The DeFi market lacks decentralization: Why is this happening?

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

Liquidity on decentralized exchanges is concentrated among a few large providers, reducing the democratization of access to the decentralized finance market, as Bank for International Settlements (BIS) analysts found in their report.

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

The study of the 250 largest liquidity pools on Uniswap V3 found that just a small group of participants hold about 80% of total value locked and make significantly higher returns than retail investors, who, on a risk-adjusted basis, often lose money.

“These players hold about 80% of total value locked and focus on liquidity pools with the most trading volume and are less volatile.”

BIS report

Retail LPs receive a smaller share of trading fees and experience low investment returns compared to institutions, who, according to BIS, lose money risk-adjusted. While the study focused on Uniswap only, the researchers noted that the findings could 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 “heritable traits” of the financial system and, therefore, also apply to DeFi.

In 2023, experts from Gauntlet 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 significant projects.

Liquidity in traditional finance is even worse

Economist Gordon Liao believes that a 15% increase in fee revenue is a negligible advantage compared to less sophisticated users.

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

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

Liquidity is controlled by big players

According to the report, sophisticated participants who actively manage their positions provide about 65-85% of liquidity. These participants typically place orders closer to the market price, similar to how traditional market makers set their offers.

Retail providers, however, are less active in managing liquidity and interact with fewer pools on average. They also receive a significantly smaller share of trading fees, only 10-25%.

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

Based on the data analysis, the study also highlights that retail liquidity providers lose significantly in profits at high levels of volatility while more sophisticated participants win. For example, only 7% of participants identified as sophisticated control about 80% of the total liquidity and fees.

But is there true centralization in the DeFi market?

In 2021, the head of the U.S. Securities and Exchange Commission, Gary Gensler, doubted the truth of the decentralization of the DeFi industry. Gensler called DeFi a misnomer since existing platforms are decentralized in some ways but very centralized in others. He especially noted projects that incentivize participants with digital tokens or other similar means.

According to Gensler, certain DeFi projects have characteristics similar to those of organizations regulated by the SEC. For example, some of them can be compared to peer-to-peer lending platforms.

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

Can DeFi’s problems be solved?

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

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