Digitisation Pitfalls: The decentralisation illusion and negative network externalities

The struggle for a synthesis between continued innovation and diversity on the one hand, while maintaining the stability of the financial system and data protection on the other, set an important new tone before the end of 2021. Banner image: Shutterstock/ProStockStudio
Digitisation Pitfalls: The decentralisation illusion and negative network externalities

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The struggle for a synthesis between continued innovation, diversity and competition on the one hand, while maintaining the stability of the financial system, data protection and the effectiveness of necessary interventions of national monetary and financial policy on the other, set an important new tone before the end of 2021.

Augustin Carstens, head of the Bank for International Settlements (BIS), in its fourth quarterly review of 6 December, again emphasised the urgency of closing regulatory loopholes for non-bank financial intermediaries (NBFIs), the importance of which has increased rapidly in the year under review. He singled out their risky, partly hidden leverage. In a special feature of the review on pages 21 ff., the Decentralised Finance (DeFi) sector was analysed, in particular its “decentralisation illusion” in view of actually observable, very strong monopolistic dynamics as described in detail. A somewhat more compromising position was adopted by the OECD in its recent report Why DeFi matters and the Policy Implications.  

Therefore, comments on such consolidation momentum from the DeFi camp itself are particularly interesting. One day after publication of the BIS quarterly review, a working paper by Alexandre Obadia of Flashbots Net and five other authors under the title Unity is Strength: A Formalization of Cross-Domain Maximal Extractable Value was posted, which describes the efficiency and cost advantages of working together as closely possible in blockchain processes. This analysis is technical and neutral; its title even indicates a positive connotation. However, negative externalities are also pointed out if the process involves very large, well-networked, profit-oriented actors who are not prepared to forego the appropriation of increasing economies of scale that multiply through networking. This confirms the observations made by the BIS hinting at monopolisation dynamics—here from the angle of possible beneficiaries. 

Against this background, Vitalik Buterin, the young Canadian-Russian co-founder of the Ethereum crypto platform, set a constructively differentiating tone in two posts on his website of 6 and 19 December. Buterin is not only known for the success of Ethereum and the associated crypto currency Ether, but also for donating over USD 1 billion in May 2021 to aid organisations in India fighting COVID-19. So claims by Buterin that with Ethereum he is aiming to bring about benefits for society as a whole—not just getting rich himself—are not unbelievable.

In the first post, entitled "Endgame", Buterin, with regret and concern, confirms the tendency towards monopolies in the blockchain process through network effects and their associated negative externalities. At the same time, he insists that these can be isolated and neutralised through a radical separation of the blockchain verification process as such (centrally specified, unswayable and retroactively unchangeable) from the validation of each newly created block by the individual user (decentralised, data-protected, surveillance and censorship-safe). Possible uses are payment transactions, but also medical diagnoses, the exchange of other scientific research results, supply chain bottleneck analyses etc., all of which can be effectuated via the Ethereum system using so-called Distributed Ledger Technology (DLT). Buterin explains in detail how this separation can be technically implemented and safeguarded. Of course, he can’t impose on platforms other than Ethereum the radical separation he demands between the central blockchain production process and the decentralised individual validation of each new block. The dramatic title "Endgame" reveals, however, that the existence and effectiveness or not of such a separation is the decisive factor for Buterin in distinguishing between usefulness of DLT for society as a whole and harmfulness. 

The BIS quarterly review does not go that far into technical detail, nor does the mainstream discourse on digitisation among political scientists, sociologists and politicians.

In the EU's political discourse on digitisation, private data protection issues currently dominate, coupled with severe threats of sanctions against platform providers for false, defamatory or discriminatory content. Not exactly seamlessly meshing with this is the discussion in the United States that primarily focuses on the 1st Amendment to the Constitution and Section 230 Communications Decency Act, guaranteeing freedom of expression and, moreover, impunity for the disseminator even of illicit content if in good faith. On both sides of the Atlantic these discussions in no way impair the scope of action for the already dominant platforms, which can, due to their superior resources compared with smaller providers, easily adapt to restrictive legal requirements. In China, the ruling doctrine of political order explicitly even justifies a pervasive state monopoly of data control and censorship for the benefit of society. In the western social sciences, the discourse on “democracy and digitisation” that became fashionable a few years ago still mainly revolves around the same empty formulas. Shoshana Zuboff's thesis, according to which data exploitation and surveillance are features of capitalism and must therefore be reformed, is enjoying widespread approval. However, she has not revealed yet how that should be achieved. Even Jürgen Habermas, the now 92-year-old proclaimer of democracy as an ongoing discourse of a critical public, has recently expressed doubts as to the realism of this concept, which he first published 60 years ago, given the increasing influence of social media, advertising, nudging, framing and fake news. How can individual maturity and responsible self-determination develop and still take effect when the ability and willingness for comparative reflection of the vast majority has narrowed down more and more to a rigid and hostile partiality of one’s own respective group (nation, religion, ethnicity, class, political party)?   

Could it be that Vitalik Buterin's separation concept, which initially appears to be purely technical, represents the Archimedean point for correcting undesirable developments as digitisation is advancing?

Of course, Buterin must be aware that his proposal of a sharp separation between central blockchain process verification and decentralised block validation at the user level—which he deems decisive for tyranny from, or freedom of DLT—cannot be implemented without strong political and regulatory support. Probably not least because of that, on 19 December, he posted "The bulldozer vs vetocracy political axis" on his website, a politically intended, no longer technically software-oriented article.

The multi-axis system that Buterin is suggesting correlates the three political polarities: bulldozer versus vetocracy, left versus right and authoritarian versus libertarian in all their conceivable combinations. The point is that Buterin does not commit to or preordain ex ante a fixed preferred political positioning within this multi-dimensional co-ordinate system, but wants to leave that to the continuous political discourse during which political priorities can wax and wane gradually, or can change direction and focus more suddenly due to more serious grievances.   

Read more: Critical (Democractic) Infrastructure and BigTech by Vincent F. Hendricks

Analogous to his remarks in “Endgame”, he presupposes that elementary principles or basic rules of the political process must be immovably established, corresponding to a national (or supranational) constitution that would fall entirely under the “bulldozer” category. At the same time, evolving changes of opinion for minority votes and innovative suggestions, full equality of opportunity and freedom should prevail, the latter falling into the “vetocracy” category. So there is a certain parallelism to the centrally specified, unswayable blockchain production process on the one hand and the deliberately decentralised and open but protected validation of the completed new blocks for their respective uses on the other. But in contrast to the technical piece “Endgame”, in Buterin's politically intended post the transitions from centralised to decentralised, i.e. from bulldozer to vetocracy and vice versa, are more permeable and fluid.

It is precisely this permeability and fluidity that might potentially lead to political congestion, social division, armed escalation or violent overthrow rather than their prevention. That calamities can occur out of the blue could be observed in Washington on 6 January, 2021. Unfortunately, similarly worrying polarisations are also increasing in Europe against the background of restrictive anti-COVID-19 measures, anti-migration sentiment etc. Is Buterin's approach therefore not too optimistic, too naïve?

Not really. On the contrary, the polarising, socially divisive, violence-prone tendencies of recent years have a great deal—possibly even decisively—to do with the described undesirable developments in the digitisation process, which have led to a breakdown of respectful, discursive social communication. Diversity, inclusiveness, equal opportunity, innovation and competition would be immediately stimulated and promoted from the bottom up by rigorous political implementation of the separation principle advocated by Buterin, while simultaneously stabilising the overall system. That is how the dialectic of “bulldozer versus vetocracy” is to be correctly understood. It can therefore only be hoped that the regulatory discourse will fully espouse the technical details of Buterin’s separation approach for DLT, to be followed up as soon as possible by consistent political implementation.

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