For decentralized finance’s (DeFi) proponents, the sector embodies financial freedom, promising everyone entry into the world of global finance without the fetters of centralization. A new study has, however, put that notion under sharp focus.
According to a new Bank of International Settlements (BIS) working paper, institutional investors control the most funds on decentralized exchanges (DEXs). The document shows large-scale investors control 65 – 85% of DEX liquidity.
Part of the paper reads:
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
The BIS paper adds that this dominance limits how much decentralized exchanges can democratize market access, contradicting the DeFi philosophy. Yet it suggests that the concentration of institutional liquidity providers (LPs) could be a positive thing as it leads to increased capital efficiency.
Retail traders earn less despite their numbers
BIS’s data shows that retail investors earn nearly $6,000 less than their sophisticated counterparts in each pool daily. That’s notwithstanding the fact that they represent 93% of all LPs. The lender attributed that disparity to several factors.
First, institutional LPs tend to participate more in pools attracting large volumes. For instance, they provide the lion’s share of the liquidity where daily transactions exceed $10M, thereby earning most of the fees. Small-scale investors, on the other hand, tend to seek pools with trading volumes under $100K.
Second, sophisticated LPs tend to show considerable skill that helps them capture a bigger share of trades and, therefore, profit more in highly volatile market conditions. They can stay put in such markets, exploiting potential profit-making opportunities. Meanwhile, retail LPs find that a difficult feat to pull off.
Again, small-scale investors provide liquidity in slim price bands. That contrasts with their institutional traders, who tend to widen their spreads, cushioning themselves from the negative impacts of poor selections. Another factor working in favor of the latter is they actively manage their liquidity more.
What’s the impact of liquidity concentration?
Liquidity is the lifeblood of the DeFi ecosystem, so its concentration among a few investors on decentralized exchanges could impact the whole sector’s health. 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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