Tuesday, November 28, 2023

Decentralized Finance Isn't

A major theme of this blog since 2014's Economies of Scale in Peer-to-Peer Networks has been that decentralized systems aren't, because economic forces overwhelm the technologies of decentralization. Last year I noted that this rule applied to Decentralized Finance (DeFi) in Shadow Banking 2.0 based on Prof. Hilary Allen's DeFi: Shadow Banking 2.0? which she summarizes thus:
TL;DR: DeFi is neither decentralized, nor very good finance, so regulators should have no qualms about clamping down on it to protect the stability of our financial system and broader economy.
And also DeFi risks and the decentralisation illusion by Sirio Aramonte, Wenqian Huang and Andreas Schrimpf of the Bank for International Settlements who write:
While the main vision of DeFi’s proponents is intermediation without centralised entities, we argue that some form of centralisation is inevitable. As such, there is a “decentralisation illusion”. First and foremost, centralised governance is needed to take strategic and operational decisions. In addition, some features in DeFi, notably the consensus mechanism, favour a concentration of power.
Below the fold I look at new evidence that the process of centralizing DeFi is essentially complete.

In DeFi Is Becoming Less Competitive a Year After FTX’s Collapse Battered Crypto Muyao Shen highlights the situation:
A small number of participants are dominating the world of decentralized finance as the crypto sector, which seeks to replicate financial markets without middlemen, still hasn’t recovered from FTX’s collapse a year ago.
Shen uses research from a "crypto-risk modeling company":
Most categories in DeFi — from peer-to-peer lending to decentralized exchanges — are seeing capital largely held in a few major projects, according to data compiled by crypto-risk modeling company Gauntlet. The firm used a popular measure of market concentration and competition called the Herfindahl-Hirschman Index.
Wikipedia explains the HHI thus:
HHI is calculated by squaring the market share of each competing firm in the industry—expressed as either fractions, decimals, or whole numbers—and then summing the resulting numbers ... The result is proportional to the average market share, weighted by market share. As such, it can range from 0 to 1.0, moving from a huge number of very small firms to a single monopolistic producer.
In Shen's graph above the HHI is expressed in "points" from 0 to 10,000. Shen comments:
Based on the metric, the most competition exists between decentralized finance exchanges, with the top four venues holding about 54% of total market share. Other categories including decentralized derivatives exchanges, DeFi lenders, and liquid staking, are much less competitive. For example, the top four liquid staking projects hold about 90% of total market share in that category, according to Gauntlet.
 $MShare %
Uniswap V35510.0
Maker DAO488.7
AAVE V3244.4
Top 4 78.2
Rari Fuse142.5
Rocket Pool142.5
Pancake Swap AMM V3132.4
Compound V2132.4
Morpho Aave V2101.8
Aura Finance81.5
Yearn Finance71.3
Shen provides a breakdown of the last 180 days revenue of DeFi projects, which I reformatted into this table. It shows that the top project, Lido, has 55% of the revenue, the top two have 2/3, and the top four projects have 78%. This is clearly a highly concentrated market, typical of cryptocurrency markets in general.

Why does the centralization of Defi matter? First, for all the bad things concentration causes in general markets — see for example Matt Stoller's Big. But more importantly, because the technologies of decentralization impose massive costs over and above those of equivalent centralized systems. The incentive to pay these additional costs is to reap the profits centralized systems sacrifice to regulation. If you are paying the costs but not evading regulation, what is the point? I discussed this in Economic Incentives.

I've argued many times, most recently to the IOSCO DeFi Working Group, that regulators should ignore the alleged "decentralization" of cryptocurrency systems and go after the major players in each area. With lawsuits against FTX' management, Coinbase, DCG/Genesis and Gemini, Kraken, and Celsius and Alex Mashinsky, and now their $4.3B criminal conviction of Binance and CZ, the US regulators no longer seem to be going after the small fry. Presumably, they used winning against the small fry to build precedents they are now using against bigger fish.

If despite claims of "decentralization" regulators can shut down the few big players in a market, the decentralized systems will be paying the massive extra costs but not reaping the unregulated profits. Of course, there is a Whac-A-Mole aspect; kill a big player and one or more smaller players will get bigger enough to be worth taking out. But it won't take many of these cycles for the market to get the message.


David. said...

This is just perfect. Molly White reports that Supply chain attack on Ledger puts much of defi at risk (my emphasis):

"A supply chain attack on the Ledger connector application has rippled throughout the world of decentralized apps, which widely use the software to enable people to connect their popular Ledger hardware wallets to perform transactions. Although hardware wallets are meant to be among the most secure ways to store crypto, they too are vulnerable to attacks when they are connected to perform transactions.

A hacker was able to obtain access to Ledger's source code management tool and push out a new release that contained code that would drain wallets as users connect them. Because the library is so widely used, many crypto applications were vulnerable — including Revoke.cash, a security-focused project intended to help people guard against attacks on their wallets."

This is precisely the problem Moxie Marlinspike described a year ago.

David. said...

Matt Levine has fun with the BarnBridge DAO shutdown that Molly White reported last month. Levine writes:

"Some decentralized crypto projects really do run as more or less autonomous code on distributed blockchains and really can’t be shut down by an SEC order.4 But there do seem to be a lot of $5 wrench vulnerabilities in crypto, where “decentralized autonomous organization” is a fancy way of saying “Discord page for voting on stuff,” and the SEC can find the Discord’s administrator and say “hey we can make your life bad if you don’t shut down this DAO” and the administrator shuts it down and everything was a lot less decentralized and autonomous and organized than people thought.
Reading the SEC order, it is a little puzzling how BarnBridge could have settled the case. It’s a DAO? Did it, like, take a vote? Apparently not; apparently the SEC got to the founders and the founders shut it down:"

David. said...

Turner Wright reports that Bitcoin hash rate drops by 34% amid freezing temperatures in Texas:

"A sudden freeze in Texas may have contributed to a 34% drop in the Bitcoin hash rate, as some miners were forced to curtail operations amid demand on the state’s energy grid.

Beginning on Jan. 14, temperatures in many parts of Texas dropped below freezing for one of the first times since a massive ice storm in February 2023. According to data from YCharts, the total Bitcoin network hash rate fell from more than 629 exahashes per second (EH/s) on Jan. 11 to roughly 415 EH/s on Jan. 15 — a 34% drop."

Texas paying miners not to mine - so Texas has a third of the entire mining industry?