“This is the day people finally realize why we need DeFi” — this is the message that has been broadcast (in various forms) all over Twitter following the GME showdown. “The people have finally realized that the “free” market is actually not free”.
As someone who has dedicated his entire time to decentralized systems since 2014, I was just as hyped as the majority of DeFi proponents on Twitter. The events around GME were a public display of why the financial system is not a “free” market, and why the “little man” will ultimately lose when playing the “suit’s game”…
However, DeFi as we know it today is not the silver bullet that we are selling it for. Ignoring the market manipulations, pump-n-dump schemes, and token scams — DeFi has indeed made a revolutionary step towards a decentralized financial system in 2020. The underlying infrastructure, however, is still the same it was in 2017, when bribing and front-running was used to get in early on ICO token sales and later dump on traders and speculators who weren’t as lucky.
Myth: This would not have happened if GME were an Ethereum token
For the sake of analysis, let’s assume GME was an ERC-20 token on Ethereum. Let’s also simplify the scenario to the following: a hedge fund shorts GME tokens, and masses of small traders collude to push the price of GME up by buying call options.
So what can the hedge fund do to avoid going bankrupt?
In a centralized setting, like with stock markets and RobinHood, it’s quite simple: the hedge fund will try to prevent small traders from buying more GME tokens (of course, we don’t know how “simple” this actually was behind the scenes — but let’s just assume the hedge fund and RobinHood share the same interests here and agree to collude).
But this would not be possible in DeFi, right? Right?!
If we imagine DeFi as a censorship-resistant market with transparent pricing that cannot be stopped or manipulated by a single party — then perhaps the hedge fund would have to accept their loss, pay up, and pack their bags.
However, if we take a closer look at the infrastructure underpinning today’s DeFi ecosystem things start to look different:
- Not all decentralized exchanges are actually decentralized. This probably doesn’t come as a surprise but if we take a closer look at the codebase of a few DEXes out there, we will find some form of central access control — typically an admin account that can upgrade the contracts or halt operation. Our hedge fund need only get in touch with the person/group in control of this account, apply some pressure or offer a lucrative bribe — and trading can at least be slowed down (until liquidity moves to DEX without backdoors). Note: this is also the case for most L2 solutions.
- Ethereum & co. are not as decentralized as it seems. Probably not big news either but the mining power on Ethereum and most other PoW (and also PoS chains) is not as “decentralized” as we often claim it to be. 3 mining pools together control more than 50% of the hash rate. And we don’t really know who controls these pools in the background / if they collude. Now, miners within these pools don’t typically choose which transactions will be accepted into a block — this is done by the operator. So if our hedge fund can try to convince pool operators to help them out and block transactions trading GME tokens. Arguably not as easy as colluding with a centralized platform — but far from impossible. Let’s also not forget that a large portion of Ethereum transactions actually never hit the mempool but are shared with miners off-chain — which hints towards the possibilities here. Note: the same applies for staking pools!
- Miners / Stakers can be bribed. This one’s tricky. While there may be altruistic actors in this space who would reject colluding with our hedge fund, history paints a different picture. MEV (miners extracted value), ICO front-running, and the evidence for private, off-chain transaction broadcasting services suggest that if bribed sufficiently by our hedge fund, miners would likely (at least temporarily) slow down trading of GME tokens.
- We have seen forks to bail out hacks. Last but not least: we have already seen hard forks to bail out victims of hacks. This is arguably a different scenario and might even be seen as “doing the right thing” — but it is a precedent for something that we don’t really anticipate happening in our ideal DeFi world. What’s to prevent this from happening in the case of GME? What if the hedge fund was a DAO that was hacked and never actually wanted to short those GME stocks? Far fetched? Probably. Impossible? Decide for yourself.
There are definitely more attack vectors and I can recommend reading up on those in the following papers:
- “Flash Boys 2.0: Frontrunning, Transaction Reordering, and Consensus Instability in Decentralized Exchange” shttps://arxiv.org/pdf/1904.05234.pdf
- “On the Instability of Bitcoin Without the Block Reward” http://library.usc.edu.ph/ACM/SIGSAC%202017/ccs/p154.pdf
- “SoK: Algorithmic Incentive Manipulation Attacks on Permissionless PoW Cryptocurrencies” https://eprint.iacr.org/2020/1614.pdf
It’s not all bad!
While the above paints a dark picture, DeFi is without question much much more difficult to manipulate than a centralized market. Users can clone/spawn new trading contracts on the fly, tokens can be traded nearly on any exchange (which don’t have whitelisting), and in the worst-case moved to multiple other blockchains for trading.
Decentralized ledgers like Bitcoin and Ethereum can indeed enable us to build a better financial system, where the GME events would not have been possible — but we’re not there… yet. We’ll need to double-down on the issues above in the coming years to be able to claim that DeFi solves it all.