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.

"The entire end-to-end setup of node structures and smart contract deployment should be auditable and clear to investors. That is not a problem specific to the current market turmoil but something more fundamental in the infrastructure of DeFi ," he said.

The failure of Celsius, which used users' money to invest on other platforms, has brought to light the importance of transparency as a component of decentralization.

"It is vital that people understand how the assets they are pledging to a centralized entity are being used. The problem with committing assets to unregulated counterparties is the black box of rehypothecation and the lack of recourse should something go wrong,"  according to Lehes.

In traditional finance, banks and other deposit-taking institutions are subject to strict regulations that limit the ways in which they can use their customers' money. It will take something like this to force DeFi to function consistently decentralized, but Lehes also contends that platforms and users should work together to promote increased self-custody.

"The easiest way to prevent institutions from being creative with client funds is to keep custody of them. The architecture of DeFi enables you to retain full control over your assets -- add to this a regulatory layer and you have a winning combination," he said.

Users should promote more decentralization, including self-custody, according to Ryan Shea.

"Companies, and crypto lenders are no different, primarily responding to customer demand because without customers there is no company. There already exist numerous functioning DeFi lenders so if users demand more decentralization within crypto lending they simply have to vote with their funds by moving them away from centralized lenders to decentralized lenders,"  he said.

Shea does point out some risks associated with the drive for further decentralization, indicating that CeFi does have some advantages.

"First, CeFi lenders have historically tended to offer higher yields on their products than DeFi exchanges. This ability to offer better returns has prompted speculation that they tend to invest in riskier products or enhance yield via rehypothecation, whereby collateral is lent out again to back another loan generating additional interest payments, ," he said.

Additionally, many DeFi platforms do not provide fiat on- and off-ramps, so many mainstream users will still favor CeFi's convenience.

"Government regulation is being increasingly applied to crypto transactions and the primary target is the on-off ramp. Indeed, it is the only viable target for governments to apply regulations, such as KYC [know your customer] and AML [anti-money laundering] rules, because they can threaten exclusion from traditional financial services for non-compliant crypto companies," he continued.

There is also the argument that decentralization will not significantly lessen the kinds of market collapses that have been occurring recently on its own.

"What really matters is the quality of the team behind the project. That said, the same is also true of DeFi lenders: is the team (even one that is crowd-sourced or running open-source software) of sufficient quality to ensure that software bugs and/or the design of the smart contracts are robust enough to withstand dramatic market events? " Shea said.

In the end, regardless of how centralized or decentralized a platform is, it is debatable that only regulation and transparency can ensure a significant decline in risk when it comes to DeFi.

"Regulation offers layers of transparency to existing products and innovation," says Timo Lehes in his conclusion. " In [the] future, investors should be advised to only engage with DeFi products where processes and smart contracts are fully auditable, there is a path for recourse in the event of malpractice and they have full transparency over how collateral is being used."

By fLEXI tEAM