Is decentralized finance really decentralized?
Updated: Jul 13, 2021
Many of us may made some hopeful New Year's resolutions for 2020, and yet as it has been perhaps one of the most eventful years seen in modern history. We now look forward to it drawing to a close! Starting with global political crises and the loss of world-renowned NBA all-star Kobe Bryant, it progressed to Covid-19 and a reality check in financial markets. Even Bitcoin, deemed to be the digital gold and the ultimate hedge against global-scale events by some, had plunged to the $4000 range, although this was only for a short time, and it eventually managed to climb back up to around $12000.
In the cryptocurrency space, a new area called "Decentralized Finance" or DeFi for short, has started to get more and more attention.
Chart via Google Trends (as of September 24, 2020)
Google Trends shows that decentralized finance is getting more attention as well. As a side note, if you are not too familiar with DeFi, I recommend you conduct some research on your own before continuing. However, to give you a quick summary, I would describe a decentralized financial service or a decentralized finance product to be an open system that aims to reduce the trust in central financial authorities. Among its many applications, the most popular ones are lending/borrowing services, stablecoins, and decentralized exchanges. You should also note that "non-custodial finance" is preferred over "decentralized finance" by some (including myself.)
DeFi is based on blockchain, the technology behind many cryptocurrencies, which allows for decentralised control of financial systems and cutting gout the middle man in a payment method (usually a bank). DeFi covers more complex financial utilisation of blockchain technology as opposed to just simple value transfer.These can include transactions but can also include loans, insurance, betting, derivatives and crowdfunding.
Many DeFi projects have yielded immense returns since the beginning of the year, and some holders of the relatively early DeFi tokens have made quite large amounts of money. One case in point, LEND, saw its value skyrocket from $0.01682 to $0.9083, making a profit slightly over 5400%. Thanks to such returns and news following them, the term "Decentralized Finance" has become a buzzword, bringing in greedy cryptocurrency investors and traders, and resulting in the launch of many new DeFi projects.
In this piece, I will share my own negative view on the space of decentralized finance. However, this does not mean to say that it is all doom and gloom. In fact, I truly believe that it has a very promising future.
I would also like to add that at the time of writing, I do not hold any decentralized finance tokens or coins and this piece should not be used to inform any investment or trading decisions. Doing your own due diligence is always recommended.
Slightly decentralized finance
Whether we like it or not, decentralization comes in relative terms and absolute terms. 100% decentralization (in terms of development, mining, and so on) is nothing more than a dream at this point. Sadly, this applies even to arguably the most decentralized entity in the space: Bitcoin. But how decentralized is decentralized finance? And does it really merit this adjective?
If you are a "child" of the 2017 cryptocurrency bull run, you should be still remembering how you bought your first cryptocurrency: Visiting a reliable fiat gateway, entering your bank details, and in return, getting some cryptocurrency, most likely Bitcoin. Once claimed to be a completely anonymous currency, now it is accepted that what Bitcoin offers in terms of privacy is at best pseudo-anonymity. But why not just mine some cryptocurrency instead? Even for the most tech-savvy amongst us, setting up a mining operation is quite complicated for a crypto-newbie. And even if you did manage it, you would need quite expensive specialized devices called ASICs. Even then, mining cryptocurrencies does not guarantee you any profits, as success is dependent on so many external factors beyond your control. Once you have put your banking details into the fiat gateway and got some Bitcoin, the fiat gateway now has your banking details and KYC documents, along with your public keys of the cryptocurrency, making it quite easy to track the journey of your coins.
What about the idea of decentralized finance as a solution to those who do not have access to a bank account? Firstly, to use a decentralized financial service, you need coins or tokens. To get these coins or tokens, you need to use either mining or get them via a fiat gateway. Mining is not sustainable for most people for many reasons, and I can only imagine how hard it would be to get an ASIC device without using any banking service. To use a fiat gateway, you need a bank account. What about cryptocurrency ATMs? Unfortunately, although more and more are being built, they are still quite rare and you have to pay large fees to use them, negating one of the reasons most people are looking to ditch centralized banking. So, either way, DeFi does not the solution. Either at the beginning or the end of your journey, you must use some kind of banking service, your privacy is still under attack and DeFi is not able to help much on this end either.
Let us consider another use case of decentralized finance, namely stablecoins. When being put to its most popular use, a stablecoin cannot be decentralized. By its definition, a stablecoin's price is aimed to be a constant value. For example, a USDT is designed to be worth $1. While the code can do many great things, on its own it cannot make your "magic Internet money" consistently equivalent to $1. In the end, a USDT is deemed to be worth $1 if it is perceived to be $1, and to be perceived to be so, its supplier must be holding some USD somewhere. In this use case as well, the price of a DeFi product depends on central factors.
Finally, the existence of master keys that the project creators can hold to gain control over tokens in emergencies, such as hacks and bugs that can turn out to be fatal for the project, creates another dilemma, perhaps much more important than those just mentioned. Even though cryptocurrencies have come a long way since their genesis in 2009, the trust in DeFi is largely misplaced or overstated. The most popular cryptocurrency in the public eye, Bitcoin, had its own troubles back in the day, yet still exists because it could parry them. Whether most other cryptocurrency projects, with a few exceptions like Ethereum and Monero, are capable of the same is quite controversial, especially when we consider the history of DeFi projects Lendf.Me (1) (2) and YIM (1).
So the dilemma considering master keys is this: If a project has master keys and someone has access to them, they still have (almost) complete control over the project. The only difference between a so-called decentralized finance project and a traditional finance project is who has the control. In the end, any bug that is exploited by a malicious actor is likely to be fatal for the project in most cases.
Does this mean that DeFi was a nonviable project from the beginning? Not exactly. The mere idea of a decentralized finance world is very promising, and my doubts will remain as such until it passes the test of the time, just as Bitcoin did. In the meantime, I think the important question we should be asking ourselves is whether DeFi is a true rival to traditional financial services or just an alternative.
Is centralization the root of all evil? That's debatable and possibly the topic for another post. We can also explore what happened when the financial markets, almost without exception, plunged and then returned to their all-time highs during the worst of the Covid-19 pandemic. In my humble opinion, it is now that we should be looking at what would happen if centralized currencies were suddenly gone and we were forced to use cryptocurrencies.
May we all live in interesting times.
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