The DeFi market lacks decentralization: Why is this happening?

Liquidity on the DEX is in the hands of a few large providers, reducing the degree of democratization of access to the DeFi market.

As Bank for International Settlements (BIS) analysts noted in their report, the concentration of liquidity on decentralized exchanges among a few large providers reduces the democratization of access to the decentralized financial market.

BIS analyzed the Ethereum blockchain and examined the 250 largest liquidity pools on Uniswap to test whether retail LPs can compete with institutional providers.

A review of the 250 largest liquidity pools on Uniswap V3 found that only a small group of participants had around 80% of the total value locked up, earning significantly higher returns than retail investors who often lost money on a risk-adjusted basis.

“These players keep around 80% of the total value locked up and focus on liquidity pools that have the highest trading volume and are less volatile.”

BIS report

Retail LPs charge a smaller share of transaction fees and earn lower returns on investment compared to institutions that lose money relative to risk, according to BIS. While the study focused solely on Uniswap, the researchers noted that the findings may also apply to other DEXs. They recommended further research to understand the roles of retail and institutional participants in various DeFi applications such as lending and borrowing.

According to BIS, the factors that drive centralization in traditional finance may be “inherited characteristics” of the financial system and therefore also apply to DeFi.

In 2023, Gauntlet experts reported that centralization is growing in the DeFi market. They found that four platforms control 54% of the DEX market and 90% of all liquid staking assets are concentrated in the four most important projects.

Liquidity in traditional finance is even worse

Economist Gordon Liao believes that a 15% increase in fee income is a negligible advantage over less sophisticated users.

Interesting article on AMM liquidity provision. Although I almost came to the opposite conclusion from the data.

“Sophisticated” traders tagged by the authors are generally responsible for ~70% of TVL and earn 80% of fees, this https://t.co/YsiR9Lgvx7 pic.twitter.com/HhcNEo5h3N

— Gordon Liao (@gordonliao) 19 November 2024

The situation in traditional finance is even worse, he said, citing a 2016 study that found individual liquidity providers should be adequately compensated for their role in the market.

Liao also disputed allegations of order manipulation, pointing out that the spread of price ranges is often well above 1-2%. However, BIS researchers noted that DeFi has fewer regulatory, operational and technological hurdles than traditional finance.

Liquidity is controlled by big players

According to the report, savvy participants who actively manage their positions provide approximately 65-85% of liquidity. These participants typically place orders close to the market price, similar to how traditional market makers set their bids.

However, retail providers are less active in liquidity management and interact with fewer pools on average. They also charge a much smaller share of transaction fees, only 10-25%.

However, professional liquidity providers demonstrated a higher success rate in conditions of market volatility, underlining their ability to adapt to economic conditions and anticipate risks.

Based on data analysis, the study also highlights that while retail liquidity providers lose significantly in profits at high levels of volatility, more informed participants gain. For example, only 7% of respondents indicated that approximately 80% of total liquidity and fees were identified as complex control.

So is there real centralization in the DeFi market?

In 2021, Gary Gensler, chairman of the US Securities and Exchange Commission, doubted the reality of decentralization of the DeFi industry. Gensler called DeFi a misnomer because current platforms are decentralized in some ways and highly centralized in others. He drew particular attention to projects that incentivize participants with digital tokens or similar tools.

If they actually try to implement this and go after developers and founders, it will push entire teams to move out of the US permanently and encourage more anon development. There’s not much they can do honestly pic.twitter.com/pdEJorBudg

— Larry Cermak (@lawmaster) 19 August 2021

According to Gensler, some DeFi projects have characteristics similar to those of SEC-regulated entities. Some of these can be compared to peer-to-peer lending platforms, for example.

Block Research analyst Larry Cermak also believes that if the SEC decides to pursue DeFi project founders and developers, they will leave the US or pursue the projects anonymously.

Can DeFi’s problems be solved?

Economic forces that favor the dominance of a few participants are increasing competition and calling into question the idea of ​​a complete democratization of liquidity in decentralized financial systems.

The future of DEXs and the DeFi concept will depend on how these unequal access and liquidity issues are addressed. A closer look at these trends can guide the development of decentralized systems, creating a more sustainable and inclusive financial environment.