Bank for International Settlements Calls DeFi’s Decentralization an Illusion

Decentralized finance’s decentralization is an “illusion” according to a new report from the Bank for International Settlements.

The latest BIS quarterly review takes a skeptical look at DeFi’s governance structure, which relies on automated voting by token holders to make any rule changes or code upgrades.

“DeFi purports to be decentralized,” the report said, noting that DeFi blockchains and the applications that run on them “are designed to run autonomously — to the extent that outcomes cannot be altered, even if erroneous.”

However, Andreas Schrimpf, head of financial markets for the BIS, argued that “although DeFi’s main vision is to be decentralized, providing financial services without intermediaries, full decentralization in DeFi is illusory.”

The problem, he said, is “contract incompleteness,” a key economic tenet that says it is impossible for companies to devise a contract that covers all potential issues.

There is a DeFi equivalent, which Schrimpf called “algorithm incompleteness.” That simply means that it’s “impossible to write code spelling out what actions to take in all contingencies,” his report said.

While the examples of contract incompleteness in the report is dealing with staff and suppliers, algorithm incompleteness was on full display in late September, when the Compound protocol introduced an upgrade with a bug that allowed users to mint $89 million in new COMP tokens. While the issue was known and a patch written, the problem could not be fixed for a week, as the smart contracts that control the blockchain have a voting process with mandatory delays between several different stages of the process.

No user funds were lost, but a code upgrade could just as easily introduce a vulnerability affecting them.

Ultimately, there is “a limit to how far you can run a whole financial system purely based on those automated transaction,” said Hyun Song Shin, a BIS economic advisor and its head of research, at the report’s release. “There will be occasions when judgement will be needed.”

A Foot in the Door

A second problem with the concept of true decentralization is that most DeFi protocols rely on a consensus mechanism called staking, which the report argues favors the concentration of decision-making power in the hands of a few large coin-holders, or validators.

This is both an area of concern and an opportunity, the report said.

First, there is the possibility of collusion by a group of these validators could allow them to gain enough control over the blockchain to manipulate it for personal gain.

However, that concentration of power creates a centralized “entry point” into DeFi for policy makers and regulators, the report said.

That, the report said, should allow authorities “to contain DeFi-related issues before this ecosystem attains systemic importance.”