Liquidity on DEX is in the hands of a few large providers, reducing the degree of democratization of access to the DeFi market.
Liquidity on decentralized exchanges is concentrated among a few large providers, reducing the democratization of access to the decentralized financial market, as Bank for International Settlements (BIS) analysts found in their report.
BIS analyzed the Ethereum blockchain and studied the 250 largest liquidity pools on Uniswap to test whether retail LPs can compete with institutional providers.
The study of the 250 largest liquidity pools on Uniswap V3 found that only a small group of participants hold around 80% of the total value locked and realize significantly higher returns than retail investors, who on a time-adjusted basis risk, often lose money.
“These players hold approximately 80% of the total value locked and focus on liquidity pools with the highest trading volume and are less volatile.”
BIS report
Retail LPs receive a lower share of trading fees and experience low investment returns compared to institutions that BIS says lose money based on risk. Although the study focused only on Uniswap, the researchers noted that the results could apply to other DEXs as well. They recommended further research to understand the roles of individual and institutional participants in various DeFi applications, such as lending and borrowing.
According to the BIS, the factors that lead to centralization in traditional finance may be “inherited traits” of the financial system and, therefore, also apply to DeFi.
In 2023, Gauntlet experts reported that centralization is growing in the DeFi market. They found that four platforms control 54% of the DEX market and that 90% of all liquid staking assets are concentrated in the four largest projects.
Liquidity in traditional finance is even worse
Economist Gordon Liao estimates that a 15% increase in fee revenue is a negligible advantage over less sophisticated users.
He said the situation in traditional finance is even worse, citing a 2016 study that found individual liquidity providers should be properly compensated for their role in the market.
Liao also disputed allegations of order manipulation, pointing out that the spread of price bands is typically much higher than 1-2%. However, BIS researchers noted that DeFi has fewer regulatory, operational, and technological hurdles than traditional finance.
Liquidity is controlled by the big players
According to the report, sophisticated participants who actively manage their positions provide approximately 65-85% of liquidity. These participants typically place orders closer to the market price, similar to how traditional market makers set their bids.
However, retail providers are less active in liquidity management and interact with fewer pools on average. They also receive a significantly lower share of trading fees, only 10-25%.
However, professional liquidity providers have demonstrated a higher success rate under conditions of market volatility, highlighting their ability to adapt to economic conditions and anticipate risks.
Based on the data analysis, the study also highlights that retail liquidity providers significantly lose profits at high volatility levels, while more sophisticated participants gain. For example, only 7% of participants identified sophisticated control over approximately 80% of total liquidity and fees.
But is there real centralization in the DeFi market?
In 2021, the head of the United States Securities and Exchange Commission, Gary Gensler, doubted the veracity of the DeFi industry’s decentralization. Gensler called DeFi a misnomer since existing platforms are decentralized in some ways but very centralized in others. He particularly highlighted projects that incentivize participants with digital tokens or other similar means.
According to Gensler, some DeFi projects have similar characteristics to SEC-regulated organizations. For example, some of them can be compared to peer-to-peer lending platforms.
Larry Cermak, an analyst at Block Research, also believes that if the SEC decides to prosecute the founders and developers of DeFi projects, they will leave the United States or continue their projects anonymously.
Can DeFi’s problems be solved?
Economic forces that favor the dominance of a few players increase competition and challenge the idea of complete democratization of liquidity in decentralized financial systems.
The future of DEXs and the DeFi concept itself will depend on how these issues of unequal access and liquidity are resolved. A closer look at these trends can guide the development of decentralized systems, creating a more sustainable and inclusive financial landscape.
