To explain what decentralization is, let us of course first explore how things used to be: centralized. Let us explore that topic with a distinctly Settlers of Catan flavor.
Centralization Step One
If you own a lot of sheep, and want to trade it for wood, it’s difficult to carry around the sheep. They bleat a lot and leave mess on the floor. So instead, you can carry around a small amount of gold, which is worth as much as a whole lot of sheep. Now everyone can just carry gold around, instead of everyone having to carry sheep and wood and stone around. But now, the problem is that your gold can easily be stolen, you need to protect it. So rather than paying an independent bodyguard to protect your gold (who you might not trust, since at least some of the body guards will be gold thieves masquerading as bodyguards). So you instead take your gold to a vault for safe keeping. That vault is trusted by lots of other people who have confirmed that their gold wasn’t stolen. And the vault is a lot more secure than one bodyguard. Everyone pays and trusts the vault, and everyone reaps the benefits. But everyone also risks that the entire lot of gold is stolen by the vault operators, or some sophisticated gold thieves. This is centralization, step one.
Centralisation Step Two
Now that everyone trusts the centralized store of value, the vault owners start getting cocky. They change their name from “vault” to “bank”. They start loaning out a little bit of everyone’s gold to other people, and charge a fee for that, and as a result, earn a huge amount of gold in fees. They sort of tell you that they’re loaning your money out when you give it to them the first time, but you were probably 15 years old and it’s also sort of not that clear. But since everyone else is doing it, you just go along with it. And most of the time, most of the people are fine, since when you go and ask for your gold, they give you the right amount, and there are no problems.
But now, you’re truly trusting the bank not only to keep your gold and not steal it, but you’re also trusting them to not loan it all out to untrustworthy people who won’t pay it back, or at least, you’re trusting them not to make too many mistakes whilst doing that. After all, if they loaned it all out, and you wanted your gold back, they might not have enough left! That’s a lot of trust placed in one organization, in one central place.
In the case that everyone comes to the bank at the same time, and everyone asks for their gold, the bank would be unable to return all the deposited gold, since a lot of it is still loaned out to others. Just like everyone flushing the toilet at the same time, it’s a total disaster, and there’s sh*t everywhere. This happens more often than you think. In the recent global financial downturn, Banks and ATMs in Greece limited the amount of cash that could be withdrawn per day.
And you may say, “Well in some countries, your bank deposit is insured by the Government up to a certain amount, for example, $100,000 USD in the US”. Very true, however now you have just swapped one centralized entity that you have to trust, for another. If banks are failing, then the situation is already potentially dire, and it’s not too far of a stretch to imagine a government failing.
So there are clearly upsides and downsides to centralization.
The underlying problem is that all the assets are centralised in one place, and that if someone were to, for example, rob an extremely large portion of the bank’s cash, or if the bank were to declare bankruptcy, then all of the people who trusted the bank would be affected. So the likelihood is low, but the impact is extremely high, and the cost for each person is low. On the other hand, hiring a bodyguard who loses your gold is high likelihood, high cost, and high impact.
There must be a better solution!
How can we arrange the situation so that we do not all need to trust one centralized entity, with low cost? That’s what the blockchain solves.
Part II, coming soon.