Introduction: What is decentralized finance?
In recent years, the crypto asset industry has experienced remarkable growth, with the total value of crypto asset markets peaking at US$2.9 trillion in 2021. Crypto assets were initially created to support a decentralized payment system by using blockchain technology to establish a digital ledger for recording token ownership and transactions. Bitcoin was the first to do this in 2008 and remains the most popular blockchain.
However, the industry has since shifted its focus from providing payments to offering a wide range of financial services. This new set of financial services, decentralized finance (DeFi), surged in popularity around 2020. They are predominantly offered on a different blockchain—Ethereum.
DeFi operates within a multi-layered structure. In the bottom (or settlement) layer, the blockchain records and settles transactions. Building on the settlement layer, developers create various crypto assets, including native tokens (e.g., ETH), stablecoins, and non-fungible tokens (NFTs). Ethereum further supports a top (or application) layer that offers financial services such as lending and asset management. The total value of crypto assets locked into DeFi contracts skyrocketed and then retreated following the collapses of several crypto asset trading platforms (e.g., Terra, Celsius and FTX) in 2022.
DeFi is the provision of financial services without relying on traditional intermediaries. The blockchain-providing DeFi achieves this by running computer programs known as smart contracts on the blockchain. To understand how a smart contract works, consider the example of collateralized loans such as a mortgage. Traditionally, loans between lenders and borrowers rely on a trusted third party (e.g., a bank) that provides custodian services to safeguard collateral pledged as security for a loan. The third party’s incentive to behave properly often depends on external law enforcement as well as the need to maintain a good reputation to stay in business.
Without a trusted party, as in the crypto space, a smart contract acts as the custodian. A borrower locks a digital asset into the contract as collateral, which is released only upon repayment. If the borrower defaults, the smart contract liquidates the collateral to repay the lender. Smart contracts execute automatically based on predetermined conditions. This eliminates the incentive problems that a traditional intermediary might face.
DeFi uses these programmable smart contracts to decentralize a host of financial services. Examples include:
- Lending and borrowing
- Decentralized exchanges
- Asset management
- Derivatives trading
Why decentralized finance?
The rise of DeFi was partly motivated by the fact that some transactions in traditional finance are time- and cost-intensive due to inefficient legacy systems and processes as well as monopoly profits earned by incumbents. Cross-border payments, for example, involve multiple currencies and a small number of correspondent banks, resulting in cost and time inefficiencies. Securities settlement also requires reconciliations across multiple ledgers. Proponents believe that DeFi can address these challenges and transform the financial system in three ways:
- Increased service offering. A unified ledger can reduce frictions in the legacy system and expand the scope of financial services currently being provided.
- Increased competition. Everyone is allowed to enter the crypto space to provide DeFi services and use services offered by others. This characteristic of DeFi can reduce market power and concentration.
- Increased transparency. Replacing intermediaries with smart contracts increases the transparency of the balance sheets and governance of DeFi platforms, thus reducing fraud and custodian risk.
Why not decentralized finance?
Despite its innovations and possibilities, the overall economic benefits of DeFi remain limited. Three key challenges hinder DeFi from realizing its potential:
- Limited tokenization. Only tokenized assets can be recorded on the blockchain and interact with smart contracts. However, few real-world assets have been tokenized thus far, resulting in a self-referential system mainly focused on speculative crypto trades. The contribution to the real-world economy remains minimal.
- Although DeFi aims to eliminate centralized intermediaries, the specialized knowledge required to manage private keys and interact with the blockchain makes it difficult for retail users to participate in the DeFi system directly. As a result, centralized, non-transparent and unregulated intermediaries called centralized finance (CeFi) have emerged. These CeFi platforms function very differently from their DeFi counterparts. While they also offer financial services using cryptoassets, they differ from DeFi in that they are run by people instead of smart contracts, which exposes investors to custodian risk and lacks transparency. Recent bankruptcies of centralized platforms like Celsius and FTX highlight the risks associated with these unregulated CeFi entities.
Regulatory Concerns for Decentralized Finance
While DeFi currently poses limited risks to financial stability, its connections to the real economy may increase over time. Many vulnerabilities in DeFi mirror those in the traditional financial system, such as run risk with stablecoins, leverage associated with DeFi lending, and interconnectedness among protocols. In addition, DeFi presents new, blockchain-specific challenges, such as:
- New points of failure emerge when the blockchains connect with each other or with the real world (e.g., cross-chain bridges and price oracles).
- New amplification channels such as flash loans allow malicious actors to acquire billions of dollars in funding without any credit checks or collateral requirements.
- The anonymous and borderless nature of public blockchains complicates regulatory oversight.
DeFi has grown rapidly in scale and scope, forming a complex ecosystem with a high degree of interconnectedness. Its innovative elements, such as smart contracts, composability, and tokenization, hold potential for future monetary and payment systems. However, challenges remain, as DeFi introduces new risks to the financial system. Policy-makers and regulators need to strike a balance between promoting innovation and mitigating risk.