What Can Be Done If DeFi Has Too Much Centralization?

Decentralized finance (DeFi) is struggling, much like the majority of the crypto industry. Since December, not only has its total value locked in decreased by 70% (according to DefiLlama data), but several platforms in the not entirely decentralized DeFi space have also been in danger of collapsing, with Celsius' suspension of withdrawals being the most recent — and arguably the most dramatic — example of the crisis.

Although Celsius is technically a "decentralized" platform (at least in terms of its use of blockchains) due to its inclusion in the DeFi sub-sector, its management of user funds shows that it was overly centralized. It has caused serious concerns about whether DeFi needs to become more fully decentralized and whether it can be done, especially in light of the collapse of Terra, which had been the second-largest DeFi platform.

There are differing views on this, with some business leaders claiming that centralization has advantages over truly decentralized platforms. The consensus appears to be that decentralization alone is not much of a defense against future crashes and collapses.

The uncomfortable degree of centralization within DeFi is highlighted by recent events involving Celsius and other platforms, according to statistics within the industry, who are largely in agreement.

Timo Lehes, co-founder of the DeFi protocol Swarm, stated that recent events involving Celsius, Three Arrows Capital, and Lido "show that lack of decentralization poses an issue to DeFi."

Lehes claims that one of the problems with DeFi is that decentralization happens on a sliding scale and that platforms are made up of a mixture of centralized and decentralized components.

"Individuals and institutions can still benefit from the architecture and deployment of DeFi innovation, like self custody and transparency, even if other parts of a service are somewhat centralized. However, the problem highlighted by recent events from major lending platforms is partly a centralization issue but also a transparency concern, including oversight of what happens inside a protocol," he said.

With regard to Celsius specifically, it likewise combines decentralized and centralized components. It can be argued, though, that it was concentrated exactly in the most delicate places.

Ryan Shea, a crypto-economist at trading platform Trakx, explained that it "utilizes the smart contracts and ledger infrastructure of DeFi but customer funds get aggregated into custodial wallets, which are controlled by the company."

According to Shea, the choice between centralization and decentralization is binary, with centralization in just one key area being sufficient to render a platform essentially centralized.

"If any part of their business model incorporates centralization — such as aggregating customer funds into a custodial wallet controlled by the lending company — then it is centralized no matter what other decentralized features it deploys. That said, many other big-name crypto lenders like BlockFi and Crypto.com also deploy centralizing structures such as hot wallets to conduct transactions ," he said.

A DeFi platform or business must operate on a more-or-less fully peer-to-peer basis, with all transactions carried out using smart contracts run on a distributed network of computers, in order to be considered "truly" decentralized.

"Good examples of such platforms include AAVE, Maker, and Compound. Unlike CeFi [centralized finance] users do not have to trust the lending company, instead they have to trust the integrity of the code that executes the smart contracts," Shea continued.

Others share the belief that, regardless of how else it might function on a distributed basis, no DeFi platform is truly decentralized if there is centralized control of user funds.

"This is the case with most DeFi platforms, which are decentralized only in name, but not in reality, such as Celsius. To avoid this problem going forward, the industry participants should focus on the push for deeper decentralization, which will, in turn, lead to a better overall product ," according to Dan Keller, co-founder of the decentralized computational network Flux.

Of course, centralization in other areas can still be problematic for DeFi platforms and crypto in general, even with the decentralization of funds and transfers.

Timo Lehes stated, "for example, if too many nodes in Lido are operated on AWS [Amazon Web Services, a cloud computing platform], it makes the network more attackable, jeopardizing the goal of distributed network infrastructure and governance."

According to Lehes, compliant structures must be introduced into DeFi through a combination of regulation and self-regulation if it wants to become more decentralized.