Alessio Saretto
Decentralized Finance, or DeFi, seeks to reinvent the way financial services are created and maintained. DeFi applications allow users to interact directly with each other to borrow, lend, insure and exchange digital assets without centralized intermediaries such as banks and custodial exchanges.
More broadly, DeFi is a set of financial services offered through smart contract protocols — pieces of computer code that automatically execute transactions when certain conditions are met. DeFi uses blockchain platforms, a relatively recent non-proprietary innovation that allows for intermediary-free accounting. Ethereum, Solana and Avalanche are among the blockchains supporting DeFi applications.
The ultimate goal is to increase participation in the financial market by reducing costs and redistributing profits directly to users.
The DeFi user base has grown rapidly since the first applications were developed in 2018. At its peak in 2021, DeFi applications surpassed $300 billion in funds allocated to various projects with a transaction volume exceeding $1 trillion. Since then, the value of such obligations has decreased, reflecting the sharp drop in cryptocurrency prices (Chart 1).
DeFi can have advantages over traditional finance
DeFi could disrupt traditional financial services. In fact, most financial assets are already digitized, making the transition to decentralized ledgers easier.
DeFi protocols are permissionless and therefore accessible to everyone. In contrast, most retail clients in the traditional financial sector face severe restrictions on the types of products they can access and often require authorization. For example, even very experienced investors in derivatives markets (e.g. options and futures) are often required to make borrowing arrangements that are not usually available to retail investors.
DeFi protocols can interact with each other and stack transactions seamlessly and transparently, much like “Money Lego”. A few lines of code allow an investor to obtain a loan and use the proceeds to purchase digital assets.
Basically, digital assets can be transferred between DeFi protocols, drastically reducing the cost for consumers when switching from one financial service to another, increasing competition and social welfare. By comparison, traditional financial transactions are relatively opaque, and financial institutions are isolated behind closed systems that interact poorly, slowly, and expensively.
The decentralized nature of the blockchain could limit the presence and market power of large established companies. There is no “secret sauce” or competitive advantage that a single developer can gain as the computer code underlying any DeFi project is publicly available and the developer will eventually share management of the application with users.
By comparison, a small number of major players control traditional financial markets, creating a great deal of counterparty risk and opportunities to manipulate even large markets, as happened in the early 2010s when some of the world’s largest banks were accused of using LIBOR (London Interbank Offered Rate) collusion ) interest rate scandal.
DeFi applications are designed to replicate and innovate all types of traditional financial services. The highest user participation is found in lending and borrowing and decentralized exchanges.
Borrowing anonymously, lending in cryptocurrency
A common protocol for borrowing and lending is compound financing. The Compound protocol works much like a traditional bank, connecting cryptocurrency savers with borrowers. In exchange for providing capital, savers receive interest payments that accrue in real time (hence the name Compound).
In the cryptocurrency world, all users are anonymous and there is no credit check. Credit risk is minimized by over-collateralisation. Since each loan pool created on Compound is managed via a standalone smart contract, some initial parameters – such as the level of collateralization – are set in advance before the contract comes into effect.
These decisions are essentially made by the users, who are given governance rights each time they provide liquidity to loan pools. In particular, once the decision is made, the parameters of the smart contract cannot be easily changed until the loan pool is liquidated and the funds are returned to the original lenders.
Because there is no differentiation, each borrower is equal and pays a common interest rate to the loan pool, which varies continuously to accommodate differences in collateral quality and the availability of loan pool funds. When most of the funds in the pool are lent, the interest rate increases to incentivize loan repayment.
For example, some level of parameterization – or traceability – is required to set the collateralization rate associated with any type of asset that can secure a loan. In the long term, users would determine these parameters by exercising governance rights acquired over time. Currently, developers retain most governance rights.
Yield farming is a core tenet of DeFi lending and DeFi applications in general. Lenders keep their assets (the cryptocurrency they contribute to the loan pool) and can benefit from possible price changes while earning interest.
Become a decentralized exchange market maker
Anyone can be a market maker, also known as a liquidity provider, on a decentralized exchange. To do this, participants must provide a trading pool with digital currencies of a prescribed value. For example, traders looking to exchange bitcoin for a stablecoin (a digital currency that wants to maintain a stable exchange rate against a traditional currency like dollars or euros) can interact with the pool by exchanging a specific amount of a token for a specific amount of that other.
When traders exchange bitcoin for stablecoin, the price of bitcoin moves according to a preset and public algorithmic formula that provides a schedule of implied prices for each quantity traded or added to the pool. This is often referred to as an automated market maker.
Digital exchanges rely on both liquidity provision to create efficient pricing mechanisms (the larger the pool, the lower the price impact of a trade) and arbitrage activity to rebalance prices. For example, when Bitcoin’s implied exchange price becomes too low relative to a dollar-denominated stablecoin, arbitrageurs buy stablecoins in the open market and use them to buy Bitcoin on the exchange. They continue to do so until the implied bitcoin price on the exchange matches the price on the open market.
The main innovation of digital exchanges is that each individual can participate in market making, which has historically been one of the largest sources of revenue for traditional financial intermediaries. Additionally, digital exchanges provide an automatic counterparty in the form of the liquidity pool, thus aiming to eliminate counterparty risk. Because a digital exchange is ultimately a smart contract, it cannot provide credit, settlement is instant, and trades can only be executed if all funds are immediately available.
As a new technology, DeFi is facing operational tests
Like all new technologies, DeFi faces technical and economic challenges. Technically, the ability of protocols to support large-scale adoption is very questionable, not only because of the costs involved in supporting the technology, but also because of their ability to handle large transaction volumes.
From an economic perspective, large-scale adoption would require a profound philosophical shift in the way risk is assessed. For example, DeFi lending markets are completely anonymous and therefore do not support credit checks, a service that traditional banks offer.
Additionally, the smooth functioning of many DeFi applications requires arbitrageurs to step in and rebalance prices. However, arbitrage as an economic mechanism can reach its limits when the availability of capital becomes scarce, particularly when markets are stressed.
Another prominent problem facing DeFi acceleration is its structure. Most DeFi applications adopt a widespread governance structure where users and original developers share control over the rights to the future of the application. For projects that grow relatively large, distributed governance can become a limiting factor.
How much DeFi protocols can or are allowed to integrate into a non-crypto economic landscape depends on whether and how efficiently these types of problems can be solved.
About the author
Alessio Saretto
Sarett is a senior research economist and consultant in the research department of the Federal Reserve Bank of Dallas.
The views expressed are those of the authors and should not be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve System.
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