The Technology of Decentralized Finance (DeFi)

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