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DeFi Suffers from Too Much Centralization, What Can Be Done?

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“If any part of their business model incorporates centralization <...> then it is centralized no matter what other decentralized features it deploys.”

“It is vital that people understand how the assets they are pledging to a centralized entity are being used.”

‘”If users demand more decentralization within crypto lending they simply have to vote with their funds by moving them.”

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Like much of the crypto sector, decentralized finance (DeFi) is having a tough time. Not only has its total value locked in fallen by 70% (per DefiLlama data) since December, but various platforms within the not-so-decentralized DeFi space have been threatened with collapse, with Celsius’ halting of withdrawals being the latest — and possibly the most dramatic — manifestation of the ongoing crisis.

While Celsius’ inclusion within the DeFi sub-sector nominally makes it a ‘decentralized’ platform (at least in its use of blockchains), its control over user funds demonstrates that it was too centralized. Coupled with the collapse of Terra (which had been the second biggest DeFi platform), it has raised serious questions as to whether DeFi needs to become more fully decentralized, and as to whether it can be.

Opinion on this is mixed, with some industry figures affirming that centralization provides various benefits over truly decentralized platforms. At the same time, there seems to be agreement that decentralization alone is hardly a guarantee against future collapses and crashes.

Too much DeFi is not really decentralized

Figures within the industry are more or less in agreement that recent events involving Celsius and other platforms highlight the uncomfortable level of centralization within DeFi.

“Recent events concerning Celsius, Three Arrows Capital, and Lido show that lack of decentralization poses an issue to DeFi,” said Timo Lehes, Co-founder of DeFi protocol Swarm.

According to Lehes, part of the issue in DeFi is that decentralization occurs on a sliding scale, with platforms being composed of a mix of decentralized and centralized elements.

“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 told Cryptonews.com.

Looking specifically at Celsius, it too is a mix of decentralized and centralized elements. However, it’s arguable that it was centralized precisely in the most sensitive areas.

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

For Shea, decentralization/centralization is a binary issue, meaning that centralization in only one important area is enough to make a platform basically 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 told Cryptonews.com.

If a DeFi platform or company wants to be ‘truly’ decentralized, it has to operate on a more or less fully peer-to-peer basis, with all transactions executed using smart contracts run on a distributed network of computers. 

“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 added.

Others agree with the view that, if there’s centralized control of user funds, then no DeFi platform is really decentralized, no matter what else it might operate on a distributed basis.

“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,” said Dan Keller, Co-founder of decentralized computational network Flux.

Of course, even with the decentralization of funds and transfers, centralization in other areas can still cause problems for DeFi platforms and crypto more generally.

“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,” said Timo Lehes.

What can DeFi do to become more decentralized?

Lehes argues that, if DeFi wants to become more decentralized, compliant structures need to be introduced, via a mixture of regulation and self-regulation. 

“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 collapse of Celsius — which used users’ funds to make investments on other platforms — highlights that an essential ingredient of decentralization should be transparency.

“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,” Lehes added.

In traditional finance, deposit-taking institutions like banks have a set of rules governing how they can use client capital and are constantly monitored. Something like this will be needed for DeFi to be compelled to operate on a consistently decentralized basis, yet Lehes also says that platforms and users alike should push for more 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.

Ryan Shea also affirms that users should push for more decentralization, including self-custody.

“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.

Centralization has its uses

However, Shea also offers some warnings in relation to the push for more decentralization, suggesting that CeFi does have some benefits.

“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.

On top of this, many DeFi platforms don’t offer fiat on- and off-ramps, meaning that many mainstream users will continue to prefer the convenience of CeFi.

“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 said.

There’s also the argument that decentralization on its own won’t cause a significant reduction in the kinds of collapses the market has witnessed in recent weeks.

“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?” said Shea. 

Ultimately, it’s arguable that only regulation and transparency can ensure a substantial decline in risk when it comes to DeFi, regardless of how centralized or not a platform is.

As Timo Lehes concludes, “Regulation offers layers of transparency to existing products and innovation. 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.”

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