BIS study questions decentralization in DeFi liquidity provision

While decentralized finance (DeFi) promises to democratize financial markets, the Bank for International Settlements (BIS) argues that liquidity providers (LPs) on decentralized exchanges (DEXs) are not as decentralized as they appear.

On Nov. 19, the BIS published a working paper diving into Uniswap v3, one of the biggest DEXs in the DeFi landscape. In the study, the BIS set out to find whether DEXs liquidity provision truly democratizes financial markets or if they mimic traditional markets, being dominated by a few large players. 

The BIS analyzed the Ethereum blockchain, looking at the top 250 liquidity pools in Uniswap to see whether retail LPs can truly compete with institutional providers. 

Liquidity provision in DeFi is “not decentralized”

The BIS found that liquidity provision is not decentralized apart from its technological implementation. Its findings suggest that retail LPs are outperformed by a few sophisticated players dominating the liquidity market.

“These players hold about 80% of total value locked and focus their attention on liquidity pools that have the most trading volume and are less volatile,” the report stated.

The study found that retail LPs earn a lower share of trading fees and experience lower relative investment returns. Additionally, the BIS noted that retail providers “lose money on a risk-adjusted basis.” 

Although the paper only focused on Uniswap, the researchers believe that Uniswap v3 is “not special,” and its findings could apply to other DEXs. They suggested that future research should examine the roles of retail and institutional participants across various DeFi applications, such as lending and borrowing.

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Institutional dominance challenges the ethos of DEXs

The BIS concluded that institutional LPs dominating the space challenge the foundational ethos of DEXs, which aim to democratize financial systems. The paper argued that the ability to provide liquidity is concentrated, leaving retail investors at a disadvantage.

The researchers also stated that the study’s results show that many economic forces that lead to centralization in traditional finance are “likely inherent characteristics of the financial system,” including DeFi. 

The paper argued that simply allowing everyone to participate does not lead to a truly “disintermediated” market. 

Despite its criticisms, the BIS acknowledged that DeFi faces fewer regulatory, operational and technological barriers than traditional finance.

Liquidity provision “much worse” in traditional finance

Meanwhile, economist Gordon Liao responded to the paper by saying he would “almost draw the opposite conclusion from the data.”

Liao, who previously worked as the head of research for Uniswap, said that the “sophisticated traders” who earn 80% of fees only get less than a 15% improvement in fee earnings. 

“That’s hardly a feat over less-sophisticated passive users,” Liao argued.

Citing a study published in the Journal of Financial Economics, Liao said the situation is “much worse” for liquidity providers in traditional finance. 

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