Decentralized Finance (DeFi): Transformative Potential and Associated Risks
Summary:
Financial services in the crypto finance world are provided by a combination of centralized finance (CeFi) organizations and decentralized finance (DeFi). CeFi's are roughly similar to traditional financial intermediaries, but DeFi seeks to provide services using smart contracts (computer code) rather than an intermediary. DeFi's unusual structure creates some interesting potential but also raises new risks in addition to those already inherent in blockchains and crypto finance. This paper reviews some of the opportunities and risks.
Key findings:
- Products offered by DeFis include lending, cryptocurrency exchanges, derivatives, payments, and asset management.
- The use of DeFi's could mitigate some risks relative to the provision of services through traditional intermediaries.
- However, DeFi's also create operational risks, some of which would arise in a "trustless" environment but others of which arise because the DeFi environment cannot be truly trustless.
- Additional risks may arise from the interface of traditional and crypto finance.
Center Affiliation: Center for Financial Innovation and Stability
JEL classification: G19, G23, G28, D23, D26, L14, L23, L86
Key words: Decentralized finance, blockchain, cryptocurrency, financial services, financial stability
https://doi.org/10.29338/ph2022-14
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