Prediction is power. We, as humans, have always sought to peek behind the curtain of time, from reading tea leaves to analyzing complex datasets. Today, AI looks poised to further enhance this capacity across DeFi, ushering in what some are dubbing DeFi 3.0 or AiFi. Are we truly building the promised utopian future, or just a high-tech house of cards poised to come crashing down? I worry that it will be the latter if we’re not intentional about taking the opposite approach.

Algorithmic Bias in DeFi Prediction?

Now, picture an AI trained on historical DeFi transaction data. If the underlying data reflects biases already present in society, such as lending rates based on demographic backgrounds, the AI will learn those patterns. Only then will it stop embedding those biases into its decisions. It's garbage in, garbage out on steroids.

This isn't just a theoretical concern. Think about credit scoring in traditional finance. For example, a study from Stanford and NYU demonstrated how algorithms are able to discriminate against minority groups, driving perpetuating cycles of poverty. Now, picture that baked into the very fabric of decentralized finance. Without democratizing access to financial services, we are instead primed to automate and amplify current inequalities. That's outrageous.

Black Swan Events: AI's Achilles Heel?

AI excels at pattern recognition. For example, it has the ability to comb through massive datasets and recognize nuanced, hidden relationships that analysts cannot identify. What happens when the unthinkable occurs? A black swan event is an event, by definition, that which is outside of the normal expectations.

Consider the 2008 financial crisis. Armies of quants built incredibly sophisticated risk models. These models were deeply insufficient in predicting the cascading failures that actually ended up bringing the global economy to its knees. Why? Because those models were constructed using extrapolated historical data which never allowed for the possibility of an abrupt systemic collapse.

Picture this, an entire DeFi ecosystem based solely on AI-based prediction. If we have a black swan event, like a big hack or a regulatory crack down, the AI will flop spectacularly. This multi-billion dollar failure might start a domino effect, leading to mass liquidations and billions of dollars in losses. Are we ready for that?

Centralization Undermining DeFi Ethos?

DeFi has the potential to build an open, transparent, and trustless financial system. This new system will be open, permissionless and censorship resistant. As AI technology continues to seep into DeFi, it may unintentionally contribute to a concentration of power.

Training and iteration of complex AI models requires a huge amount of resource. It takes huge troves of data, massive computing infrastructure, and deep specialized expertise to be successful. This makes a barrier to entry which is favorable to the big players with lots of cash.

Take the case of proprietary trading firms in old finance. These firms have invested a tremendous amount of capital into algorithms and data analytics, providing them with a tremendous informational advantage over retail traders. And the end result of this byzantine mess, it turns out, is a massive transfer of public wealth from the many to the few. Is that what we want in DeFi? I don't think so.

What’s worse, picture having a small set of organizations determine the winner and losers with AI-powered prediction models in DeFi. Instead, they might be able to jump markets, front-run trades, and siphon rents at the expense of less-resourced actors. The irony is almost palpable. What should be a system to empower the people could easily turn into a machine to make the rich more powerful.

Bittensor Subnets: A Double-Edged Sword!

For instance, we hear about the Bittensor subnets such as Synth and their synergies with Mode L2. Though these initiatives are hopeful, it highlights the dangers of potential centralization and control. The dTAO incentive mechanism is indeed novel. It risks inadvertently rewarding the few who can afford to monopolize these subnets, resulting in a more concentrated predictive power.

Regulation: Can We Tame the Beast?

Regulating AI in DeFi is a Herculean task. Current regulatory frameworks are too rigid or siloed to address the unique intricacies of decentralized systems and ever-changing technologies.

How do you summon disruption wreaked by an AI to account? Who should be liable when an AI system wrongly predicts that someone will default on a loan and the lender suffers major damages? These are unavoidably hard questions with no simple solutions.

Further, excessive or misapplied regulation may discourage innovation and push DeFi activity out of sight. Yet an absolute absence of regulation would result in a Wild West frontier where anything is permissible. Finding the right balance is crucial. A balanced approach that places a premium on transparency, accountability, and consumer protection needs to be front and center.

Unexpected Connection: AI & Climate Change

The energy consumption of training large AI models is astronomical. As AI grows in prominence within the DeFi ecosystem, the environmental consequences of these technologies are sure to mount. Do we really want to sacrifice fiscal prudence for environmental responsibility? This is a question that we must address, honestly and forthrightly. That's a serious question.

The Path Forward: Decentralized AI & XAI

The future of AI in DeFi doesn’t need to be dystopian. There are steps we can take to make sure that these technologies aren’t making us less safe.

  • Decentralized AI: Exploring federated learning and other decentralized AI techniques can reduce the risk of centralization and bias.
  • Explainable AI (XAI): Developing AI models that are transparent and explainable allows users to understand the reasoning behind their predictions.

AI in DeFi 3.0 is an exciting frontier with tremendous potential, but rife dangers as well. We need to avoid oversteering, without compromising on ethics, solid risk management structures and a dedication to decentralization. The future of finance depends on it.