The DeFi market lacks decentralization: Why is this happening?

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As a seasoned crypto investor with over a decade of experience navigating both traditional finance and decentralized markets, I find myself deeply concerned about the current state of liquidity distribution in DeFi. The BIS report on Uniswap V3 highlights a troubling trend where a small group of large providers control the majority of the Total Value Locked (TVL) and reap most of the rewards, leaving retail investors in the dust.

The liquidity within Decentralized Exchanges (DEX) is primarily controlled by a small number of significant providers, thereby limiting the overall level of decentralization when it comes to accessing the DeFi market.

The concentration of liquidity on decentralized trading platforms primarily lies with just a handful of significant suppliers. This situation limits the distribution of opportunities in the decentralized financial market, which was one of the key findings from a study conducted by researchers at the Bank for International Settlements (BIS).

BIS examined the Ethereum blockchain, focusing on the top 250 liquidity pools on Uniswap, to determine if individual liquidity providers (retail) could match the performance of institutional liquidity providers.

An analysis of the top 250 liquidity pools on Uniswap V3 revealed that a relatively small number of users control approximately 80% of the total value deposited, earning considerably higher yields compared to individual investors. In many cases, these retail investors incur losses when considering risk-adjusted returns.

Most of the overall value is controlled by these players, who primarily concentrate on the liquidity pools with the highest trading activity. These pools tend to have lower volatility.

BIS report

In simpler terms, retail investors (individuals) involved in Decentralized Exchanges (DEXs), like Uniswap, tend to earn less from trading fees and have lower investment returns compared to institutional investors. Interestingly, institutions, according to the Bank for International Settlements (BIS), often end up losing money when considering risk factors. However, it’s important to note that this research was primarily focused on Uniswap, but its findings might also apply to other DEXs. The researchers suggest conducting more studies to better understand the roles of retail and institutional investors in different Decentralized Finance (DeFi) applications such as lending and borrowing.

Based on BIS findings, the elements that lead to centralization within traditional finance might be innate characteristics of the financial system, meaning these factors could also pertain to Decentralized Finance (DeFi).

2023 saw specialists at Gauntlet observe a rise in centralization within the Decentralized Finance (DeFi) sector. Their findings showed that just four platforms account for an impressive 54% of the Decentralized Exchange (DEX) market, while an even more concentrated 90% of all liquid staking assets are held by the top four major projects.

Liquidity in traditional finance is even worse

Economist Gordon Liao contends that a 15% boost in fee income offers minimal benefit over users who are relatively unsophisticated.

The paper discusses AMM liquidity provision, but I find myself arriving at a contrasting interpretation based on the data presented. In this study, the so-called “expert” traders contribute approximately 70% of the Total Value Locked (TVL) and receive around 80% of the fees. This represents a relatively small increase in fee earnings, about 15%.

— Gordon Liao (@gordonliao) November 19, 2024

He said that the situation in traditional finance is even worse, citing a 2016 study that found that individual liquidity providers must be adequately compensated for their role in the market.

Liao additionally challenged the allegations of manipulated sequences, emphasizing that the usual spread of price levels tends to surpass 1-2 percent. On the other hand, Bank for International Settlements (BIS) researchers acknowledged that Decentralized Finance (DeFi) encounters fewer regulatory, operational, and technological hurdles compared to conventional banking systems.

Liquidity is controlled by big players

As a researcher, I’ve discovered that it’s these savvy participants, who proactively handle their positions, who contribute roughly 65-85% of the market liquidity. Notably, they tend to place their orders near the current market price, mirroring the strategy traditional market makers employ when setting their offers.

While wholesale suppliers tend to be more engaged in managing liquidity and connect with a larger number of pools, retail providers typically have less involvement and work with fewer pools on average. Additionally, they collect a relatively small percentage of trading fees, ranging from 10% to 25%.

In volatile market conditions, it was professional liquidity providers who showed greater success, revealing their knack for adapting to economic fluctuations and predicting potential risks.

As a seasoned crypto investor, I’ve noticed from my own data analysis that during periods of high market volatility, it’s often the retail investors who suffer significant losses in profits. Meanwhile, more experienced and sophisticated participants tend to thrive. To put it into perspective, roughly 7% of all participants categorized as ‘sophisticated’ control about 80% of the total liquidity and fees in the market.

But is there true centralization in the DeFi market?

In 2021, Gary Gensler, who leads the U.S. Securities and Exchange Commission, expressed skepticism about the true decentralization of the Decentralized Finance (DeFi) sector. Gensler argued that while DeFi platforms may appear to be decentralized in certain aspects, they are actually quite centralized in many others. He specifically pointed out projects that motivate participants using digital tokens or similar methods.

If efforts are made to implement this rule and target developers and founders, it could lead to all teams deciding to relocate permanently beyond the United States. Additionally, such actions might stimulate a surge in anonymous development with little more options available for regulation.

— Larry Cermak (@lawmaster) August 19, 2021

As per Gensler’s statement, specific Decentralized Finance (DeFi) initiatives share traits akin to those managed by the Securities and Exchange Commission (SEC). To illustrate, these projects can be likened to person-to-person lending networks, similar to traditional peer-to-peer lending platforms.

According to Block Research analyst Larry Cermak, it’s likely that if the SEC chooses to target DeFi project creators and developers, many of them might relocate outside the U.S. or opt for anonymous work on their projects instead.

Can DeFi’s problems be solved?

The growing economic trends favoring the dominance of a select number of players are intensifying competition and sparking doubts about the feasibility of complete democratization of liquidity in decentralized financial ecosystems.

The fate of Decentralized Exchanges (DEXs) and the entire DeFi sector hinges upon resolving issues related to uneven access and liquidity. By scrutinizing these developments, we can shape the evolution of decentralized finance systems, fostering a more durable and equitable financial environment.

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2024-11-22 02:25