DeFi Is An Illusion, BIS Says

December 9, 2021
A new report by the Bank for International Settlements (BIS) says decentralised finance (DeFi) is an illusion and may impose severe vulnerabilities on financial stability.

A new report by the Bank for International Settlements (BIS) says decentralised finance (DeFi) is an illusion and may impose severe vulnerabilities on financial stability.

DeFi is a new and growing form of intermediation in crypto markets, in the sense that it provides financial services without intermediaries, using automated smart contracts on blockchains and stablecoins to facilitate fund transfers.

Decentralised platforms state that their transactions run autonomously on the blockchain through smart contracts, without the need for a central party overseeing the process.

In a new paper titled DeFi risks and the decentralisation illusion, the BIS concludes there is always a need for some form of centralised governance, noting that, “full decentralisation in DeFi is illusory,” because it is impossible to come up with contracts that cover all possible eventualities, such as all the various examples of interactions with staff or suppliers.

It is centralisation that allows firms to deal with this "algorithm incompleteness."

All DeFi platforms have central governance frameworks outlining how to set strategic and operational priorities or new business lines. These decisions are typically made by holders of governance tokens and, as such, show an element of centralisation.

Concentration of power

DeFi, although growing rapidly, still faces challenges that need to be addressed.

Blockchain scalability and large-scale tokenisation of traditional securities are issues that need to be improved before the service can grow to become an important player in the financial system.

Despite recent announcements that show that blockchain technology can be capable of processing 1,000,000 transactions per second, decentralised payments platforms such as Bitcoin can process around 3-7 transactions per second while Ethereum can process 15-25. Way too small to support mass payments usage.

One of the solutions to improve scalability is proof-of-stake processing which means those who own more coins have a higher chance to validate the block and receive compensation.

The BIS notes, however, that this feature favours the “concentration of decision power” in the hands of large coin-holders. Transaction validators need to receive compensation that is sufficient to incentivise them to participate without committing fraud. Since the associated operational costs are mostly fixed, this setup could lead to concentration.

In addition, many blockchains “allocate a substantial part of their initial coins to insiders, exacerbating concentration issues.”

Such a concentration raises the risk that a small number of large validators can gain enough power to alter the blockchain for financial gain, the paper warns.

With all these risks and vulnerabilities highlighted within this model, the BIS warns DeFi needs to be properly regulated before it can be adopted by the masses.

Public authorities would need to engage with DeFi platforms to understand the inherent governance structures and ensure these businesses have sufficient financial stability safeguards as well as mechanisms to protect investors and guard against illegal activities.

Although regulations concerning DeFi are in early stages around the world, there have been initiatives that encourage the adoption of the new structure.

This July, the U.S. state of Wyoming became the first to allow decentralised autonomous organisations (DAOs), which govern many DeFi applications, to register as limited liability companies in the state.

“In principle, DeFi has the potential to complement traditional financial activities. At present, however, it has few real-economy uses and, for the most part, supports speculation and arbitrage across multiple crypto assets,” the BIS concludes.

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