Summary
Focus
Decentralised finance (DeFi) builds on distributed ledger technologies (DLT) to offer services such as trading, lending and investing without using a traditional centralised intermediary. The fact that DeFi components can be programmed may open up new possibilities for more competitive financial markets, and could bring efficiency gains. However, DeFi introduces enormous technological and economic complexity that makes it increasingly difficult to assess the risks and potential of DeFi financial products. But financial institutions and regulators dealing with DeFi need just such a systematic evaluation of these factors.
Contribution
This paper seeks to provide a comprehensive overview and classification of DeFi. It aims to explain the technical details to a broad audience and to introduce the financial protocols that the DeFi ecosystem builds upon. It explains the system's complexity and reviews how DeFi might be used in the future. We consider recent findings that help to clarify the functioning and design of DeFi systems, and how they can interoperate.
DeFi is defined here as a competitive, contestable, composable and non-custodial financial ecosystem built on technology that does not require a central organisation to operate. To explain the functioning, design and interoperability of such systems, the paper uses a DeFi stack reference (DSR) model to conceptualise the stack-layer components of their technical primitives and financial functions.
Findings
The DSR model comprises three layers: settlement, applications and interfaces. The settlement layer is responsible for completing financial transactions and discharging obligations. The application layer comprises applications implemented through smart contracts, thus combining cryptoassets, DeFi protocols and compositions. The interface layer provides front-end interfaces that facilitate user-friendly interaction with the smart contract logic.
The paper next outlines the technical primitives such as DLT and smart contracts, the spectrum of cryptoassets used to represent and transfer value, and the design and financial functions of the most prominent DeFi protocol families. It also reviews how DeFi protocols can be combined into compositions. Finally, the paper outlines an interdisciplinary agenda for future research.
Abstract
Decentralized Finance (DeFi) is a new financial paradigm that leverages distributed ledger technologies to offer services such as lending, investing, or exchanging cryptoassets without relying on a traditional centralized intermediary. A range of DeFi protocols implements these services as a suite of smart contracts, ie software programs that encode the logic of conventional financial operations. Instead of transacting with a counterparty, DeFi users thus interact with software programs that pool the resources of other DeFi users to maintain control over their funds. This paper provides a deep dive into the overall architecture, the technical primitives, and the financial functionalities of DeFi protocols. We analyse and explain the individual components and how they interact through the lens of a DeFi stack reference (DSR) model featuring three layers: settlement, applications and interfaces. We discuss the technical aspects of each layer of the DSR model. Then, we describe the financial services for the most relevant DeFi categories, ie decentralized exchanges, lending protocols, derivatives protocols and aggregators. The latter exploit the property that smart contracts can be "composed", ie utilize the functionalities of other protocols to provide novel financial services. We discuss how composability allows complex financial products to be assembled, which could have applications in the traditional financial industry. We discuss potential sources of systemic risk and conclude by mapping out an agenda for research in this area.
JEL classification: E42, E58, F31, G19, G23, L50, O33, G12
Keywords: Financial engineering, decentralized finance, DeFi, blockchain, Ethereum, DLT, cryptocurrencies, stablecoins, cryptoassets
FAQs
Decentralized finance, or DeFi, uses emerging technology to remove third parties and centralized institutions from financial transactions. The components of DeFi are cryptocurrencies, blockchain technology, and software that allow people to transact financially with each other.
What is the DeFi answer? ›
Decentralized finance (DeFi) is a new financial framework consisting of decentralized blockchain protocols and underlying smart contract technology. DeFi, as it is most commonly known, makes it possible for users to access different types of financial products and services without the need for a centralized authority.
How does decentralized finance, DeFi provide access to a range of financial products without relying on a central authority? ›
DeFi empowers individuals by giving them full control over their assets. Without relying on banks or financial institutions, users can manage their finances directly through their digital wallets, maintaining full custody of their funds.
What is an example of decentralized finance, DeFi? ›
As an example, DeFi applications like Uniswap and SushiSwap have revolutionized the way cryptocurrencies are exchanged; both are decentralized exchanges that allow users around the world to swap and exchange a wide variety of digital assets, such ERC20 tokens, an Ethereum token standard for fungible tokens, in the ...
How safe is DeFi? ›
The decentralized nature of DeFi creates potential opportunities for scammers to exploit unsuspecting users. Honeypot scams, fake accounts, and other deceitful tactics are prevalent.
How does DeFi work? ›
How does DeFi work? DeFi uses smart contracts that don't require traditional financial institutions to act as guarantors for transactions—participants in the decentralized finance ecosystem instead transact with each other directly, and transactions are secured through blockchain technology.
Is DeFi good or bad? ›
Faulty smart contracts are among the most common risks of DeFi. Malicious actors eager to steal users' funds can exploit smart contracts that have weak coding. Most decentralized exchanges enable trading through the use of liquidity pools.
How to make money with DeFi? ›
Top 10 Ways to Earn Passive Income with DeFi in 2024
- Staking: The Power of Network Participation. ...
- Liquidity Providing: Fueling the DeFi Engine. ...
- Yield Farming: Chasing the Highest Returns. ...
- DeFi Lending and Borrowing: A Peer-to-Peer Lending Market. ...
- Interest-bearing Crypto Accounts: Earning Interest the Simpler Way.
Why is DeFi important? DeFi takes the basic premise of Bitcoin — digital money — and expands on it, creating an entire digital alternative to Wall Street, but without all the associated costs (think office towers, trading floors, banker salaries).
Why is decentralized finance bad? ›
DeFi does not offer many of the consumer protections and remedies available for traditional financial transactions. Users may have little recourse if a transaction goes wrong, and the parties involved in the transaction could literally be located anywhere in the world.
Top 10 Leading DeFi Platforms of 2024
- Aave. ...
- MakerDAO. ...
- SushiSwap. ...
- PancakeSwap. ...
- Yearn Finance. ...
- Curve Finance. ...
- Synthetix. Empowering users to trade various synthetic assets on the blockchain, Synthetix's decentralized nature and diverse asset offerings contribute to its prominence in the DeFi ecosystem. ...
- Terra.
Benefits of DeFi
DeFi aims to make financial services faster, more reliable, and more accessible. When smart contracts are used to facilitate financial contracts, both human error and manual validation are eliminated from the processing and validation functions.
Who owns DeFi? ›
The ownership structure of DeFi Technologies (TSE:DEFI) stock is a mix of institutional, retail and individual investors. Approximately 0.04% of the company's stock is owned by Institutional Investors, 50.36% is owned by Insiders and 49.60% is owned by Public Companies and Individual Investors.
Is decentralized finance legit? ›
Most financial experts categorize DeFi as speculative, recommending only to invest 3-5% of your net worth into crypto. Without a central authority, DeFi offers many benefits. Improved accessibility, lower transaction fees, and higher interest rates, to name a few.
Is DeFi really decentralized? ›
Although a DeFi network cannot be manipulated by a minority of participants, it still remains possible for a majority to 'band together' In fact, far from being decentralised, consensus mechanisms rely on validators (PDF 543KB) who must be incentivised to maintain the transaction ledger.
What are decentralized technologies? ›
Decentralized applications, or dApps, are software programs that run on a blockchain or peer-to-peer (P2P) network of computers instead of on a single computer. Rather than operating under the control of a single authority, dApps are spread across the network to be collectively controlled by its users.
What is the difference between DeFi and crypto? ›
The biggest differentiator between DeFi and Bitcoin is their concept. While DeFi is a decentralized financial services system, Bitcoin is a cryptocurrency. Simply put, DeFi is the environment that facilitates Bitcoin transactions between two individuals or parties.
