Is DeFi still decentralized?

Author: Santisa; Compiler: Block unicorn

Decentralized Finance (DeFi) was born to create an open, permissionless, and trustless financial system. Early projects such as MakerDAO, Uniswap, and Compound fully implemented this concept, with community governance, transparency, and self-custody. However, as DeFi has grown to its current scale, I have to ask: Is it still decentralized? More importantly, does it really matter? And what can you do to solve this problem?   

On Crypto Twitter (CT), many people did not experience the birth of DeFi in 2017/2018, and even missed the DeFi craze in 2020. At that time, decentralization was at the core of everything. We care about technology, check whether smart contracts have scams or custody risks, and cheer for security experts who find vulnerabilities.   

Those who trust centralized institutions such as BlockFi, Celsius, Nexo, and Genesis? They are also ordinary people who can’t ride the DeFi wave. And when these centralized entities collapsed, their users were left to pick up the pieces and enter years of costly bankruptcy proceedings. This only further deepened our aversion to centralization.   

And now? Most participants have not experienced the trauma of a centralized system collapsing. Therefore, it is not surprising that most new DeFi projects have abandoned decentralization. Decentralization is a trade-off. You sacrifice efficiency in exchange for security. If people don’t value security, why should projects make such sacrifices?   

Decentralization is a spectrum

We don’t have a unique definition of what a “decentralized” system is. So I’ll try to formulate one myself. What constitutes a “decentralized” system?    

• Direct custody of your own assets:Custody of assets held directly by an individual. If the rules of the system allow it (e.g., there is enough liquidity in the funding market, the cooling-off period has ended, etc.), you should be able to withdraw your funds without external authorization.

• Personal funds cannot be frozen:The operator of the system cannot freeze or confiscate your funds. You always maintain full control over your assets.

• The system is not upgradeable, or at least has a long lock-up period:Immutability guarantees that the rules will remain the same when you enter the system.

• Decentralization of governance:Is the system you are using decentralized enough? Have blockchain participants ever colluded to freeze or block someone's funds? Are there multiple nodes? Is the stake dispersed? Do validators actually perform validation, or just blindly sign the instructions of the foundation? Do they control the entire system (e.g., L2 in Phase 0)?

• External factors:Does the system rely on the intervention of a centralized third party to function properly? If your funding market relies on an oracle set by a centralized risk curator, then your funding depends on the integrity of that curator.   

Next, let's see how some protocols perform in this test.

As shown in the figure, earlier projects scored higher on decentralization, while newer projects performed less well. This clearly reflects the market's preferences.

In 2024, centralized on-chain investment funds accumulated $8 billion in deposits, with DAI/USD growing at 2.3%, while decentralized stablecoins such as LUSD fell 65%.   

I grew up in an environment where decentralization is the concept, so it is not easy to adapt to this new trend. I have not completely given up on decentralization, but I am learning to adapt. Below, I will list some examples and share some suggestions for surviving in this environment without being eliminated.  

Examples of Centralization in "Decentralized Finance" (DeFi)

1. Hyperliquid:An on-chain, KYC-free centralized exchange. You send funds to an address on Arbitrum and then get USDC on their platform. They control the funds and the platform. The only advantage is that their deposit addresses are public and can be verified in real time.

2. Ethena:An investment fund that primarily does base trading. Whitelisted users send them funds, and these users can sell LP shares on the secondary market. Ethena controls all funding, payment, and redemption operations. USDe funds cannot be frozen.

3. Usual:Similar to Ethena, Usual operates a fund that holds treasury bonds. They set the rules for redemption and asset pricing. Usual shows us the risks of centralization by unilaterally determining the redemption price of locked bonds, while Gauntlet and MEV Capital hard-code their oracles to $1 through polls.

4. MakerDAO:Maker is now an investment fund operated by a DAO. The community votes on fund allocations, including investments in centralized custodians and projects such as Blocktower Andromeda and Ethena (via a hard-coded Morpho pool).

5. Uniswap:Uniswap is considered fully decentralized on the Ethereum mainnet. You maintain full control over your funds, don’t rely on external data, and the smart contracts are immutable. Hats off to Uniswap here!

These setups come with huge trust assumptions and a lot of binary risk. You either get “harvested” or you don’t. We haven’t seen any major crashes yet, but once these centralized projects go down, the consequences will be devastating: frozen redemptions, legal action, and sky-high fees (e.g. FTX assets).

How to Minimize Risk

1. Lend against risky collateral:Don’t hold risky centralized assets directly. Instead, use them as collateral for a loan. If the price of the risky asset drops, you will not lose anything while earning a similar return. DeFi will always be a leveraged venue, so there will be no shortage of venues to lend against these risky collateral.

2. Withdraw during market turmoil:When market turmoil occurs, withdraw early. You may pay some gas fees and lose a few basis points (e.g., a 100% annualized rate of return may only equate to 18 basis points in 24 hours), but it is better than losing all your funds.

3. Set a minimum risk premium:Decide in advance what risks are worth taking. If a high-risk investment can provide 2-3 times the benchmark return, it may be worth it. But if the gap is narrowed to 30%, don't be greedy.

4. Monitor on-chain activity:Keep an eye on large transfers or insider transactions. For example, if you tracked the USD0++ run, you can exit at $0.99 instead of $0.9251.

5. Understand the risks:Be clear about the risks you are taking. Understand that in addition to risk, you need to actively monitor your positions. During market downturns, gas fees can skyrocket (300-400 gwei), so adjust your positions appropriately. If positioning is an issue, choose Layer 2.

Conclusion

Decentralization was once the core attraction of DeFi. But now, many projects have abandoned decentralization for efficiency and mainstream adoption. This undoubtedly weakens the original vision, but it is also the reality of the market.

I do believe that things will tend to be centralized over time. We saw the initial state of centralization, then the "Cambrian explosion" of user initiative, and finally we will see large centralized institutions dictating our every move. We are slowly transitioning to a world of on-chain centralization. Centralized stablecoins are the market favorites, and decentralized projects will eventually become centralized over time to remain relevant. Decentralized money markets include custody of collateral to increase profits, decentralized stablecoin projects peg their tokens to fiat-backed tokens for stability, and decentralized exchanges remove decentralization altogether for efficiency. The 2022/2023 wave of bankruptcies is a bump on our path to centralization. The only way to prevent this, at least in the short term, is for the current centralized groups to hit a wall and eventually "harvest" everyone.

In ancient Rome, Octavian (Augustus) ruled as a dictator for 41 years after killing the Republic. It was so long, and the rules and incentives were so entrenched, that when Octavian died, the Senate and people of Rome did not restore their freedom. They just asked "Who should we trust next?" I hope that DeFi is still a long way from reaching this point, and we can get rid of tyrants for the time being.

So, is DeFi decentralized? Actually not. Does it matter? That depends. If you act quickly before these emerging centralized institutions collapse, you can make a lot of money. If you are in the money management business, leave your ideals at the door.

Either way, staying informed and prepared is the best way to survive in this game.