What Is Decentralization?

January 31, 2023

The world of crypto is, in some ways, completely different from the world of more conventional finance, but there are some similarities. One of those similarities is a penchant for jargon. There are a few reasons why that might be so. The charitable version is that the unique and highly technical nature of crypto makes specificity in word choice important. The less charitable is that jargon is a good way of creating barriers to entry into a lucrative business and of making those that use it look and feel smarter than you.

Whatever the reason, though, the fact is that newcomers to crypto are often faced with a barrage of words and an assumption that they understand what those words mean. One example would be “decentralization”. It kind of sounds like a good thing and is usually used in that way in crypto, but what does it actually mean?

To understand it, you first have to understand its opposite, centralization.

What is Centralization?

The Collins English Dictionary defines centralization as “The concentration of administrative power in a central government, authority, etc.”, which basically describes what it means in the context of crypto. When it comes to monetary policy and currencies, though, there is a little more to it than that.

A centralized monetary system is that which most of us are used to. It is where a government or central bank controls the supply of money, and centralized institutions such as banks keep records of transactions. There is, inevitably, a degree of trust involved in that. We, as the owners of the money, trust that the issuing authority won’t devalue it too much by issuing more, and that the records they keep will be fair and accurate.

What Is Decentralization?

Decentralization removes the need for trust. It is a system, such as that used in the Bitcoin network, where control of the system and record keeping goes to the users of a network or currency. No one user can unilaterally make a decision that will impact the others, and records are kept collectively and openly.

Centralized and Decentralized Exchanges

In crypto, you will often hear talk of two types of exchange, centralized and decentralized. The distinction here is also one of where control lies, but again there is a bit more to it than that.

If you use a centralized exchange, you deposit funds with them, and when you trade, the exchange uses a clearing house process to match your order with an order on the other side of the trade. The proceeds and cost of the trade are recorded as a plus and minus in the currencies involved in your account.

With a decentralized exchange, there is no middleman. You trade directly with someone else, with funds coming and going directly from your own wallet.

Why Decentralization Matters

The financial world is in a state of flux right now. Conventional banks no longer have complete control, with people increasingly reluctant to hand them the power to make all of the decisions around money in a centralized fashion. When Natalie Brunell appeared on SmartFi’s podcast, Tilton Talks Crypto, she talked of how her trust in the banking system was eroded by the events of 2008 and 2009, leading her to investigate the trustless nature of Bitcoin, and there are many like her.

Decentralization provides the answer for people like Natalie, in that decentralized finance is about returning power over money to its users. There is no need to trust an individual or institution in a decentralized system and as a result, it reduces the risk of bad actors who do harm. And let’s face it, the crypto world saw enough of that in 2022 to last a lifetime.

Decentralization is by no means perfect. It can make transactions clumsy and slow, for example, as anyone who has ever executed a trade on a decentralized exchange knows all too well, and in today’s fast-moving crypto markets, that can be a big disadvantage. It does, however, have advantages in some situations over a centralized system, and as the world of finance continues to develop, it will play an increasingly large role.

Author: Martin Tillier
Martin has around forty years of market experience and, in addition to his role as Head of Research at SmartFi, is a daily contributor of market analysis and opinion to Nasdaq.com. He first became interested in crypto 2014, when he started writing regularly on the subject. He is from England but now lives in Connecticut, USA with his wife, his dogs, and his three kids’ college tuition bills. 

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