Centralized vs Decentralized Systems: Which are Better at Fraud Prevention?

by | Aug 26, 2022 | Blockchain, Blog

One of the broadest debates in the IT world is whether decentralized or centralized networks do a better job at preventing fraud and other types of security breaches on communication networks and information systems.

Although centralized communication networks are still the norm, many experts believe that to improve security a server should be decentralized, as this reduces the chance that the single central point of failure in a network system is attacked. 

One of the most exciting things about blockchain is its potential to improve fraud prevention at multiple levels in the financial system.

Traditionally, central administrators have served to process and record transactions, verify the authenticity of users and fix any bugs or issues that may arise in the system.

Blockchain technologies emerged following the imperative of decentralization, with networks that make intermediaries and central entities no longer necessary for the system to operate, where users have decentralized tools to improve their mutual trust instead.

These principles are part of the reason why some people believe that to improve security, a server should be decentralized, and blockchain technologies are often the perfect tool to create safe decentralized networks.

However, as blockchain technologies have continued to grow, many new challenges have emerged, and skepticism has been strengthened by a lot of these challenges, leading many people to ask whether it’s truly possible to reduce or fully prevent fraud within decentralized systems.

What is Decentralization in Blockchain?

Decentralized financial systems originated with the creation of the blockchain, a distributed ledger platform that allows transactions to be made without requiring a central entity while maintaining a high level of security and transparency.

A blockchain is a special type of software designed to allow users to make transactions while keeping an extensive record that is distributed among multiple nodes, which are held by different independent users.

The nodes are devices owned by independent users and entities, that provide computing power to authenticate and record transactions in the distributed ledger, and then verify this data by checking it against other nodes to make sure that it coincides, through what’s called a consensus mechanism.

Consensus mechanisms ensure that the data about all recorded transactions is certifiable and that it cannot be altered by any third parties. In blockchain networks, this data is stored in “blocks”, which are closed and chained into the rest of the ledger.

In blockchains, the transactions are stored and processed by multiple unrelated voluntary parties, hence there isn’t a single point of failure in their systems. 

As a result, users do not require explicit mutual trust for their transactions, because they can all access the ledger to verify all data concerning their specific transactions.

Centralized vs Decentralized

Whether blockchain is a truly useful tool for fraud prevention needs to be measured in comparison to traditional transaction systems. Decentralization has many advantages, but can also create some important risks.

Here are some of the most important aspects to consider when comparing decentralized and centralized systems in relation to fraud prevention. 

Centralized Systems

Nearly all of the traditional financial systems that existed before blockchain technologies were invented relied on some sort of central entity to verify and keep track of transactions, whether it’s a bank, a government, a corporation, or any other type of processor or intermediary.

For mutual trust to exist and be reliable, parties should have extensive information about each other to help them assess their intentions and likeliness to fulfill their obligations.

The presence of a neutral third party with no specific interest in this agreement can help reduce the need for that information and trust, ensuring that there’ll be objective information about the transaction, which neither one of the parties has been able to alter, in case there is a future dispute about the transactions’ conditions.

Third parties also comply, in most cases, with extensive regulations about how they manage the information that they’re given and can provide it as evidence in legal disputes in case there is a disagreement among the parties regarding a transaction.

Finally, if anything goes wrong with the transaction, or if the party making the transaction makes a mistake, a central intermediary, such as a bank, can provide mechanisms to allow that party to gain back their money

In this way, centralization helps prevent fraud by decentralizing it through vigilance and, in case a fraud is committed the central third party has faculties to provide evidence in a possible trial and reinstitute the victims.

However, the presence of a neutral intermediary has a cost. Usually, the parties need to pay the central entity a certain amount of resources to benefit from its services, which can come in the form of fees of different kinds.

Likewise, a neutral entity such as a bank exercises a certain amount of power over the conditions of the transactions and can, in the worst-case scenarios, be biased in their intermediation or even be an accomplice in possible fraud.

This is where decentralization comes in as a possible solution, automating the processing and recording of transactions, with a distributed ledger that has no single point of failure.

Decentralized Systems

Decentralized systems have many advantages, including potentially lower transaction costs and the removal of the possibility of human error or complicity, which is inherent to centralized systems.

They also prevent fraud by allowing users to keep their anonymity while maintaining a transparent and accessible ledger. 

When it comes to fraud prevention, the most important aspect of decentralized systems is not having a single point of failure.

The reason why there isn’t a single point of failure is that transactions in decentralized blockchain systems operate by allowing any user to provide their device as a node to validate transactions. Thus, validation is carried out from multiple independent points.

This ensures that the ledger cannot be altered by third parties, making it trustworthy and transparent, as anyone in the network can access the ledger without it compromising the network’s security.

Thus, the parties that use systems such as blockchain for their transactions have exact clarity about information such as the amount and the exact time in which transactions were carried out without having to rely on mutual trust or a third party.

These types of systems can be used for fraud prevention at different levels to great effect. At the public level, it could be used to prevent corruption by making an unalterable record for public transactions. 

At a private level, on a broad scale, blockchain could provide the base for fraud prevention mechanisms for a truly globalized financial platform that does not require the fees and long transaction times from systems such as SWIFT

Likewise, there are ways in which AI can be implemented into blockchain systems to create innovative methods of blockchain cybersecurity, taking advantage of decentralization to prevent special types of asymmetric threats such as DDoS attacks, which do not work on systems where there isn’t a single point of failure. 

Are Blockchains Immune to Fraud?

The simple answer to this question is no, as there are types of frauds that can occur even using blockchain transactions.

Some of the most common frauds committed using blockchain technologies include phishing through fake websites and messages, which have been relatively common types of fraud even in traditional financial systems.

Unfortunately, part of the reason why such frauds tend to occur with increasing frequency in the blockchain space is due to a lack of regulation in many global jurisdictions, which puts decentralized finance systems in a legal vacuum that allows scammers to operate without repercussions.

One example of this occurred at the beginning of the year as the celebrity YouTuber known as Ice Poseidon took $500,000 from his followers via a scam known as rug pull, where the promise of a financial product is made only for its creator to run away with its liquidity pool. 

Although the YouTuber admitted to the act, there were no repercussions due to the lack of laws explicitly prohibiting these types of practices under the jurisdiction where it occurred.

Other blockchain security issues can stem from the fact that just as there isn’t a single point of failure, there isn’t a single entity to rely on when things do fail, which can result in problems when scenarios such as the 51% attack occur. 

Due to the lack of regulations, these types of attacks are hard to prevent in smaller blockchain platforms and usually end with impunity. This paves the road for scammers and fraudsters to take advantage of blockchain security vulnerabilities. 

Blockchains can help prevent fraud by providing secure, decentralized, and inalterable financial ledgers that any user can access at any time, however, if these systems aren’t complemented with proper regulation, it can be difficult for users to make use of those ledgers to create legal cases against scammers.

The Road Decentralized Fraud Prevention

Blockchains are a tool to allow users to carry out transactions in a secure and transparent environment without compromising their privacy while eliminating the need for third parties or other intermediaries.

This, in and of itself, isn’t enough to prevent fraud, as examples have shown that frauds are an unfortunately common occurrence within the world of cryptocurrencies and non-fungible tokens (NFTs).

Despite this being the case, the tools provided by blockchain technologies make it far easier for any user to consult the data of their transactions and possibly track scammers.

If complemented with proper regulation and implementation into legal systems, these tools could be far more effective at preventing and combating fraud, allowing users to employ the content of the distributed ledger as a tool for law enforcement and a tool for legal processes.