Cryptocurrency Wealth Concentration: Exploring the Problem and Possible Solutions
There are many criticisms of cryptocurrencies thrown about by the media, bankers, government officials, and other defenders of the economic status quo, and although many of these criticisms may have some truth to them, members of the cryptocurrency and blockchain community can just as easily counter most of them with their own arguments. Criticisms such as the widespread use of cryptocurrencies for nefarious activities, highly volatile prices, inability to scale, and inefficient use of electricity either already have existing solutions or can be argued as invalid points when seen in the light of their comparison to traditional banking and financial structures.
However, one rarely mentioned criticism that is much harder to defend, yet not discussed nearly enough outside of or inside the community is the issue of centralized wealth and power. Status quo actors such as banking institutions won’t, of course take issue with such problems of inequality for obvious reasons (i.e. they already benefit from it), while cryptocurrency tech fans and investors may be either blinded by their biased confidence in cryptocurrencies’ ability to take over the financial world or by the wealth cryptocurrencies have brought them (or that they hope will be theirs in the near future).
But it is a problem nonetheless, a problem that runs counter to the very founding principles of the cryptocurrency movement. We’ll go over why exactly it’s a problem in a moment, but first, a bit of history and background.
As many readers no doubt already know, Bitcoin and cryptocurrencies in general were founded in 2008 on the cyberpunk-driven premise of limiting the government’s power over one’s freedom of expression and access to information, which naturally led to the proliferation of the idea in the early Bitcoin community that finance, like religion, should be kept outside of government control and manipulation.
Indeed, anonymous blockchain creator and Bitcoin founder Satoshi Nakamoto was vocal in their reasons for launching the beginnings of a decentralized financial system: to bypass and replace the current banking and credit system that is controlled by a few powerful individuals.
Exploring the Problem
Unfortunately, most cryptocurrencies now seem to be susceptible to control and manipulations of another kind: so called “whales” who own large amounts of a given currency.
A few examples:
In January, Bloomberg sources analyzing the public blockchain noted that the top 100 Bitcoin addresses controlled 17.3 percent of all bitcoins. At that time, Ethereum’s ether cryptocurrency saw the top 100 addresses controlling 40 percent of the supply, while smaller currencies such as Gnosis, Qtum, and Storj saw top holders controlling more than 90 percent.
Switzerland-based bank Credit Suisse analyzed Bitcoin addresses in January 2018 and found that 97 percent of all bitcoin were held at that point by 4 percent of all bitcoin addresses. Although some of those addresses are exchange addresses, this still points to massive concentration of available coins in a few wallets that have power over the markets.
Even if exchange wallets are many of the large holders, this is still reason for concern, as exchanges may also be responsible for manipulation as suggested here and here. On top of this, other analyses that go beyond just looking at the amount of money in specific addresses also show that crypto wealth concentration is likely out of control.
So, what’s the problem with this centralization of wealth anyway? The problem is, whales can move markets inadvertently simply by buying and selling large amounts of a cryptocurrency (or even smaller amounts with low market cap, low liquidity coins). Or worse yet, they may purposefully manipulate markets, leaving small and medium investors in the dust and further concentrating wealth.
Manipulation may include “spoofing” (placing large buy or sell orders without the intention of filling them), wash trading (buying and selling the same currency to generate fake volume that makes an asset seem more appealing), or simply flooding markets with an asset to influence price.
Such practices are illegal in established securities markets, but in the largely unregulated and unmonitored world of cryptocurrencies rife with new traders, many sources say they are common practice.
One example of price manipulation that made headlines on crypto news sites through 2017 is an entity referred to as “Spoofy”, a spoofing trader or group of traders on the popular cryptocurrency exchange Bitfinex who regularly places large Bitcoin bids, and then quickly cancels them before the price moves too close to their order price.
If Bitcoin’s price is falling and traders see a multi-million-dollar order come up at a higher price point, the price will likely go up in reaction to this order. This activity has been well documented by observers, who regularly record 900 to 5,000 BTC orders being placed on Bitfinex and other exchanges and then being cancelled before they are filled.
Examples like this are likely why the US Justice Department is currently working with CFTC officials on price manipulation investigations for Bitcoin and Ethereum.
Before taking a look at some possible solutions to these issues, let’s take a quick look at some of the probable reasons for such concentration of wealth.
First, it’s fairly obvious that many individuals and groups who have large sums of fiat (government issued) money as a result of our already wealth imbalanced global economy will also have an advantage in the cryptocurrency market. Wealth begets wealth, and cryptocurrency can be purchased with fiat money, after all.
So, what then is the reason for the even more imbalanced cryptocurrency economy?
This is no doubt caused partly by the price manipulators themselves benefiting from their manipulations, but another key problem is the underlying technology itself and how it works. In fact, it’s pretty simple to understand how the algorithms responsible for securing many blockchain networks, validating transactions on said networks, and distributing rewards for this work to network participants called “miners” are also a big part of the problem.
We can see this in the most popular cryptocurrency algorithm, Proof of Work (PoW), which is currently in use by Bitcoin and Ethereum, and the second most popular algorithm, Proof of Stake (PoS), currently in use by Dash and NEO, for example.
Profitable PoW mining requires expensive computers with specialized CPUs, and because of this, most of the mining on PoW blockchains is now done by large mining pools made up of companies and wealthy individuals who can afford large numbers of specialized computers making up so-called “mining farms”. Again, wealth begets wealth.
Meanwhile, PoS is perhaps even worse, since it specifically increases the chances for cryptocurrency miners who hold more of the currency to be rewarded with more of the currency, therefore directly allowing large holders to earn more. The more one “stakes” in their wallet, offering it up as evidence of their commitment to the network, the more one can earn. It’s pretty obvious how this leads to wealth concentration.
The fact that mining itself is centralized is a whole other (related) issue. Both Bitcoin and Ethereum mining are controlled by very few entities, with the top four miners in Bitcoin and the top three miners in Ethereum receiving more than 50 percent of network mining rewards. The entire blockchains for both networks are secured by less than 20 entities.
One problem of such centralized mining: As a 2013 paper by Cornell professor Emin Gün Sirer described, such concentration of mining power leads to “selfish mining” where a group of miners can join together to manipulate blockchain networks into wasting resources on mining blocks (groups of transactions) that will never be validated, while they generate valid blocks for rewards.
Besides this issue, there’s nothing stopping such well-resourced mining pools from collectively deciding to hoard a given cryptocurrency to drive the price up, or to flood the market with it to drive the price down—all for their own benefit.
Since mining in general has become centralized because of the aforementioned issues, and since price manipulation by whales will also logically continue to further concentrate cryptocurrency wealth unless something is done to challenge the status quo, the cryptocurrency community should focus on adopting solutions to these problems.
Luckily, there are solutions.
Probably one of the easiest, albeit controversial solutions is to eliminate mining altogether. One such technology that does just that is called Directed Acyclic Graphs (DAGs), a concept used in network theory for years.
In short, DAGs are like more decentralized blockchains, relying on users in the network to confirm transactions in the process of making their own transactions. This not only eliminates the possibility of power concentrating within centralized groups of network nodes, but also reduces or eliminates fees and creates a much more scalable solution for payment networks compared to PoW and PoS. This is because the network will basically scale infinitely, with everyone contributing roughly the same or more processing power than they use to process their own transactions.
Although DAGs could solve the problem of network node centralization, the question then becomes how to ensure that currencies are initially distributed evenly among network participants.
Another potential solution to both mining centralization and scalability issues that may offer such a solution is Holochain, which isn’t even really a blockchain, but does many of the same things (and more). Like Ethereum, Holochain can be used for decentralized applications (dapps), but instead of relying on semi-centralized network nodes to run the network, Holochain, like DAGs, operates via the network users themselves. In Holochain, each network node in the public Holochain ledger essentially maintains a private fork, and this in turn is stored and managed in a limited way on the public distributed hash table (similar to blockchains).
Holochain users earn Holo fuel for sharing their extra space and computer power to host apps for others on the network. Anyone can host apps without needing expensive equipment or a ton of cryptocurrency to increase their odds of being paid.
Of course, it is true that users who can afford to “rent out” more space and computer resources would still earn more money, but nonetheless, this model is still much fairer than requiring specialized equipment or staking of large amounts of the currency.
Although it is a potential solution for taking control of distributed ledgers and dapps out of the hands of a few individuals, Holochain isn’t actually designed as a currency in the first place, however.
If we’re talking about approaches to decentralizing cryptocurrencies in particular (with a focus on fair distribution of actual currencies), another idea to limit centralization might be to randomly give out a given currency to network participants based on nothing other than their participation in the network, regardless of what kind of device they’re using.
Another idea would be to indiscriminately distribute a currency to anyone who signs up, similar to how the mannabase project distributes a Universal Basic Income to its users.
To truly address the issue of wealth inequality, however, we also need to look at the investment landscape. Initial Coin Offerings (ICOs) are increasingly only allowing large investors to invest at a good price (with private presales becoming the norm), thus neglecting a major potential advantage of cryptocurrencies: the ability for crowd funding with smaller contributions. At the same time, it’s reported that large investors are simply quickly flipping their presale crypto holdings as soon as they hit the market, leaving small investors holding the bag.
If more projects allowed any level of investor to participate in presales and early-stage funding, this would allow smaller investors to make potentially higher returns instead of only large investors getting the best deals. This would not only give smaller investors an opportunity to improve their financial situations, but would also help to ensure technologies and companies are invested in beyond just those that are beneficial to or highly regarded by the wealthy.
Although it is impossible to know just how much wealth is concentrated in the cryptocurrency market, it is obvious from what we do know that it is a problem.
Just because PoW cryptocurrencies have been around the longest, we must not forget that they now reward mostly those people who can buy the most expensive mining equipment and pay for the infrastructure and electricity to run huge mining farms, thus decreasing the security of the network and opening currencies to potential price manipulation or 51% attacks.
PoS, on the other hand, may be less likely to concentrate mining power, while also wasting less electricity, but is still unnecessarily unfair—operating counter to the very founding principals of cryptocurrencies by rewarding people who already have the most cryptocurrency in their accounts.
Since fiat wealth can already be used to build crypto wealth, with large investors having the ability to leverage their money to get the best deals in ICOs, and with some “whales” no doubt buying up large amounts of cryptocurrencies and manipulating markets for their own benefit, we should be thinking of ways to lessen the impact of and decrease wealth concentration instead of encouraging it, as current technologies and investment practices do.
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