DeFi Paradoxon

Decentralization is the biggest threat for DeFi

DeFi is a powerful idea...

The value of DeFi protocols has increased remarkably in the last 5 years. Projects on permissionless blockchains like Ethereum and BNB Chain attracted many retail investors and the total value locked in DeFi contracts reached triple-digits billions. The use case of DeFi - decentralized, autonomous, and immutable smart contracts for financial solutions - is immense. Traditional finance, start-ups, and regulators are all forming their opinions with mixed views reaching from DeFi being a part of the "unregulated shadow banking system" (mostly regulatory view) to DeFi being the future of finance (mostly entrepreneur view). We think DeFi is here to stay. However, DeFi's biggest strength is also its biggest weakness: Decentralization.

...but exploiting decentralization can kill it

While there are many new types of risks emerging from DeFi, e.g. smart contract risks, oracle risks, and governance risks, we think the biggest risk is the misuse of decentralization. Projects purportedly classified as decentralized can exploit the very nature of DeFi when malicious developers are pushing a few buttons. We have all seen it more than once, developers pulling the liquidity immediately after the launch of a token, or them just tricking investors through newly minted tokens to their own wallets or running away with collected taxes and stopping the work. Investors have no chance to know whether a developer is acting with good or bad intentions ex-ante.

The information asymmetry between anonymous developers and investors is elevated in DeFi. The developer is clearly the winner of this state of asymmetry. This is similar to the well-known lemons problem in economics (https://en.wikipedia.org/wiki/The_Market_for_Lemons), where the seller of a used car always knows more about the quality of the car than a potential buyer. Information mismatches are a key problem in such markets such that investors cannot distinguish between scammers and legit developers. The result is that investors are hesitant or do not invest at all in legit projects, reducing the efficient use of capital.

We think it is the biggest existential threat to DeFi if there is no trust in any project anymore. Investors would simply stop to invest in fear of total loss and legit developers would halt their work that could have otherwise led to financial innovations.