Decentralization Is A Red Herring
The term DeFi (decentralized finance) is commonly used as a grand financial alternative to central banks and fiat currencies. Its decentralized structure removes central authorities manipulating its market value – or does it? More and more, it appears that decentralization is a red herring foisted upon investors to mask highly centralized control through coins and exchanges.
Levels of centralization
From well-meaning companies that issue coins and tokens to outright Ponzi schemes [1][2][3][4][5], crypto and NFT investors are always at the behest of a central authority that can either be compromised through a hack or manipulated by a nefarious executive. Either way, investors keep paying the tab.
In truth, there is only one decentralized cryptocurrency: bitcoin (BTC). BTC is difficult, if not impossible, to hack or price manipulate. With other cryptos, especially exchanges, there is no decentralization, only varying degrees of centralization. Investors can consider the following five areas of so-called decentralization as they can be financial pitfalls.
Centralized points of control
Despite the decentralization of blockchain technology, many DeFi platforms are centralized points of control. A DeFi platform built by a company and sold as a singular product is a centralized service.
For example, a DeFi platform can have a central group of developers augment existing code or build new code that alters the brand’s entire service. Relatedly, network bridges are also a form of centralization as they connect data transfer points.
2. Oracles
DeFi platforms rely on external data sources, called oracles, to provide information not housed on the platform natively. These external data sources may include market data, price feeds, and other relevant information required to execute the smart contract.
Because an oracle is centralized, it can become a single point of failure that can undermine the protocol’s security or durability. One example of a single point of failure would be interference in price feed. If a hacker manipulated a market price, it would cause an incorrect execution of the smart contract resulting in significant losses.
3. Liquidity pools
Liquidity is one of the most centralized parts of decentralized finance. It is often concentrated in very small pools, which presents many problems.
First, a few large-cap investors can sway the number of coins in the pool, decreasing stake dividends for smaller-cap investors.
Second, liquidity pools rely on large-cap investors to deposit significant funds to make the coin’s liquidity match the number of coins in circulation.
Third, a liquidity pool can lead to a small group of whales or entities gaining control of the coin’s circulating supply, market price, and governance.
4. Regulatory compliance
Some of the biggest headaches for crypto companies based in the U.S. comes from grey areas in regulation. Without clear regulation, a small central at the head of a crypto company must make certain decisions that can affect the entire enterprise or even the market.
While the Whitehouse has proposed several proposed crypto market regulations, Congress has been slow to act. With a lack of understanding of blockchain technology and its rapid growth and applications, it is unlikely that appropriate legislation will soon catch up.
5. Governance
Governance tokens present another problem for DeFi projects. The more governance tokens a person has, the weightier their vote is on a project’s decisions. If a whale owns 51% of all governance tokens, it can potentially control the project’s roadmap.
Worse yet, governance tokens can be controlled by a single person who owns multiple wallets. This was the case in the TerraLUNA crash, where CEO Do Kwon owned several wallets, making it appear that multiple people were voting when in fact Kwon himself was manipulating the vote tally.
Conclusion
Running a singular, so-called ‘decentralized’ company under a central executive team that uses centralized code scripts built on a central main-net is hardly decentralized.
