DeFi lending has a centralization problem

A new report from the International Monetary Fund found that decentralized finance (DeFi) is… pretty centralized. Half the money available to be borrowed on most DeFi lending platforms comes from fewer than 10 depositors, IMF researchers reported in April’s Global Financial Stability Report.

Why it matters: Crypto products are open so they can be resilient, the theory being openness leads to many participants. But if most funds available for lending come from a few giant depositors, that could cause a one-person bank run.

How it works: The IMF zero’ed in on crypto lending, so here’s how that works:

• Someone deposits, say, $1,500 worth of ether. This gives them the right to borrow maybe $1,000 in something else (for example).
• They are cautious, though, so they only borrow $800.
• The borrower will get burned badly if the value of ether (their collateral) takes a sudden turn south.
• Their collateral will be sold, their loan closed and they will take a haircut on whatever collateral remains. It happens every day.
• Usually, though, it’s fine and allows traders to make more moves.

Be smart: Borrowing is great for speculation. “Leveraged longs and short selling are frequent strategies employed by DeFi users,” the report says.

• Example: If you really believe in ether, you can deposit it, borrow a stablecoin and buy more ether. Then if the price of ether rises as you expected, you can sell some to close your debt but still end up with more ether than you had before.

Yes, but: DeFi’s over-exposure to a few large depositors creates a systemic risk for these platforms that many users might not be aware of.

• “Idiosyncratic withdrawal of funds by any of those large depositors can have a material impact on the liquidity condition of the platform,” the IMF report states.
• Translation: DeFi lenders promise depositors that they can withdraw at any time, but that commitment would break down fast if one or two big depositors suddenly walked away.

Quick take: The report’s suggestions about fostering better risk management in DeFi lending reads as fairly half-hearted, like the authors realize there’s no especially direct way to get a handle on the space. “DeFi poses unique challenges to regulators,” the report states.

• The DeFi Education Fund, an advocacy organization, expressed some of its own concerns about the regulatory suggestions made by the IMF, while noting that “regulators across the globe are starting to take notice of DeFi in a big way.”

The bottom line: There’s often a disconnect between crypto’s stated ideals and the realities on the ground (and by “ground” we mean “blockchain”).