Prof. Hilary Allen bursts BTC’s ‘decentralization’ bubble

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If regulators are serious about tackling the systemic corruption that lies at the heart of ‘crypto,’ they need to bust the myth of ‘decentralization’ that tries to obfuscate responsibility for the sector’s criminality.

Many of those who tuned in to Wednesday’s U.S. Senate Committee on Banking, Housing and Urban Affairs hearing into the collapse of the FTX digital asset exchange took great delight in mocking Kevin O’Leary, the self-described Mr. Wonderful, bemoaning the loss of the $15 million—in tokens held on FTX—he received for being FTX’s paid spokesman.

But many of those laughing at O’Leary felt nothing but venom for another of the hearing’s invited guests, Hilary J. Allen, Professor of Law at the American University Washington College of Law. The aggro directed Allen’s way had little to do with anything she said specifically about FTX, but rather her demolition of one of BTC’s most treasured myths: the notion that BTC is superior to traditional financial systems because BTC is decentralized.

Cleary she is reading @RealCoinGeek and @Dr_CSWright blog! https://t.co/nIWFPJuBHv

— BSV Bulldoggy (@bsvbulldoggy) December 15, 2022

In her prepared statement to the committee, Allen listed a number of popular narratives as to what brought down FTX. These included the fact that FTX was a centralized exchange and thus the public had no way of spotting FTX’s thieving of customer deposits to mask massive trading losses at FTX’s sister company Alameda Research. An exchange based on ‘decentralized finance’ (DeFi), the argument goes, would be far more transparent about its activities, but would also avoid such mischief because it “lacks the kinds of conflicts of interest and profit motives that drove FTX to siphon off customer assets.”

But this narrative, according to Allen, “overstates DeFi’s decentralization … the reality is that wealth and power in DeFi are more concentrated than in traditional finance, and this centralization creates conflicts of interest and affords opportunities for exploitation.”

“For example, individuals holding the majority of the governance tokens controlling a decentralized exchange could potentially change the exchange’s protocol to allow the transfer of customers’ assets somewhere they shouldn’t go. Although DeFi proponents may claim that it has a clean record, it’s important to remember that Terra/Luna was considered DeFi until it failed (Do Kwon’s central economic role in managing Terra/Luna is now generally recognized).”

Allen acknowledged that any act by Congress to ban digital assets wouldn’t necessarily be able to directly target the decentralized autonomous organizations (DAOs) that run decentralized exchanges such as Uniswap. But ownership of the governance tokens that permit holders to vote on DAO proposals tend to be “reasonably concentrated with the founders, venture capitalist funders, and crypto whales, so enforcement efforts would only have to target a limited number of holders to be effective.”

Allen let even more hot air out of the decentralized balloon by pointing out that “decentralized players are not immune from problematic behavior. Bad actors can easily establish economic control over technologically decentralized platforms, so decentralization cannot guarantee that future FTXs will be avoided.”

BTC Core’s original crime

Bad actors can indeed stage coups to assume control of technology. In the blockchain sector, the most infamous of these followed the withdrawal from the public stage by Satoshi Nakamoto, author of the 2008 Bitcoin white paper.

In 2010, Satoshi told developer Gavin Andresen that Bitcoin’s “core design was set in stone for the rest of its lifetime.” With that, Satoshi bowed out, leaving Bitcoin’s open source software on Sourceforge and Andresen as lead developer. But shortly thereafter, a group of developers that came to be known as ‘Bitcoin Core’ transferred the Bitcoin source code to GitHub and perverted Satoshi’s vision for their own selfish ends.

Many of these early ‘Core’ members came from the Blockstream blockchain infrastructure firm, including co-founder Luke Dash Jr., who assumed the sole role of deciding which Bitcoin Improvement Proposals (BIP) were to be implemented to the source code by the Maintainers. Many of these Maintainers were also Blockstream developers, leaving Bitcoin’s code in the hands of individuals with shared financial interests.

In 2017, required activation for SegWit was fluctuating between 25 – 40%

To activate required 95%.

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A deal was done with exchanges (@coinbase etc).

This led to a forced implementation.

— Dr Craig S Wright (@Dr_CSWright) December 14, 2022

This coup paid off when it came time to address Bitcoin’s scaling issues. Instead of the sensible proposal to simply increase the capacity of the blockchain’s individual blocks, the Core camp decided to shunt 90% of Bitcoin transactions onto a patented ‘sidechain’ that Blockstream conveniently happened to support called the Lightning Network.

The Core camp also weren’t big on dissent. When individuals like Andresen protested these changes, his commit access to Bitcoin’s source code was revoked. In the end, Bitcoin became BTC and Blockstream became the guardians of the payment rails on and off this neutered blockchain. (Fortunately, a Bitcoin rescue party was swiftly organized.)

On Wednesday, in response to a question from Sen. Robert Menendez (D-NJ), Allen summarized this hostile takeover, saying BTC “is controlled by a few core software developers, fewer than 10, and they make changes to the software and then that software is implemented by mining pools and there’s just a few of them. In all these spaces, there are definitely people – often a very few people – pulling the strings … that is not an ideal space to be in.”

Not so fast, Vitalik

Allen is an equal opportunity scold of decentralization claims. In October, she took issue with claims by Ethereum proponents that the much-ballyhooed ‘Merge’ had resolved the blockchain’s numerous problems. While Allen stated the shift from a ‘proof of work’ consensus mechanism to one based on ‘proof of stake’ “brings the Ethereum blockchain’s other problems into even starker relief.”

Chief among these other problems is the fact that the more ether (ETH) one has to stake, the more likely one is to create the next block on the chain. “This creates incentives to acquire even more ether, and it seems reasonable to predict that any blockchain that relies on proof-of-stake will start to concentrate the ability to process transactions in just a few hands. Staking is already a highly centralised business … [and] more centralisation seems inevitable.”

“Remember that the whole point of having a blockchain with a consensus mechanism is to avoid having to rely on centralised intermediaries to verify transactions. Without meaningful decentralisation, one has to wonder if all the other problems associated with Ethereum are worth it.”

We want regulation! No, not that regulation!

Most crypto bros desperately sought—and still seek, even after FTX’s downfall—U.S. regulatory structures that give primary oversight of digital assets to the Commodity Futures Trading Commission (CFTC) rather than the Securities and Exchange Commission (SEC). The reasons for this preference are legion, but it’s primarily down to two things: the SEC’s general skepticism toward all things crypto, and the SEC’s much larger enforcement budget to target those who traffic in unregistered securities.

On Wednesday, Allen told the Committee that the CFTC also “has no statutory investor protection mandate, has limited experience regulating retail-dominated markets, and the application of the CFTC’s self-certification regime to crypto [as proposed under the Digital Commodities Consumer Protection Act] would allow an unlimited supply of crypto assets to proliferate.”

Allen reminded the Committee that FTX’s unhealthy reliance on its in-house FTT token was a major contributor to the exchange’s downfall. Other major exchanges have issued their own tokens out of thin air, including Binance’s BNB and the ‘wrapped’ version of its BUSD stablecoin. Allen warned that “the CFTC’s self-certification process would allow issuers to bless their own unlimited supplies of self-minted assets.”

While crypto bros have made a big show of pleading for what they claim to be regulatory clarity re digital assets, Allen clarified that “FTX went abroad for more lax regulation, not more certain regulation.” SEC chief Gary Gensler has confirmed on multiple occasions that existing securities laws apply to digital assets, and that “not liking the message isn’t the same thing as not receiving it.”

For years, CoinGeek has tried to sound the alarm that regulators are losing patience with the digital asset sector, often to no avail. As FTX founder Sam Bankman-Fried discovered when he was arrested this week, the financial laws already on the books are all the authorities need to bring digital asset companies into line.

Most of the crypto-friendly proposals that have surfaced in Congress over the past few years have primarily been about amending securities laws to accommodate crypto. But Allen argues that “there are no compelling justifications for accommodating or legitimizing crypto with a lighter-touch, bespoke regulatory regime – taming regulation is needed instead … if crypto cannot comply with existing securities laws, then it shouldn’t exist.”

Follow CoinGeek’s Crypto Crime Cartel series, which delves into the stream of groups—from BitMEX to Binance, Bitcoin.com, Blockstream, ShapeShift, Coinbase, Ripple,
Ethereum, FTX and Tether—who have co-opted the digital asset revolution and turned the industry into a minefield for naïve (and even experienced) players in the market.