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.
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.
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.
|Pancake Swap AMM V3
|Morpho Aave V2
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.