Measuring Decentralization in Crypto
There never were in the world two opinions alike, no more than two hairs or two grains; the most universal quality is diversity.- Michel de Montaigne
The crypto space — with its central promise of decentralization — thrives on a diversity of projects. This post measures the extent of decentralization (diversification) in crypto, reviews its evolution, and provides insights on the nature of the crypto economy.
Measures of diversity have been developed in ecology, demography, economics and politics. In this analysis, we use the Herfindahl Score (aka Herfindahl–Hirschman Index) as a measure for decentralization in crypto space. It measures the size of participants in relation to the ecosystem and reflects the competition among them. This Decentralization Score (DS) is the squared sum of weights (market shares) of the participants in a system:
where the w are the weights for the N assets.
DS is frequently used to assess the extent of competition among companies — company market caps in relation to the industry are used to calculate market share. A small score indicates high concentration whereas a larger score indicates a competitive industry. DS can range from 0, for a monopoly, to 1, for a large number of participants with small market shares.
Decentralized crypto economies will require a wide variety of services as they grow, which we expect will be provided by a large number of projects. In constructing the DS for Crypto, we use market caps (aka network values) of individual projects in relation to total crypto market cap. The market cap of a crypto project is calculated by multiplying the price of a coin by the number of coins in circulation. The market share — based on the price assigned by investors to various coins — encapsulates the diversity of innovation, philosophies, ideas and investor views in the crypto economy.
Let’s use a few simple examples to illustrate the behavior of the measure. Back in the day when Bitcoin was the only project in the crypto space and had 100% of the market share:
If instead the space had two projects, each with 50% share:
For three projects, where one has 50% market share, and the other two each have 25% share:
And what if there were 100 projects, each with 1% market share:
From above examples, it can be observed that DS rises rapidly — at a quadratic rate — as the number of participants increase, and take market share.
Crypto is growing and decentralizing rapidly…
The chart below shows crypto DS and market cap since 2013. Both DS and market cap have been rising since 2013, and saw a dramatic uptick in 2017.
The DS underscores investor confidence in the overall crypto economy. It’s been volatile — no surprise there — but has demonstrated a strong uptrend. Higher highs and higher lows have been registered every year since 2013.
Even during the long winter of Bitcoin — from late 2013 to late 2015 — the DScontinued to rise, indicating that the larger crypto economy was still functioning.
Most recently, the DS registered a higher low, and has started rising again after the ~70% drawdown in cypto market cap in the first quarter of 2018. Although market cap is still recovering, the DS is already closing in on its all-time highs.
… number of projects (coins) has been rising…
Number of coins, and hence projects, has grown steadily from a handful in 2013 to over 1500 in 2018. There is also a clear inflection point in 2017 where the number of projects started rising at a faster rate, and the curve steepened significantly.
… and Bitcoin’s market share has been falling.
Although Bitcoin’s market cap has risen significantly over the period, its market share has fallen — from over 90% in 2013 to under 40% at present — while other innovative projects have gained market share.
However, very few projects have been able to retain market share
In the tables below we review the top 10 projects by market share at the end of every year since 2013, and compare with their current market share (at the end of April 2018) to see how they fared.
At the end of 2013, Bitcoin had ~88% market share followed by Litecoin at ~6%, and Ripple at ~2%. Omni and all other coins that featured in the top 10 in 2013 have since lost market share and rank considerably lower at present.
Bitcoin market share dropped to 78% by the end of 2014, Ripple shot up to ~14%. Paycoin rose to ~3% but lost market share rapidly since, and has fallen way down the ranks.
Bitcoin reasserted itself with a ~92% market share in 2015, Ripple’s share fell to 3% and Litecoin ended the year ~2%. Ethereum emerged on the scene and took 1% market share.
Ethereum forked in 2016, and privacy coins like Monero and Dash found positions in the top 10.
2017 was a year of rapid market share erosion for Bitcoin which fell to ~39%. New projects like Cardano and IOTA featured in the top 10.
The crypto leaderboard has changed dramatically year over year, and continues to evolve. This constant change aligns well with crypto’s promise of decentralization, and lowering of barriers for new entrants. Proliferation of new, innovative projects is to be expected in this space.
How does Crypto DS compare with real world economies?
Crypto projects have been likened to economies in several studies — where the crypto network value is analogous to the GDP (Gross Domestic Product) of a real world economy. A comparison of the decentralization in the crypto economy to that witnessed in real economies provides us with a projection for the levels of decentralization crypto could potentially achieve.
Each country is a participant in the world economy. Individual country real-GDP — inflation-adjusted value of goods and services produced in a country over a year — is divided by world real-GDP to calculate its market share. Squared weights are then used to calculate the aggregate DS the same way we did earlier with crypto.
The World Bank makes GDP data available from 1960 to 2016. The DS for real economies was ~85% in the 60s, and has continued to gradually rise.
Information technology and global trade are two major trends that shaped the world economy in recent decades, and contributed to the rising DS. World’s largest corporations operate and compete in a global marketplace. The internet and smart phones continue to bring the world closer — informationally, socially and economically.
Interestingly, crypto economies naturally benefit from both these trends — permissionless and hooked up to the internet, most crypto projects are global out of the box. As can be seen from the above chart, a real world economy changes at a much slower rate as compared to the crypto economy. As crypto begins to live up to its central promises of decentralization and lowering barriers to entry, we expect it’s DS to rise to levels higher than real economies in the future.
What does this mean for crypto investors?
The Decentralization Score is a useful measure for the overall health of the crypto economy. A rising DS indicates that innovation continues to flourish in this young space.
We have witnessed a proliferation of innovative projects in the crypto space. Some of these younger projects will gain market share, while currently dominant projects lose market share over time. There will be several winners. The rising DS for crypto indicates investors should look at a diversified portfolio as a cornerstone of their strategy.
The chart below demonstrates that top 10 coins (Bitcoin + coins ranked from 2 through 10) have been able to capture ~80% share of the crypto market so far. An investor looking to benefit from the growth of the crypto economy — but without the resources to research projects in depth — can opt for a simple market-cap weighted portfolio of top n coins with regular rebalancing based on changing market shares.
At present, there is a dearth of solutions in the crypto space that make it easy to invest in a diversified portfolio. In the US as an example, a few crypto index funds have become available — but only to accredited investors, and the management fees are high when compared with traditional assets. Moreover, the custody is centralized, making such funds a fertile ground for hackers.
Equally importantly, solutions (wallets) that allow for safe and secure access to crypto, one-stop portfolio view, and analytics are also lacking.
We are positive that solutions will become available in the near future. We at Ethos.io are at work solving some of these problems to make crypto accessible to everyone — to build a financial ecosystem that is open, safe and fair for everybody.
As new entrants gain market share and dye the fabric of crypto with vibrant colors, we eagerly await the day when crypto DS crosses higher than world economy DS! Will it happen at crypto speed in the next few weeks/months or will we need to wait longer? We will continue to monitor…
Acknowledgements: Many thanks to Shingo Lavine, Adam Lavine, Stephen Corliss, Kevin Dean Pettit, Dan Caley for their valuable feedback in reviewing this post, and to Aidan Gordon, and Andrew Carpenter for helping build the analytics.