Nick Chong · 5 days ago · 2 min read · Insights via Grayscale Investments
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Wealth concentration by the numbers
In August, blockchain analytics firm Coin Metrics released data around different coins and their wealth concentrations. Here are snippets for the top three coins by market capitalization:
The numbers show that Bitcoin, as the largest network, has the largest total number of addresses with meaningful balances—indicating a leading distribution of funds and greater usage when compared to other coins.
Meanwhile, Ethereum addresses tend to have the smallest balances of the top three, indicating relatively strong wealth dispersion. Finally, tokens on XRP appear highly concentrated, potentially posing greater price risk for holders.
These figures are even more striking when normalized by market capitalization.
Once adjusted, Ethereum is by far in the lead in terms of meaningful accounts and wealth dispersion. Moreover, it closes the gap between XRP and Bitcoin in terms of meaningful accounts as well.
The most alarming aspect though is the difference between median address balances. Adjusted median balances for XRP is 5-times that of Bitcoin and 32-times that of Ethereum. This may indicate that relatively few people are using XRP to meaningfully transact, despite much lower fees than Bitcoin and Ethereum. It is also suggestive of higher overall levels of centralization.
Critics may argue that the average is skewed because Ripple and its insiders hold over 50 percent of the token supply (worth approximately $13 billion at current prices). However, given that these reserves are only held in a handful of addresses the median shouldn’t be materially impacted.
It’s important to keep in mind that these figures aren’t directly comparable and should only be used to approximate wealth concentration. A single user can easily own multiple addresses while multiple users can also control a single address (through multi-signature accounts).
Fundamentally, these protocols also have characteristics that may skew the above metrics. Ethereum is an account-based protocol, which means users often re-use addresses, meaning the number accounts could be under-counted.
Bitcoin uses a UTXO-based protocol, which tends to result in many throwaway addresses which could inflate its numbers. But, Ethereum’s gas fee mechanic tends to leave behind small balances in accounts, dragging the average down. Appropriately adjusting for all of these factors is a difficult task.
Why this is important
Wealth distribution is important for the health of a public blockchain for several reasons, primarily in relation to decentralization—a key value proposition of the technology. As said by Ethereum co-founder Vitalik Buterin in a 2017 essay:
“Many have said that decentralization is the most important property of systems like Bitcoin and Ethereum.”
Brad Garlinghouse, the CEO of Ripple, has been emphatic that XRP Ledger is decentralized. In October of 2018 at the Ripple-sponsored “Swell” conference in San Francisco, he called the ledger “very clearly decentralized,” arguing that “anybody can participate in the XRP ecosystem.” This narrative has been echoed by CTO David Schwartz and disseminated through the company’s official channels.
Thought leaders in the industry care about decentralization. Experts in the field have argued that decentralization imbues well-designed blockchain systems with several useful properties. Blockchains are less likely to fail than traditional systems, more expensive to attack and destroy, and more resistant to collusion from participants, argued Buterin.
In contrast, high levels of wealth concentration are correlated to high-levels of decision-making centralization. It also puts purchasers at a disadvantage because it only takes a single entity to harm the price. In all, wealth concentration poses additional risk for investors.
One well-discussed example is the price action around XRP. Much of the value of the coin is derived from the success and actions of Ripple, a single corporation. If Ripple wanted to extract value from investors it could sell its holdings on the open market while reallocating those resources to services that have no relation to XRP. Worse yet, If Ripple decided to extricate itself from XRP it would result in catastrophic losses for investors.
Wealth concentration problems are exacerbated on proof-of-work systems, like what is planned for ETH 2.0 and what is already implemented on EOS. Systems which use tokens to determine the outcome of elections and make decisions give tokens direct power of the system.
Consequently, for proof-of-stake systems it’s essential tokens are distributed widely and equitably, otherwise the system is at risk of unwanted collusion and rent-seeking. Over the long-run, these systems are in jeopardy of increasing amounts of decision-making centralization as large token-holders implement rules which benefit themselves at the expense of users on the platform.
Though, there are also sound counter arguments to the theory that public blockchains require fair levels of wealth distribution. In a July 2017 essay, the former CTO of Coinbase Balaji Srinivasan argued:
“In practice it appears that a very high level of wealth centralization is still compatible with the operation of a decentralized protocol.”
At the time, Srinivasan discussed a framework for measuring decentralization to assess the resilience of a blockchain. He theorized that blockchains are bottle-necked by their most centralized point of failure. In other words, a blockchain is only as decentralized as its most centralized part.
If this is the case, then high levels of wealth concentration may not matter if there is an even more egregious point of centralization for BTC, ETH, and XRP.
Risks for the three coins
When applied to cryptos these theories could help investors make better decisions about each of the platforms.
For Bitcoin, large amounts of wealth concentration allow whales to manipulate the markets. By conducting strategic trades with large amounts of BTC it’s possible to take advantage of retail investors for profit.
Though, other less liquid coins such as ETH and XRP are at an even greater risk of market manipulation. However, small volume also means the potential profit from such behavior is constrained.
Under Balaji Srinivasan’s framework wealth concentration may not be Bitcoin’s main risk. Something like mining concentration in China could act as an even greater point of failure for the network.
For Ethereum, as the protocol moves to proof-of-stake in ETH 2.0, then token holdings will translate directly into political control over the system’s governance. These systems run the risk of turning into plutocracies, where rich token holders enact policies to enrich themselves at the expense of average users, making a blockchain less competitive over time. This phenomenon tends to be exacerbated by low voter participation on public blockchains, as demonstrated by EOS and TRON.
Finally, for those investing in XRP there are other concerns. Many enthusiasts think Ripple is a good steward of their reserves. Because they locked the majority of their coins in escrow and pegged the sales to market trading volume, token holders can supposedly have more confidence they won’t get diluted.
But, many of these large token holders aren’t Ripple and would not have the same self-imposed restrictions. In addition to Ripple regularly selling large chunks of XRP these large token holders could also be holding down the price of the coin.
Understanding wealth concentration for each cryptocurrency is an important factor to consider. Incorporating the metric into the assessment for each protocol helps people make better decisions about long-term growth potential and fundamental risk.