Who will control crypto?
0x44fB
August 22nd, 2022

By Saffron Huang & Josh Stark

The rise of statechains

Imagine that Ethereum succeeds. Blockchains become widely used for global commerce and coordination. Anyone with an internet connection and a phone can plug directly into a global network for money, value and identity. Every day, billions interact with an ecosystem of L2 chains secured by Ethereum. Security practices have improved at every level of the stack and major hacks are essentially nonexistent. It is commonplace for businesses and individuals to create crypto-tokens, and nations issue their fiat currency onto these networks.

The legal, social and economic codes of society have been completely reconfigured by the new organizations, interaction patterns and digital objects (NFTs, and more) that are now commonplace; the global economy adopts the “API” of blockchains as default.

But over time, a gradual shift takes place behind the scenes. The decentralised protocols that pioneered this revolution slowly lose market share to more centralised alternatives.

Libertarian sentiment within the now massive crypto community decreases against the backdrop of success. Convenience and cost become greater priorities. Governments and central banks have had time to catch up and launch their own centralised blockchains, exclusively issuing their fiat currency and bonds onto them, which draws economic activity onto these “statechains”. Businesses and individuals use these to pay their taxes. In some countries, the government requires that their statechain be the only legal blockchain used by their citizens.

Many people use the statechains. It's almost frictionless to do so; they are unlike the hefty paperwork and bank-letter verification systems of the old days. People can use the same wallets they are accustomed to from decentralized blockchains, to do most of the same things. Governments may even require the most popular wallets to only enable access to their chosen chains, like how some states require big internet companies to restrict access to certain content today.

Every application on an open blockchain is eventually deployed onto a statechain. Your favourite decentralised exchange, altcoin, and NFT game are all available within that walled garden. Governments offer tax forgiveness plans to entice users to migrate assets to statechains. Other benefits of using statechains include automatic tax calculations and VAT deductions.

The world's largest tech companies, pressured by governments, nudge users to migrate to statechains. The most popular phones come with the state-sanctioned blockchain wallet installed, with easy directives and intuitive UI for setting up a wallet, moving open-chain assets onto the statechain, and tax calculations. While people can use open-chain wallets or interact with statechains using third-party clients, it's really easy not to.

These statechains provide governments great influence over their national economies and the activity of their citizens. The way they use this power varies around the world. In some places, complete financial surveillance and occasional censorship becomes normal. In others, this power becomes political; factions compete to influence the features and parameters of the statechain. They whitelist or blacklist addresses, add or remove privacy-enhancing features, or introduce new automatically-enforced taxes. Economic reform, gender and sexuality, foreign affairs and other issues become debates over whether to modify statechains for efficient enforcement.

In some countries, laws are introduced that try to limit governments’ control over the statechain. But in most cases, giving the state easy access to personal transaction data slowly becomes a (sometimes begrudgingly) accepted privacy norm, even as people rehash debates over the merits of privacy vs. safety.

Even when there are legal limits on governments’ control of statechains, laws change in unpredictable ways. At some times and in some places, switching back to decentralised chains is legal—but not always. And when activities become prohibited, extensive historical data on the statechains of almost everyone’s complete transactional activity, mean that there’s little recourse to the obscurity of time. The past becomes dredged up by powerful actors in surprising ways.

Statechains become better maintained than open chains. They’re centralized, which allows the core engineers to upgrade them easily and quickly. This helps with national and international scale mass adoption. Open chains are viewed as less reliable, and become less trusted. The conventional wisdom is that there are effectively no hacks on the statechains; the force of the law comes swiftly down on any attempts at exploitation, and they can rewrite the blockchain state easily. On the open chains, consumers are less well-protected. Some people whisper about the possibility that powerful actors are intentionally raising doubt about open protocols by putting resources into conducting small disruptions and attacks — not to destroy them, but to demonstrate unreliability, and fragment their shrinking communities. This confirms to the citizens that they are right to be freely choosing the statechain.

Over time, the open networks fade into obscurity.

The Master Switch and the Cycle

The forces that determine who controls a technology, and how, are turbulent. The open networks that began the crypto revolution may not last to see the end of this century. The statechain scenario is one of multiple possible future trajectories in which parts or all of the blockchain ecosystem end up under the control of one or a few actors. We think this is similar to a process that legal scholar Tim Wu calls "The Cycle."

In his book The Master Switch (2011), Wu theorizes that there is a phenomenon in information industries, where an initially new, open medium of communication becomes a controlled, closed system. Wu draws upon examples of industries from 19th and 20th century U.S. history, including telephone, radio, film and TV, creating narratives wherein the heroes of openness often lose to the villains of control and capture in each industry. While he does not provide definitive criteria for the final stage of the Cycle, one can think of the Cycle as a general process of capture and control over an information technology. One or few entities capture the bulk of the industry’s revenue, prevents new entrants and controls the medium tightly.

What causes the Cycle? Wu doesn’t have a theory for a clear, consistent causal mechanism for this process; each industry analyzed in the book experiences a very different means by which it becomes closed and dominated by one or a few entities. For the telephone business, AT&T's mission to consolidate power was helped greatly by its access to capital via J.P. Morgan; in film, big studios invented new business models of distribution such as the theatre chain, which leveraged vertical integration to destroy independent theatre owners.

However, that does not mean that some causal mechanism does not exist. For example, it may just be that regardless of the method of capture, once an industry is captured, it is hard to un-capture (especially when antitrust law is weak, and network effects make scale profitable). If crypto is open and power is distributed merely because it is new and unregulated, surely the arrow of time will bring forth attempts at capturing power and money; some of these will be successful and difficult to reverse.

Or maybe different mediums are vulnerable to different modes of capture, which can be found and exploited by interested parties. The best way to capture the blockchain ecosystem is likely very different from the best method to do so for TV or radio, especially as many open chains are explicitly designed against such outcomes.

Before proceeding - what do we mean when we talk about the Cycle happening in crypto? In this piece, we’ll use “capture” and “centralisation” fairly interchangeably; both terms have pros and cons. “Capture” frames the process as a fairly deliberate, even sinister one; “centralisation” allows for more ambiguous intentions for why some entities might have more control, but it is a contested and ill-defined term. For now, let’s define centralisation or capture as: “one or very few entities can or do exercise disproportionate control over the medium, and over the free movement of competitors and users in or out of the ecosystem.

Our definition is broad because we are considering not just centralization of a blockchain itself, but of the broader ecosystem and environment that influence how blockchains are used. There are at least three “layers” where centralization might take place: the protocol layer, the application layer, or the social layer.

For instance, a blockchain might be centralized at the protocol layer if its design results in a handful of parties controlling a majority of full nodes, making it easier to manipulate the network. This is the type of centralization risk that people in the blockchain ecosystem tend to focus on.

However, even a blockchain ecosystem which is decentralized at the protocol layer might end up centralized through other means. For instance, if a handful of centralized applications end up with disproportionate control - maybe because they effectively control how most users interact with blockchains. This would be similar to the web today, where although the internet is built on “decentralized protocols”, a huge amount of traffic is controlled by Google and Facebook.

Lastly, even if the protocol and application layers remain decentralized, there is a much larger world beyond crypto. The “social layer” refers to everything else - how people, communities, ideologies, governments, legal systems, and others influence crypto.

Our statechain scenario is focused on capture at the social level. Even though Ethereum itself might remain decentralized, nation-states can use their considerable power to influence people’s actions - by creating incentives to use a statechain, and discincentives to use decentralized blockchains. Blockchains could remain decentralized, while the global marketplace for digital value creation & transfer slowly falls under the control of a handful of centralized entities. If a blockchain remains decentralized forever, but no one uses it, did it matter?

Ways crypto could become captured

Admittedly, even when equipped with a definition and a layer-by-layer breakdown, it’s hard to visualise what centralised or captured crypto may look like, as the current environment is so varied, new, and fast-moving. To gain some insight, we can look at historical and crypto-specific factors.

In The Master Switch, many of the network industries that Wu talks about became centralised because incumbent powers exerted regulatory, financial or physical power onto the new medium in order to dominate or destroy it.

Regulatory pressure

Regulatory action played a big part in the centralisation of previous network industries. For the radio industry, the U.S. government passed laws to favour fewer high-powered stations, based on the shaky premise that wave interference made it necessary (Wu, 2011, p. 83). In the film industry, the Edison Trust relied a lot on using patents, price-fixing, lawsuits and other legal strategies to do things like stop independent filmmakers and distributors from importing foreign films and banning certain stars (p. 66-72).

By design, crypto is harder to regulate and control than film or radio. It is built to be decentralised, transnational, and preserve many dimensions of anonymity. In previous industries, incumbents and incumbent-friendly governments used regulation and enforcement to slow or shut down competing inventors and businesses. It’s challenging to target any one institution or body responsible for crypto’s administration, because much of it is code not “owned” by anyone. One way regulation can lead to more centralisation, is by pushing people towards more centralised chains simply because they’re easier to regulate. Governments could exert this pressure by regulating assets unevenly across chains, such that people move towards those that have fewer nodes or more centralised consensus mechanisms.

It’s likely, in any case, that regulation will heavily impact how crypto appears in people’s lives, e.g. via fiat onramps, securities and exchange regulations. States will largely determine whether there can be sufficient social, regulatory and technical infrastructure for people to use crypto to pay for groceries, or real estate; this is a good reason for the crypto community to talk to and involve policymakers in their work.

Financing

Another way that the Cycle happened in history is through a large competitor being much better financed than their smaller counterparts. In some ways, crypto is obviously different. One of the first things that crypto enabled was decentralised crowdfunding and the creation of new speculative assets, useful to get around constraints of traditional funding sources. (Regulation could, of course, change this.)

Still, centralised players could tip the balance in favour of one project or another. Money helps with advocacy towards policymakers. Also, it’s easy to invest in new crypto projects, which blurs the line between old and new industries; traditional VCs hold many tokens in new protocols. Particularly when web 2.0 giants are rebranding themselves “Meta” and “Block” to get a piece of the new pie, we should not ignore the power and influence of private corporations to influence the fate of crypto.

Control over infrastructure

Another factor in past Cycles was infrastructure. Ongoing control of physical infrastructure helped old giants like AT&T stay dominant. Building on top of fundamentally centralised infrastructure or protocols gives the controller(s) of that protocol all sorts of leg-ups in the future. AT&T kept rising from the ashes and regaining power because its control over telephone and cable lines gave it an outsized say not just in telephone, but also over the emerging industries of radio, TV, and the internet.

Crypto is not built on top of some fundamentally centralised protocol. It uses the internet, which is very fragmented; it is not administered by any single body, who could shut down or change the protocol at any time. The TCP/IP protocol transmits data in a decentralised way along varying routes, not privileging or relying on any single path or node. If ISPs attempt to block access to specific crypto web apps or packet transmission, it would take significant international coordination to make a dent. Also, the most successful protocols - Bitcoin and Ethereum - are specifically designed to prevent any particular actor from gaining majority control.

However, there are still a number of factors related to physical infra which can lead to centralisation.

Although internet protocols are decentralised, the internet does still rely on physical infrastructure which can be controlled (or destroyed) by powerful actors like states. Many nations have established significant degrees of control over how their citizens use the internet, and they could prevent users from accessing crypto applications. This might be extremely limiting for many people, even if they don’t bring down blockchain networks entirely.

Protocols themselves can be weakened by over-reliance on centralised services, such as cloud computing platforms like AWS. The Ethereum ecosystem is often criticized because many popular applications rely on a few professional node services. Users and applications can always exit to an alternative node provider, which means AWS has no hard power over the network. But reliance on services like AWS can introduce subtle means of influence. People might be censored without knowledge; platforms may accumulate political or social leverage which may or may not rise to levels where users can be bothered to migrate. Other entities could also target those services as points of weakness for influence over the crypto ecosystem.

More generally, the need for specialized equipment means that those who supply or own it have outsized control. Bitcoin mining has to be done on specialized hardware, manufactured by only a few suppliers, which is a large barrier to entry. Startup costs and operational knowledge can be prohibitive, and the compan(ies) making and distributing this equipment can have a lot of direct or indirect control over who gets the equipment and how. Geographic centralisation of such physical infra can mean vulnerability to one particular state’s policies and to geopolitical manoeuvring.

Quality of services

Customer demands for quality and scale can also contribute to centralisation. In The Master Switch, AT&T had an early advantage in radio, because they owned long distance telephone infrastructure – which happened to be good for carrying radio programs too. It was ultimately the only company that could make a radio broadcast network; economies of scale meant that it could produce one show for sixteen stations, pooling those revenues to create a single, higher quality product (p. 76).

Technical novelty can wear out, such that consumers become dissatisfied with the quality and the reliability or security of service. This is something crypto can learn from, being an extremely novel, exciting technology that nevertheless is slow and expensive, where dapps are often hamstrung by bad UX, and devs find it hard to build on certain protocols. This stops people who aren’t intrinsically interested in crypto from using blockchain services. And even for those excited by the promise of crypto, if quality stays low, many may move away from crypto and back to corporate platforms.


When it comes to the question of, can crypto be destroyed by centralised entities, we must ask – what are the incentives for other people to shut crypto down? In the past, dynamics like market cannibalization led to suppression of new technologies. RCA suppressed and fought Edwin Armonstrong’s invention of FM radio, given its threat to AM, so brutally that it led to Armstrong’s death (Wu, 2011, p. 134). Magnetic recording tapes never made it out of Bell Labs because AT&T were worried it would cannabilize their answering machine business (p. 106).

For crypto, it seems that it’s easy for existing private companies to invest and gain upside in the new technology by buying tokens or marketing NFTs, which mitigates some of the incentive to destroy.

Even so, a future that widely integrates blockchain technology may prove devastating to many incumbents in the long run, who cannot avoid being replaced. Banks are an obvious example of an industry who may be threatened or forced to transform through the new innovations in payments, fundraising and securities in crypto. The automation of “management” structures using smart contracts may threaten any industry that brokers agreements between people, including lawyers and traditional corporate managers. This is a large chunk of people who may have incentives to co-opt, dominate or shut down the decentralised crypto world.

But, in many ways, the crypto genie is already out of the bottle. It would be near impossible for incumbents to vanquish blockchain technologies at this point, so we will see how they adapt and react to this new future.

How can crypto resist the Cycle?

Satoshi’s great leap was to create a protocol that, through the use of cryptography and economic incentives, would be highly resistant to capture. The point of a blockchain is to preserve an equitable and widely-dispersed relationship among the entities who maintain and participate in that blockchain. Only then can its contents—assets, smart contracts, data of various kinds—have the necessary permanence or hardness for humans to rely on it. Protocol-layer capture resistance is the foundation of credible neutrality; preserving it is necessary for the crypto ecosystem to succeed.

Other network technologies like radio or the internet are very different. Their fundamental designs and value propositions don’t factor in who controls the underlying infrastructure. A radio wave or a packet of information travels at the same speed, and can offer the same user-experience, irrespective of who owns the wires.

Preserving credible neutrality at the protocol layer is necessary – but it is not sufficient for resisting capture more broadly. The crypto community can learn from others’ experiences: there is a centuries-long history of network technologies succeeding and failing to resist capture by centralized entities. What can we learn from the past?

Preserve the funding advantage

Previous technology movements have failed when they have been outspent by incumbents. Open source work is critical to crypto but is often underfunded. So far the crypto ecosystem has been able to address that problem, by enabling an open market to bet on its own future and innovating with new funding mechanisms.

New funding and innovation models can create the space, resources, and flexibility to foster constant creative advancements, so that decentralised networks can not only survive, but maintain a lead on quality and novelty of use-cases at the application layer. If these use-cases can generate significant economic and social value in a decentralised way, especially if it’s due to decentralisation, people will use decentralised blockchains, migrate to them, and advocate for them.

The open-source funding advantage needs to be preserved in the long term. History tells us that the fight for the future of crypto will be fought over decades, not fiscal quarters.

Grow crypto’s global community

Blockchains may be the first real post-internet technology movement. Given that the internet has already been established, the crypto community has an advantage that was not available to the early radio or film industry: the means to expand to every corner of the globe where free internet access exists.

Many threats to crypto are nation-state specific. That includes severe regulatory responses or actions by powerful incumbents, who are often limited to certain countries or regions. But crypto, built on top of the internet, is default global, and it would be useful to deepen this advantage. Nurturing many independent, self-sufficient communities in different regions of the world, would strengthen the ecosystem at all layers.

Crypto must be a choice

In our statechain scenario, we assumed that most people would prioritize convenience and ease of use. This takes it for granted that people will approach blockchains only as consumers. What if they approach crypto more as citizens?

A big difference between crypto and previous network technologies is the strong imprint of specific values in the founding of the ecosystem. Crypto has always been an explicitly political movement, as much as it is a technological project.

Decentralized blockchains were made to offer humanity something that is different from the largely-centralized systems that dominate our world today. If people begin to recognize and value that difference, we can begin to create an ecosystem that makes it possible for large numbers of people to opt in, and to prioritize those values over mere convenience. Democracy itself is rarely the most convenient or expedient way of managing a society. But because large numbers of people value democratic ideals, and are willing to fight to defend them, democracies have survived for hundreds of years.

In order for people to choose and advocate for blockchains, like they do for democracy, people must understand blockchains and what they stand for. If we are asking people to vote through their choices - what specifically are they voting for? When the statechains come online, and developers, businesses, and users are asked to make a choice, what will we say to them and show them?


Thanks to Connor, Vitalik, Bastian and Danny for helpful comments and feedback.


References

Wu, T. (2011). The Master Switch: The rise and fall of information empires. Vintage.

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