What is the Nakamoto Coefficient? Exploring a lesser-known blockchain concept
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When compared to older asset classes, cryptocurrencies remain relatively newcomers to the ecosystem, but that doesn’t mean they hold no appeal for members of the general public. Even the people who aren’t interested in trading have at least a vague idea of what digital coins and tokens are, while the ones who have decided to integrate them into their trading portfolios are currently looking for ways to boost their earnings via diversification. In order to make the most of what the marketplace has to offer, investors have started looking into the latest market movements, including the ETH/BTC pair that displays the exchange rate between Bitcoin and Ethereum.
Bitcoin is the first and most well-known digital asset in the world, the one that inspired the creation of all the altcoins that followed in its footsteps. It is also commonly referred to as “digital gold” due to its ability to act as a store of value. The system backing Bitcoin is highly complex, and it is this intricacy that has caused many potential investors to steer clear of it, worrying that the losses they could deal with would be more substantial than their gains. Learning about the concepts that make up the blockchain and the features that have the potential to influence investments is crucial for the well-being of your portfolio, so learning as much as you can about them is the only way to enjoy success in the marketplace.
One of the ideas that is particularly important to understand is the Nakamoto Coefficient. But what does this metric mean, and how does it help with your trading strategy?
Measuring decentralization
The blockchain is a decentralized network that doesn’t depend on any centralized authority, such as banks, financial institutions, or government organizations, to carry out its tasks and complete its proceedings. This is one of the features that has attracted many investors in the first place, as they seek to operate in a market that guarantees their anonymity and fundamentally ensures that their assets will never be at risk of being frozen. The blockchain is also helpful when it comes to security, with all the data recorded on it being impossible to edit or modify after entering the system.
The fact that there’s no way to tamper with the records makes traders feel more confident and allows them to focus on their strategies fully. However, some analysts have discussed the possibility that some blockchains are becoming more centralized as a result of whale investors accumulating large amounts of crypto coins. This makes them uniquely powerful entities that have far more power than the average investor and can, therefore, act as authorities. This is in complete antithesis to the fundamentals of the blockchain, as it means that decision-making would no longer take place across the platform but that it would be concentrated in the hands of only a few individuals.
The Nakamoto Coefficient is able to quantify the degree of decentralization present in a blockchain. The metric represents the lowest possible number of independent entities, including miners, node operators, and validators, that would have to be in cahoots in order to disrupt or even entirely compromise a network’s normal operations and functionality.
How does it work?
The concept of the Nakamoto Coefficient was introduced by Balaji Srinivasan in 2017, with its name derived from the pseudonym used by Bitcoin’s creator, Satoshi Nakamoto. The higher the coefficient is the more it indicates decentralization and security within the blockchain. These systems benefit from a wider distribution of control among the participants, meaning that it is incredibly challenging, if not altogether impossible, for a small faction to manipulate the blockchain in any way or coordinate an attack.
The reverse situation, in which the Nakamoto coefficient is low, suggests that a small number of entities have significant control, a scenario that increases the risk of centralization and vulnerabilities. For example, if a blockchain has a Nakamoto Coefficient of 1, it would be regarded as dangerously centralized. The figure shows that a single person could control the blockchain if they chose to. When the coefficient is around 10, that means that at least 10 independent entities would need to conspire in order to achieve control, a situation that reflects a far more decentralized and secure network structure.
The limitations
Like any other technical analysis tool, the Nakamoto coefficient has its limitations as well. This doesn’t mean that the metric isn’t reliable or that it shouldn’t be used anymore; it's just that investors need to be aware of these factors in order to detect possible biases and irregularities when they carry out assessments. The most obvious drawback is that the coefficient offers a static snapshot of decentralization, which reflects the minimum number of entities needed to cause problems for a network at a given time.
The blockchain is a highly dynamic structure that is constantly changing and evolving, with factors such as staking, node participation, and shifts in mining power impacting numbers. As a result, the coefficient may not be 100% accurate, depending on conditions. Different blockchains have different consensus mechanisms as well, with each having a distinct impact on decentralization. Some believe that it is impossible for the Nakamoto coefficient to apply uniformly across all of them, meaning that an additional, more tailored approach must become part of the analysis as well if you’re looking to get results that are as accurate as possible.
The importance of external factors cannot be neglected as well. Since cryptocurrencies are entirely decentralized, they are more vulnerable to external factors like market dynamics, tech advancements, politics, and macroeconomics. Never underestimate the importance of these factors. The Nakamoto Coefficient might not take these externalities into account, which could make it not comprehensive enough for some investors.
To sum up, the coefficient is a very useful tool when it comes to assessing blockchain decentralization. However, depending on the information you’re looking for, you should always integrate additional metrics like qualitative assessments for a more complete understanding of the network’s security.
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