How decentralised should DeFi platforms be?

The 2008 financial crisis wreaked havoc not just within the global banking system but also challenged the very concept of centralised finance.  

So, it is perhaps no surprise that Bitcoin, a decentralised blockchain technology that allows the mining of a cryptocurrency with the same name, was announced the following year amid a wave of interest in decentralised finance (DeFi) that was advocated as a better alternative to traditional banks.  

While, more than a decade later, DeFi hasn’t really gone mainstream yet (and I explore some of the reasons why in another article), the narrative persists.

Indeed, earlier this year Conor Ryder, a research analyst at the crypto data firm Kaiko, highlighted how the recent resurgence in the price of Bitcoin was driven in large part by the current US banking crisis.  

While it can be tempting to assume that centralisation exists as a binary concept with traditional banks at one end and cryptocurrencies and DeFi at the other, the reality is that it’s a concept that exists on a spectrum. 

This was evident in research I did with Maximilian Locca and Maxwell Burda, of Copenhagen Business School in Denmark, where we highlighted that there is often a high degree of centralisation during the development stage of DeFi platforms before more decentralisation is introduced when governance tokens are distributed to community members. Despite this, however, full decentralisation of DeFi platforms is often a myth. 

This spectrum is important to recognise, as striving for complete decentralisation of DeFi platforms is often highly impractical and may even result in an inability to tackle security vulnerabilities and respond to critical operational inefficiencies due to co-ordination difficulties and delayed decision-making.

A more desirable path is to find the right balance between centralisation and decentralisation to allow for more sustainable governance of DeFi platforms. 

When is a DeFi platform truly decentralised?

There are various things to consider when examining the level of decentralisation. For instance, it's important to understand the way in which voting rights are determined for the community. 

While DeFi platforms grant its community power to resolve key decisions, such as fee structures, listing new assets, and protocol upgrades, these voting rights can end up being concentrated in the hands of several users (the minority rules) instead of being largely distributed across the community. This runs counter to the argument of decentralisation.  

It's also important there is a high degree of transparency and accountability, with clear governance processes, disclosure of information, and robust mechanisms for the community to challenge decisions.

This helps to ensure that the community's power is exercised responsibly and in the best interests of all participants. 

One of the reasons why centralisation is so commonplace in the early days of a DeFi platform is because of the expertise among the founding team. But it's important to strike a balance between community participation and the involvement of domain experts.  

While the input of the community is valuable, specialised knowledge in areas like technology, economics, and risk management can help ensure informed decision-making and prevent the undue concentration of power. 

And with major failures of DeFi platforms in recent years, one may wonder whether decentralisation is always preferred.

In times of crises such as cyberattacks, during which hackers try to steal cryptocurrencies, the community is often slow to respond to the events playing out, leading to undesirable outcomes. In such cases, the founding team is often brought back in a centralised manner to deal with the crisis. 

Too much centralisation, however, which recently led to the downfall of some of the largest crypto exchanges, like the FTX scandal, is also undesirable.  

Why the DeFi community needs a voice on a platform

 While our research offers valuable insights into the impact of how power is distributed within communities, there are a couple of important caveats.  

Firstly, we focus solely on the influence of how ‘decision-rights' are distributed among the community and do not consider other factors that may affect a platform’s success, such as the technology used, the security protocols deployed, or any regulatory challenges the platform may face.  

As identified earlier, each of these factors influences the distribution of power and decision-rights in a community, so more work is needed to understand the interplay between them. 

Secondly, the study's sample size of seven DeFi platforms may limit the generalisability of the findings. 

While the platforms studied are significant players in the DeFi space, there is a need for broader research encompassing a larger sample size to validate and expand upon these findings.  

Additionally, considering DeFi platforms from diverse blockchain ecosystems would provide a more comprehensive understanding of the dynamics at play. 

Nonetheless, it's clear that a community’s voice within crypto ecosystems has seldom been more important. Indeed, the Uniswap exchange recently demonstrated the power of its community after plans to charge liquidity provider fees were overturned by the users. 

Many will argue that the very essence of DeFi revolves around concepts such as decentralisation and autonomy, with the empowerment of the community central to these principles.  

Advocates claim that by providing votes to users, DeFi platforms can tap into the ‘wisdom of the crowd’ while also staying true to the decentralised ethos of crypto itself. 

But finding the right balance between centralisation and decentralisation of a DeFi platform is an ongoing process that requires engagement, open dialogue, and feedback from its participants. 

The goal should be to create a governance model that promotes decentralisation, inclusivity, transparency, and accountability while also ensuring its efficiency in troubled times where centralised decision-making may work better.  

Further reading:

How are interest rates set on DeFi platforms?

What does DeFi need to go mainstream?

Decision rights decentralization in DeFi platforms

Kalina Staykova is Assistant Professor of Information Systems and a member of the Gillmore Centre for Financial Technology. She teaches Cybersecurity in Business and Knowledge, Work, and Innovation on the MSc Management of Information Systems and Digital Innovation and Digital Ventures on the Undergraduate programme.

Learn more about digital platforms on the four-day executive course Leading Digital Transformation at WBS London at The Shard.

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