Is DeFi decentralization an illusion?

Although DeFi is not the newest kid on the block in the world of crypto and blockchain applications, the segment has reached an inflection point where it has quickly become the hottest topic around. Even though true believers insist that DeFi represents the future of finance, there are several concerns to be raised in its current shape and form.

In the latest quarterly newsletter from BIS, an organization representing leading central banks worldwide, DeFi and implications for financial stability is in the spotlight.

For those unfamiliar with DeFi, the abbreviation is short for “decentralized finance,” an umbrella term for a variety of financial applications in cryptocurrency or blockchain geared toward disrupting financial intermediaries. Unlike a bank or brokerage account, a government-issued ID, Social Security number, or proof of address are not necessary to use DeFi. More specifically, DeFi refers to a system by which software written on blockchains makes it possible for buyers, sellers, lenders, and borrowers to interact peer to peer or with a strictly software-based middleman rather than a company or institution facilitating a transaction. As of Dec 8^th, DeFi is a 160 BUSD market according to Coinmarketcap.  

For regulators, the decentralized nature of DeFi is somewhat of a headache, as it is cumbersome to regulate something when no single entity is to be held accountable. In traditional finance applications, the linchpin that enables the enforcement of financial regulations is the personal responsibility held by executives in the financial services industry. This causes regulators to express increased concern regarding the regulation of cryptocurrencies and DeFi.

However, in BIS latest report, it is argued that DeFi is far from as decentralized as we are led to believe. The point raised in the special feature is that there’s a limit to how far you can run a whole financial system purely based on those automated transactions. According to the report, “there are some incentive issues related to the fact that, through this decentralization, at some point you end up with some agents that play an important role, and not necessarily for the best [interests] of users of financial services.”

According to the report, the tendency for blockchain consensus mechanisms to concentrate power also makes it easy for a small number of stakeholders to make big decisions. The existence of so-called governance tokens which are cryptocurrencies that represent voting power in decentralized systems is one of the factors the report highlights as a threat to the promise of decentralization.

Governance-token holders can influence a DeFi project by voting on proposals or changes to the governance system. These governing bodies are called decentralized autonomous organizations and each one can oversee multiple DeFi projects. A DAO can even register as a limited liability company in the state of Wyoming. Although these concentration entities could act as entry points for fit-for-purpose regulations, the downside is that decision-making power on DeFi blockchains runs the risk of being concentrated in a small group of large investors and may facilitate collusion and limit blockchain viability. It raises the risk that a small number of large validators can gain enough power to alter the blockchain for financial gain. The report states further that the power concentration among a few large validators could also congest the blockchain with artificial trades between their own wallets or risk insider trading.

Venturing beyond the discrepancy between perceived decentralization and actual decentralization, the report also flagged several severe vulnerabilities in the Defi sector, including highly-leveraged trades, liquidity issues, and a lack of shock absorbers such as banks.

Although lending through DeFi platforms at first glance is well collateralized, where most initial loans are smaller than the assets used as collateral for it, funds/assets borrowed in one instance is often re-used as collateral in other transactions, allowing investors to build layers of leverage on top of each other. It doesn’t take a rocket scientist to see the risk profile of building an increasingly large exposure based on previous loans.

Another risk pointed out by the report is the dependency of stablecoins as a currency to facilitate transactions on several DeFi platforms as well as a act as a link to traditional finance. The growth of stablecoins has been exponential since mid-2020 when DeFi activities started to take off. In particular, USD Tether has gained substantial scale as a “vehicle currency” for investors who seek to trade in and out of crypto assets. Although the majority of stableoins are tied to off-chain currencies, others such as DAI, are DeFi stablecoins that are managed on-chain. The review warns that stablecoins like DAI, which are backed by crypto assets, are “exposed to market risk because the value of these assets can quickly drop below the face value of stablecoins.” The crypto arena doesn’t have a fallback like banks that can provide liquidity at times of stress.

In the case of Tether, questions are being raised on exactly how the coin is linked to USD. A report by Bloomberg states that the stablecoin issuer may hold billions of assets directly exposed to large Chinese companies, including infamous real estate developer Evergrande (although denied by the issuers of Tether). The report also revealed that the stablecoin company also provided a billion-dollar loan to Celsius, a centralized crypto lending platform that was recently accused of violating securities laws by the U.S. States of Alabama, Texas, and New Jersey. With strong ties to questionable assets, the value of loans backing Tether’s stablecoin reserves could be a risk factor for the crypto industry.

As the crypto space is coming of age, the gap between traditional finance and so-called decentralized finance is shortening as incumbents are showing an increasing interest in the crypto space as well as the approval of crypto-linked ETFs. With the exception of tethers ties to questionable assets in the world of traditional finance, DeFi still operates almost solely within the world of crypto, where most DeFi-lending activities appear to involve the process of using digital-asset collateral to acquire new digital assets. DeFi lending, therefore, poses a limited threat to the existing core franchise of traditional lenders. Several hurdles must be cleared before DeFi lenders can bridge the gap to traditional finance at scale. However, should recent trials prove successful, more traditional use cases could take off, and these protocols could start competing with traditional lenders.

With this in mind, if it looks like a duck, walks like a duck, and quacks like a duck, it is probably a duck. In the case of DeFi, if something looks like a bank, it should also be regulated as a bank, regardless of the underlying technology. If history has taught us anything, is that regulators are there for a reason.