Decentralised finance (DeFi) risks and the decentralisation illusion

Sirio Aramonte, Wenqian Huang and Andreas Schrimpf in this BIS Quarterly Review analyse the growing Decentralised finance (DeFi) sector. They say that decentralisation bit about DeFi is an illusion:

Decentralised finance (DeFi) is touted as a new form of intermediation in crypto markets. The key elements of this ecosystem are novel automated protocols on blockchains – to support trading, lending and investment of cryptoassets – and stablecoins that facilitate fund transfers. There is a “decentralisation illusion” in DeFi since the need for governance makes some level of centralisation inevitable and structural aspects of the system lead to a concentration of power. If DeFi were to become widespread, its vulnerabilities might undermine financial stability. These can be severe because of high leverage, liquidity mismatches, built-in interconnectedness and the lack of shock absorbers such as banks. Existing governance mechanisms in DeFi would provide natural reference points for authorities in addressing issues related to financial stability, investor protection and illicit activities.

More on centralisation bit:

DeFi purports to be decentralised. This is the case for both blockchains and the applications they support, which are designed to run autonomously – to the extent that outcomes cannot be altered, even if erroneous.10

But full decentralisation in DeFi is illusory. A key tenet of economic analysis is that enterprises are unable to devise contracts that cover all possible eventualities, eg in terms of interactions with staff or suppliers. Centralisation allows firms to deal with this “contract incompleteness” (Coase (1937) and Grossman and Hart (1986)). In DeFi, the equivalent concept is “algorithm incompleteness”, whereby it is impossible to write code spelling out what actions to take in all contingencies.

This first-principles argument has crucial practical implications. All DeFi platforms have central governance frameworks outlining how to set strategic and operational priorities, eg as regards new business lines.11 Thus, all DeFi platforms have an element of centralisation, which typically revolves around holders of “governance tokens” (often platform developers) who vote on proposals, not unlike corporate shareholders. This element of centralisation can serve as the basis for recognising DeFi platforms as legal entities similar to corporations. While legal systems are in the early stages of adapting, decentralised autonomous organisations (DAOs), which govern many DeFi applications, have been allowed to register as limited liability companies in the US state of Wyoming since mid-2021.

In addition, certain features of DeFi blockchains favour the concentration of decision power in the hands of large coin-holders. Transaction validators need to receive compensation that is sufficient to incentivise them to participate without committing fraud. Blockchains based on proof-of-stake, which are expected to improve scalability, allow validators to stake more of their coins so that they have a higher chance of “winning” the next block and receiving compensation. Since the associated operational costs are mostly fixed, this setup naturally leads to concentration (Auer et al (2021)).12 Many blockchains also allocate a substantial part of their initial coins to insiders, exacerbating concentration issues (Graph 3, right-hand panel).


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