DeFi - The illusion of decentralization?
This week we take a closer look at the "De" in DeFi, why full decentralization might be illusory and how DeFi is really "self-custodial atomized finance."
DeFi - Some Definitions
DeFi can be loosely-described as an alternative finance ecosystem where people transfer, trade, borrow and lend cryptocurrency independently of traditional financial institutions and the existing regulatory structures.
A difference between DeFi and Centralized Finance (CeFi) lies in whether the financial service is automated via smart contracts on a blockchain or is provided by intermediaries. DeFi proponents believe that automating the contracting processes improves efficiency, reduces intermediation and provides users with greater anonymity.
A more technical definition for DeFi is that they are financial applications run by smart contracts on permissionless blockchains. Here is an illustration and some examples of the platforms in each category:
The “De” in DeFi
It would be natural to think that DeFi would be very decentralized, meaning it cannot fall under the control of any single party or entity and that it operates as a function of a large, scattered number of individuals. But the “De” in DeFi is actually more nuanced.
This brings us back to Vitalik’s blog post mentioned in the first newsletter about the meaning of decentralization. In a similar vein, in Prasad’s “Future of Money“ (shameless plug), decentralization is appraised across multiple dimensions:
Decentralized architectures (no centralized point of failure),
Decentralized governance (control rests with the members of a network rather than a central authority), and
Decentralized trust (trust is achieved through public consensus mechanisms).
In addition to the above, there are some extra considerations when evaluating the level of decentralization in DeFi protocols:
Censorship resistance - can you be prevented from using the service?
Token distribution - who owns the majority of governance tokens?
Social decentralization - if the project goes down, how easily can the community fork it and start fresh?
Maintenance and updates - how easily can the smart contract be upgraded and how?
Transparency and audits - who can view and audit the code?
The point here is that the “De” in DeFi is really a spectrum composed of multiple different factors. As Lex Sokolin from ConsenSys puts it:
“You can have a decentralized network with a permissionless financial product used by anyone anywhere, but it can be built and governed by a party with centralized control.”
The Illusion of Decentralization?
With these concepts in mind, we can now take a look at a recent report from the Bank of International Settlement, which examines DeFi’s promise to remove the need for centralized intermediaries.
The report concludes that there is a “decentralization illusion” in DeFi since the need for governance makes some level of centralization inevitable and certain structural aspects of the system lead to a concentration of power.
Here’s the authors’ line of thoughts from a first principle basis.
Consider how a normal business functions. Businesses are inherently unable to devise contracts that cover all possible eventualities, (e.g. in terms of interactions with staff or suppliers). Centralization allows firms to deal with “contract incompleteness”.
Similarly, the problem of “algorithm incompleteness” exists in DeFi. Just as a business is unable to consider all eventualities, it is impossible to write code spelling out what actions to take in all contingencies. As a result, all DeFi platforms must have some central governance frameworks stipulating how to set operational priorities.
This means that DeFi has an element of centralization revolving around holders of “governance tokens” who vote on proposals, similar to corporate shareholders. The authors believe that this element of centralization serves as the basis for recognizing DeFi platforms as legal entities similar to corporations:
Platforms have groups of stakeholders that make and implement decisions, exercising managerial or ownership benefits. These groups, and the governance protocols on which their interactions are based, are the natural entry points for policymakers. These entry points should allow public authorities to contain DeFi-related issues before this ecosystem attains systemic importance.
DeFi… more like… self-custodial atomized finance?
The term DeFi fits into the broader crypto utopian narrative which envisions a somewhat anarchic future without the need for government or any centralized entity. It’s a great moniker that captures the imagination of the public and draws in users. But perhaps a more fitting name for financial applications running on blockchain would be self-custodial atomized finance.
The applications are “self-custodial” because users have to interact with them using non-custodial crypto wallets. It means users technically never relinquish custody of the assets to a centralized processor. Users take control of their own private keys to their wallets and bear the responsibility of safeguarding access to them. The applications are also “atomized” due to the distributed nature of the underlying digital infrastructure, since discrete nodes collectively power the network.
I’m not saying that we should start calling DeFi self-custodial atomized finance — it’s obviously a terrible name. But the word “decentralization” seems to have this anti-establishment undertone that spooks governments around the world. If the authorities can look beyond the label and realize that the predominant features of DeFi are self-custody, atomization, open-source, composability and modularity, policy discussions surrounding DeFi could be much more productive.
Resources & Further Reading:
WEF - Decentralized Finance (DeFi) Policy-Maker Toolkit
a16z - Decentralized Finance: What It Is, Why It Matters