Bank for International Settlements: Decentralization in DeFi is just an illusion, governance tokens and consensus mechanisms foster centralization of power

The Bank for International Settlements (BIS) released its quarterly report last week, mentioning challenges faced by the Defi sector since its inception, and claiming that its decentralized nature is nothing but an illusion. The issue of reserves backing stablecoins, although frequently discussed, still lacks regulatory frameworks to govern it.

Decentralization Illusion

Although DeFi protocols can provide financial services without intermediaries and assist users with various operations through smart contracts, the BIS believes that a certain degree of centralization is inevitable. The decentralized vision of most DeFi supporters is merely an illusion.

"Firstly, centralized governance is needed for making strategic and operational decisions. In addition, certain functionalities of DeFi, especially the consensus mechanism, contribute to the concentration of power," the BIS stated.

Most DeFi projects have their governance tokens, and holders of these governance tokens can influence the development of DeFi projects by voting on proposals or changes to the governance system. The more governance tokens one holds, the greater and more centralized their decision-making power. When examining the issuance mechanism of these governance tokens, it is often found that development teams and early investors hold a significant proportion of the tokens, exacerbating the centralization issue.

Vulnerabilities and Instability in DeFi

High leverage has been a prominent feature of DeFi platforms since their development. Even though lending platforms often require overcollateralization to lend out funds, the rehypothecation of loans can allow users to generate significant exposure with a small amount of capital.

The chart below shows the liquidation amounts caused by fluctuations in ETH prices across major DeFi lending platforms. It can be observed that when prices change drastically, the cascading liquidation amounts resulting from excessive leverage can be substantial. Due to this characteristic, the BIS believes that the current stability of the DeFi market is far from that of traditional financial industries.

Stablecoins are Not in a NQA State

The risks associated with stablecoins have been highlighted in various reports and meetings, with the transparency of reserve assets and liquidity issues being the primary sources of risk. In its report, the BIS uses the term NQA (no-questions-asked) to describe the current issues with stablecoins, where NQA in this context means "users can receive the currency in transactions without conducting a proper investigation into its value."

However, stablecoins are not quite like that. Most investors are willing to use stablecoins due to their trust and convenience for exchange. If one day the value of the reserve assets behind stablecoins changes, it will inevitably cause panic among holders. In other words, without NQA, if stablecoin holders suspect a significant drop in the value of the assets supporting the currency, it often triggers a run. The lack of transparency and regulation of reserve assets is the main factor eroding this trust.

Connecting Traditional Finance with the Crypto Industry

Although the above issues require further legislative solutions from regulatory authorities, the attitude of traditional finance towards the crypto industry is becoming more open. As seen in the lower left figure, traditional banking institutions are willing to invest in crypto-related enterprises. The lower right figure also indicates a rapid increase in the total funds managed by crypto funds in recent years.

Furthermore, the U.S. has recently allowed Bitcoin futures to be used as the underlying asset for ETFs, indicating that this rapidly growing industry urgently needs regulatory constraints and is quickly becoming integrated into people's lives.