In this post:
- DEXs, or decentralized cryptocurrency exchanges, might not be as democratic as we once believed.
- Data from the Bank of International Settlements supports this.
- According to that statistics, the majority of the liquidity on decentralized exchanges is controlled by a small number of individuals.
Proponents of decentralized finance (DeFi) see the industry as a symbol of financial freedom that allows anybody to access the global financial system without being constrained by centralization. However, a recent study has brought that idea into stark relief.
The majority of funds on decentralized exchanges (DEXs) are controlled by institutional investors, citing a recent working paper from the Bank of International Settlements (BIS). According to the study, 65–85% of DEX liquidity is controlled by major investors.
A section of the document says:
We show that liquidity provision on DEXs is concentrated among a small, skilled group of sophisticated (institutional) participants rather than a broad, diverse set of users.~BIS
In contrast to the DeFi ideology, the BIS report notes that this dominance restricts the extent to which decentralized exchanges can democratize market access. However, it implies that since it promotes greater capital efficiency, the concentration of institutional liquidity providers (LPs) may be advantageous.
Despite their numbers, retail dealers make less money
Retail investors in each pool make over $6,000 less each day than their more experienced peers, according to BIS data. This is in spite of the fact that they account for 93% of all LPs. The lender cited a number of reasons for the discrepancy.
First, institutional LPs are more likely to take part in pools that draw high volumes. For example, they earn the majority of fees since they supply the majority of the liquidity in situations where daily transactions surpass $10 million. Conversely, small-scale investors hand, tend to seek pools with trading volumes under $100K.
Second, in extremely volatile market situations, sophisticated LPs typically exhibit a high level of expertise that enables them to capture a larger share of trades and, thus, make more money. In these markets, they can remain stationary and take advantage of possible profit-making possibilities. Retail LPs, on the other hand, struggle to accomplish that.
Once more, liquidity is supplied by small-scale investors in narrow price ranges. In contrast, their institutional traders typically increase their spreads to protect themselves from the detrimental effects of bad choices. They actively manage their liquidity more, which is another aspect that favors the latter.
What effect does liquidity concentration have?
Since liquidity is essential to the DeFi ecosystem, its concentration among a small number of investors on decentralized exchanges may have an effect on the overall health of the industry. As we’ve seen earlier, a significant plus of such sway could make the affected platforms more efficient. But it has its downsides, too.
One setback is that it introduces market vulnerabilities. When a few LPs control the giant’s share of liquidity, there’s the danger of market manipulation and heightened volatility. A key LP pulling its funds from the DEX can send prices spiralling.
Moreover, this dominance could cause anti-competitive behavior, with the powerful players setting barriers for new entrants. Ultimately, that scenario may distort the price discovery process, leading to the mispricing of assets.
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