains Are Really Decentralized

Decentralization is the foundation of blockchain technology, promising a more resilient and censorship-resistant alternative to centralized systems. But are the industry's leading protocols as decentralized as they claim to be?

Decentralization can be measured across multiple dimensions. At first glance, the number of entities participating in the validation or block-mining process of a network is one of the simplest and most apparent metrics. However, other factors also contribute to the enhancement or erosion of decentralization:

Hosting facilities: Where nodes are hosted directly impacts who controls them. If thousands of entities host nodes on facilities controlled by one or few entities, it puts the network at risk. For example, Hetzner unilaterally shut down 40% of Solana validators in 2022.
Jurisdiction: Geographic location is relevant because it provides diversification of risk related to unfavorable or unpredictable regulatory action.
Client Software: A blockchain with nodes all running on a single client software is at a higher risk of bugs and vulnerabilities than those on single code.

The following table compares the degree of decentralization of leading protocols using these dimensions:

Source: Solana Decentralization Report, Ethernodes Geographic location of ETH Nodes, Tron Nodes, Polkawatch

Decentralization comes at a cost: the longer the distance between peers, the higher the latency. Latency is crucial for validators to complete assigned tasks in a reasonable period of time. Not meeting these deadlines translates to missed rewards for validators, increasing the incentive to be placed close to larger clusters of peers, thus increasing the centralization. The bigger the block size, or the shorter the block duration, the higher the incentives for centralization.

In other words, many protocols indirectly penalize decentralization by diminishing rewards of those who dare to deploy infrastructure in territories where no one else is doing it. Pioneers carry the burden of blockchain resiliency with no incentive other than doing what needs to be done, where it needs to be done.

Few are the protocols which provide some kind of predictable and explicit incentives at the protocol level (e.g., higher priority at proposing blocks, higher issuance rewards participation) to drive decentralization of the network. In most cases, the incentives are managed as arbitrary grants or delegations from the protocol foundations to specific network participants on a per case basis.

If decentralization remains the cornerstone of blockchain's ethos, the industry must act accordingly. Protocols need to adopt mechanisms that incentivize nodes to operate in diverse jurisdictions, be hosted on independent facilities, and use varied client software (if available). Without such incentives, the natural pull of economic efficiency will drive centralization, threatening blockchain's very own promise: censorship resistance resilience.

The future of blockchain depends on networks that are designed to remain decentralized, not by accident or goodwill, but by design.

Let's ensure decentralization isn't just an aspiration and that it's a measurable, incentivized reality.

- Pablo Larguia, CEO, SenseiNode

Institutional Outlook

Still Learning After All These Years

Last June, a sailing buddy (and aerospace engineer) asked if I could check out a family friend's "bitcoin." He forwarded me an image of a plastic bitcoin wallet held with a private key partially obscured. The family friend had received the card as some sort of "gimmick at a conference" and tossed it in a drawer.

This is one of those moments where I find imposter syndrome perched on my shoulder, nodding its head, lips pursed. Two years in the business preceded by another two monkeying around in my personal account didn't give me nearly enough crypto cred to say, "Oh, yeah, wow. I remember these." Fine, I'm a noob. I made a no-promises disclaimer and quickly changed the subject.

Back home, I opened the image and set to work with the solemn determination of Quincy, M.E. (although forensic examination is an inapt metaphor, given the complete absence of foul play). How did these ancient wallets work? If the private key is printed on the card, how is that secure? I knew BIP39, but what's BIP38?

Learning ensued. Then, I checked the bitcoin blockchain and noted that exactly one bitcoin had been moved to this address nine-and-a-half years earlier, when a bitcoin fetched just over $325. No activity since. As for the obscured BIP38 "private" key, you need a passphrase to decrypt it. Uh-oh. Did the family friend save the passphrase for ten years, on a Post-it® now worth $100,000?

—

This week, we were out to see a show with a different group of friends. I offered to reimburse them for our tickets with crypto. "Set up a Phantom wallet, copy and securely store the seed phrase, and send me your Ethereum address. I'll pay you in ether or USDC, your choice."

I saw all the faces. Chuckle, eyeroll, are you serious, wait-a-minute, hmmm, why not, OK! I'm still waiting for that Ethereum address, but I have no doubt this will happen. Another "gimmick," ten years later.

Why ETH or USDC? Why not bitcoin? In 2025, bitcoin is no longer a mystery. Folks get it, and if they are thinking about buying a digital asset, they'll find bitcoin on many shelves. It's a store of value. It's scarce. As more buyers enter the market over time, its value should rise.

Many folks do not get Ethereum, nor smart contract platform blockchains. Folks don't get stablecoins either, nor the fact that they rely on other blockchains, and involve paying fees in ETH or SOL or a dozen other blockchain coins. For the "5%ers" — those who will eventually spend 5% of their investing energy and resources on crypto — this feels like the next key intuition unlock.

There is no better way to get there than to put a few "learning dollars" (i.e., not "investment dollars") on-chain and move them around. I hope my friends take their new USDC and throw some on AAVE, bridge some to Solana, and buy something on Uniswap.

This primary research might solidify an investor's conviction in a single platform. Or, just the opposite: it may solidify conviction that picking winners is hard in what is likely to be a year of explosive growth. XRP, XLM, and HBAR sat atop the 2024 leaderboard of the CoinDesk 20 Index, an outcome few would have predicted. We feel — actually, we are expecting — that investors and advisors will choose diversified market beta over the possibility of selection alpha.

The holders of the plastic-wallet bitcoin did not "take the bait" and become active bitcoin enthusiasts (presumably), although, ex post, they did the right thing by throwing the wallet in a drawer for 10 years (along with a Post-it® with the passphrase; whew!). These days, I'm trying to take as many opportunities as possible to get folks to fire up a wallet and get some blockchain experience. (But if not, I'll still be good for the theater tickets with fiat.)

- Andy Baehr, head of product, CoinDesk Indices