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Decentralized Finance – A Present-Day Evaluation of its Axioms

Decentralized Finance, or DeFi, has been one of the fastest growing subsectors within blockchain in the last couple of years. Its elusive but visionary premise is to replace centralized parties in the financial world, such as banks, exchanges, insurance companies, and other intermediaries. Currently, hundreds of projects, known as Decentralized Applications (dApps), have been up-and-running, as well as thousands which are in development across many different blockchain networks.

Yet, how successful have these DeFi projects been until now, and do they really fulfil their promise of a safe, open, transparent, and decentralized financial environment? This article will give an overview of the space and assess the current state of the sprawling subsector with respect to its fundamental values.

Firstly, let us define and explain DeFi’s values and objectives which will be used to assess the space:

1. Non-Custodial: Unlike banks, where one’s funds are being kept under custody by the institution and thus has control over it, DeFi has the goal of individual users having full control of their funds and unaffected by changes in the environment it is facing. This independence has the advantage of not being subject to custodial risk – the “risk of a loss being incurred on securities [or other assets, like cash] in custody as a result of a custodian’s insolvency, negligence, misuse of assets, fraud, poor administration or inadequate record-keeping.”[1] The given definition in traditional finance (TradFi) can be applied to DeFi, and thus will be used to assess a network’s or an application’s custodial risk, allowing us to determine to what degree it is non-custodial.

It is also important to mention the drawbacks of this notion. Independence assumes that each user has the technical knowledge and abilities to safeguard their assets, which in the “wild-west” of DeFi, is not at all guaranteed.

2. Open: This aspect is quite straightforward; DeFi should be open to everyone, regardless of who they are – all one needs is an internet connection. Also, as of now, there are little to no KnowYour-Customer (KYC) procedures on DeFi, making the dApps that sit on top of their respective blockchains only subject to the anonymity guaranteed by the native blockchain. For example, Ethereum is pseudonymous, meaning that each wallet address is open for everyone to see but without knowing the wallet owner’s real-world identity. This means that Ethereum dApp users’ transactions are pseudonymous as well, unless the given dApp introduces some forms of identification requirements.

While this aspect lowers the barriers to entry for many, making it more open, it also has some drawbacks. Because real-world identities are not known, participants with malicious intents, for instance hackers, can more easily get away with crimes. The consequence of this is that regulators around the world may intend to force blockchain and dApp developers to implement such measures, which could potentially stifle innovation.

Again, technological knowledge and expertise are a barrier, and therefore means that not everyone can reliably access and use the dApps. This hinders some platforms from being truly open, whether intended or not.

3. Transparent: The ability for anyone to view the code behind the dApps is essential in securing the trust of existing and potential users, as well as regulators batting an eye at the space, ensuring that the dApps are safe to use. It also makes available the heaps of available information for whatever the given stakeholder wishes to use it for, thus contributing to no information asymmetry on that frontier, at least on paper. Furthermore, dApps are often open-source projects, meaning that anyone can attempt to contribute to the code – a process which will be discussed later – or copy it to some extent to develop improved versions of the applications. This is not only a key driver for innovation, but allows stakeholders to identify possible errors in the code, thus saving the ecosystem time and resources.

The downside here is, once again, related to technical expertise. Because not nearly every user can understand the coding language used or the technicalities behind the code, users must trust developers, others users, or general stakeholders – which themselves probably have incomplete knowledge of everything - thereby hindering the platforms from being truly “trustless”.

Moreover, the fact that anyone can copy ideas quite easily means that some of the treacherous work behind the construction of complex digital infrastructure can all seemingly be taken away from developers by someone else. This aspect would thus work as a potential disincentive to develop projects on the blockchain.

4. Decentralized: This aspect is inarguably the most complex to describe and assess.

Decentralization is, by definition, “the process by which the activities of an organization, particularly those regarding planning and decision making, are distributed or delegated away from a central, authoritative location or group.” DeFi projects, when fully launched onto the blockchain, are governed as Decentralized Autonomous Organizations (DAOs). DAOs, like companies, have a set of rules or a charter by which they are governed. Instead of shares in a company, governance tokens are distributed by developers on main-net launch to developers, community members, investors, and more. These are used to vote on changes to the protocols and are used as incentive mechanisms to pursue stakeholders’ goals such as liquidity, equitability, greater activity, and more.

The clearest distinction between the way a company is run, and a DAO is that to make any change to the code, a proposal has to be drafted. This is then voted on, and unlike in a company, where for major decisions a plurality of voting shares must be deployed in favour for the change to take place, a majority of governance tokens that are actively voting have to vote in favour. This means that, in theory, a proposal is drafted by someone with enough tokens – there is always a quorum for the number of voting tokens – and nobody challenges this, then the changes can take place after the proposal delay. This means that the developers as well as the wider community cannot be asleep at the wheel: there needs to be an awareness of what is going on in the ecosystem at all times.

Now, this new governance structure has several implications for the development of any project operating under the helm of a DAO: as an advantage, transparency is achieved, as all stakeholders can witness changes happening to the ecosystem. Also, any token holder exceeding the token threshold can participate in the voting processes by voting or proposing drafts, rendering the procedure quasidemocratic. Conversely, a clear disadvantage, which will be further elaborated on, is that if only a countable number of token holders vote, decision making is centralized, and allows not only for illintended behaviour that enriches the few participants at the expense of other stakeholders, but permits for costly, but genuine, errors to be made.

Thus, in DeFi, decentralization can be assessed by analysing how dApps make decisions in their respective DAOs.

Analysis

Now, the described criteria will be used to broadly assess the DeFi space by picking out relevant examples along the way.

Firstly, where do users keep their assets?

In DeFi, this greatly varies as dApps are different in nature and structure. Therefore, it is most sensible to look at where the greatest activity lies, namely in Decentralized Exchanges (DEXs) and Lending Protocols.

With DEXs, the way they are powered is through liquidity pools (the structure and elemental mechanisms will not be discussed in this article). When liquidity providers (LPs) deposit their tokens in the liquidity pools to earn yield on their assets through transaction fees on the DEX, they rely on the liquidity pools’ security, as well as that of the rest of the protocol. This also applies to traders, who trust that the trading mechanism functions reliably, such that most importantly, funds are not lost. In other words, users rely on the technical integrity of the smart contracts. Now, the smart contracts are developed by developers taking part in the DAO. Therefore, it is important to analyse the DAO’s governance to see to what extent the structure allows for errors in new code to be spotted before they are implemented. This is called “smart contract risk”.

Also, one needs to take a look at the governance token itself to establish how safe the governance mechanisms will function in the future. The nomenclature for this factor is “counterparty risk”.



There don’t exist a set number of metrics one can use to assess these factors, meaning that some sort of qualitative opinion has to be built. Thus, we can consult professional opinion. Here, we will use a table constructed by Aave, the largest lending protocol by Total Value Locked, where they rate the respective Crypto assets scores ranging from A+ to D-, similar to companies’ credit scores. It is important to mention that the analysis given regarding each Crypto asset relates to the way the Aave mechanism is constructed, thereby meaning that their opinion might be biased, thus potentially favouring a particular market outcome. Furthermore, the analysis on each token is only briefly summarised, with little insight into the details of how the criteria were assessed.

Nonetheless, the most popular DEX, UniSwap – with governance token UNI – is rated a B- in the smart contract risk criterion (it has been updated since the table’s publishing date), with the reasoning that the DAO has, “a diverse crowd of governors”[1] and is the “DAO with the highest value under management.” Asfor counterparty risk, UniSwap received a B+, owing to the fact that the UNI token is audited, uses code from the COMP token – which has shown to be safe – and is “battle tested”, with the token having been exchanged more than a million times.

All in all, this means that for LPs and traders on UniSwap, their assets should be fairly safe, with users having complete autonomy over the use of their funds at all times. This case is a microcosm of the larger DeFi space: funds will be relatively safe, and generally, the smaller the dApp, the greater the risk is. On the other hand, no dApp is immune to errors, as seen with Compound Finance, the second largest lending protocol on Ethereum, when it accidentally dished out $90m worth of tokens to users in an unintended fluke in early October. Therefore, DeFi savants need to be aware that indeed, their assets are always at risk.

Finally, one must also assess what happens when user’s funds are not within dApps. In other words, what happens when assets are stored in hot DeFi wallets. The most prevalent wallet used in the DeFi space is the MetaMask wallet. MetaMask to date has not experienced any substantial bugs which led to users’ loss of funds. Also, the fact that it stores the user’s seed phrase – a common method to secure a wallet – encrypted with the user’s chosen password makes it safer than most other options. Thus, in aggregate, DeFi users utilizing a hot wallet can be assured of their assets’ safety, although hot wallets, no matter the design choices, are riskier than cold wallets.

To conclude, in the non-custodial criterion, DeFi scores well as the DeFi projects that most users interact with such as their hot wallets, DEXs, and liquidity pools, are highly secure, yet are not immune to human error.

Now, for the second aspect: How open is DeFi?

To fully be able to use dApps, all one needs is an internet connection and some Crypto. This makes DeFi quite open – there is a reason DeFi’s only synonym is “Open Finance”. The obvious issue here is that for some, converting their fiat currency into Crypto is difficult because there don’t exist centralized exchanges which accept their fiat currency, for example in African and Asian countries. This limits the scope DeFi can reach, making it less open.

A less obvious problem is that to be able to properly participate in the diverse activities one can choose from in the space, one needs to be able to afford the associated gas (blockchain transaction) fees. The fewer assets the user has, the less accessible dApps are as the incentive to use them diminishes. Because Ethereum, the network with the greatest DeFi activity, currently has immensely high gas fees – having reached upwards of $100 a transaction on UniSwap for extended periods this year - the assets one needs to effectively use the platform are high. Therefore, accessibility is limited to the more Cryptowealthy.

Overall, though, this is the criterion DeFi scores the best in, as anyone with enough Crypto assets can access any of the different hubs at the forefront of innovation, yet investors beware, regulation is looming, and it might affect your favourite DeFi project in adverse ways regarding accessibility. How Transparent is DeFi?

Transparency is another measure where DeFi can boast an impressive track record. The biggest projects are all open-source and voting can take place on the projects’ websites as well as external ones, for instance tally, where anyone can view what is going on and contribute. Tally hosts some of DeFi’s most important projects like UniSwap, Compound, Fei, and more, signifying that transparency is taken very seriously by some of the space’s biggest players.

How Decentralized is DeFi?

Decentralization is, without a doubt, DeFi’s biggest laggard. As previously stated, decentralization can be best observed when the governance of the DAOs is analysed.

Tally is a very handy tool in determining the state of this criterion. Compound, the site’s most active project, posts the following numbers: the first measure displayed is that 40.46% of the total supply of governance tokens have been deployed for voting. Seems like Compound engages many of its users to vote, marking the process relatively democratic, right? A closer look would suggest otherwise. Out of the many proposals run by the protocol on the site, 1.74K out of the total 179.73K holders actually voted. That makes for a dismal 0.97% of wallets that actually end up voting. This is by no means decentralized.

Further evidence points to the same conclusion, only making the situation look gloomier. A proposition changing the collateral factor of the SAI token to 35%, a rather significant change considering collateral factors are some of the most vital contributors to a lending protocol’s health, growth and success, was voted on by a grand total of 26 addresses. They dwarfed the required 400K token quorum by a factor of 2 and the proposition did not have a single objection nor a single abstention.

This is not a mere cherry-pick; most executed proposals are voted on by around 20-50 wallets, with the largest number of addresses participating in a single vote being 200 – another unanimous vote.

Moreover, the number of tokens needed to draft a proposal is 65K tokens, a current market value greater than $18m, making it nearly impossible for someone other than the developer team, which extensively renumerated themselves with tokens on the project’s launch, or another “whale” to contribute to the project. This fiercely contradicts the values of open-source digital infrastructure, thus being yet another factor contributing to a falsely labelled governance process.

To be fair, the DeFi space is still in its relative infancy, meaning that developers, for many of which this is their life’s work, want to see it progress in their own hands until some milestones are reached, and the ecosystem slowly matures. Developers and other key stakeholders, though, need to eventually prove their willingness to introduce changes which construct a more decentralized and equitable governance mechanisms.

In conclusion, it can be proudly said that Decentralized Finance has come far and is at the forefront of blockchain’s development as well as the next generation of finance. For most, it will be safe, relatively accessible, and transparent. Yet the biggest issue facing the space in its current form is the unambiguous centralized governance process, an issue which will undoubtedly rein in the burgeoning subsector’s ability to naturally grow in a healthy manner. Sooner or later, changes will have to be made, a development which will be fervently watched by DeFi enthusiasts, Crypto fanatics, and watchdogs

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