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Branch Business & Information
Systems Engineering,
Fraunhofer Institute for Applied
Information Technology FIT
Decentralized Finance
(DeFi)
Foundations, Applications, Potentials, and Challenges
Decentralized Finance (DeFi)
Foundations, Applications, Potentials, and Challenges
Authors
Vincent Gramlich, Marc Principato, Benjamin Schellinger, Johannes Sedlmeir, Julia Amend, Jan Stramm,
Till Zwede, Prof. Dr. Jens Strüker, and Prof. Dr. Nils Urbach
The Branch Business & Information Systems Engineering of Fraunhofer FIT, located in Augsburg and
Bayreuth, has proven expertise at the interface of Financial Management, Information Management, and
Business & Information Systems Engineering. The ability to combine methodological know-how at the high-
est scientic level with a customer-focused and solution-oriented way of working, is our distinctive feature.
Fraunhofer Institute for Applied Information Technology FIT
Branch Business & Information Systems Engineering
Wittelsbacherring 10
95444 Bayreuth
Acknowledgement
We gratefully acknowledge the Bavarian Ministry of Economic Affairs, Regional Development and Energy for
their support of the project “Fraunhofer Blockchain Center (20-3066-2-6-14)” that made this paper possible.
We also thank Martin Brennecke, Bjarne Huuck, Felix Paetzold, and Vincent Schlatt for their support in ad-
ministration, form, language review, illustrations, and content for this paper.
Disclaimer
This study has been prepared by the Fraunhofer Institute for Applied Information Technology FIT to the best
of its knowledge and belief, using professional diligence. Fraunhofer FIT, its legal representatives, and/or vi-
carious agents do not guarantee that the contents of this study are secure, completely usable for specic
purposes, or otherwise free of errors. The use of this study is entirely at the user’s own risk. In no event shall
Fraunhofer FIT, its legal representatives, and/or agents be liable for any damages whatsoever, whether di-
rectly or indirectly, arising out of or in connection with the use of this study.
Recommended citation
Gramlich, V., Principato, M., Schellinger, B., Sedlmeir, J., Amend, J., Stramm, J., Zwede, T., Strüker, J., and
Urbach, N. (2022): Decentralized Finance (DeFi) – Foundations, Applications, Potentials, and Challenges.
Branch Business & Information Systems Engineering of Fraunhofer FIT.
Image sources
©https://www.stock.adobe.com/,https://www.shutterstock.com/
DeFi enables
innovative nancial
services and offers efciency
gains via modularity and openness,
but it also leads to enormous legal,
technical, and socio-economic
challenges that need
to be resolved.
Preface
Preface
Bitcoin and other cryptocurrencies built on blockchains have increasingly attracted investors in recent years.
Motivated by the opportunities of this technology, blockchain-based applications in various sectors have
also been explored. Yet, so far, nance-related applications have arguably remained the most advanced and
relevant area of blockchain usage. The resulting nancial ecosystem based on blockchains as infrastructure
is often referred to as decentralized nance (DeFi). DeFi integrates not only basic payment functionali-
ties, but also provides highly complex applications that interconnect different building blocks and services.
These features result in the creation of an open, trustless, composable, and permissionless nancial ecosys-
tem. Protocols built on blockchains, i.e., smart contracts, facilitate automation and highly customizable DeFi
applications. Thus, smart contracts enable a wide range of nancial services such as digital assets (e.g., sta-
blecoins and derivatives), participation mechanisms (e.g., governance in decentralized autonomous organiza-
tions (DAOs)), and investment opportunities (e.g., non-fungible tokens (NFTs) and fractional ownership).
Proponents of DeFi argue that removing central entities in the value chain of traditional nance (TradFi)
improves access to nancial services, lowers transaction costs, increases exibility, and drives innovation.
However, the nascent stage of DeFi still poses major risks and challenges: Regulatory bodies are looking for
means to prevent money laundering and to hold entities accountable for misbehavior. Also, the transparent
nature of blockchains raises questions regarding compliance with data protection and related privacy regu-
lations. Bridging cryptocurrencies, DeFi-based transactions, and the real world is another multi-faced chal-
lenge. Furthermore, security and scalability issues hamper the development of promising applications. The
current scalability issues, for example, cause high transaction costs that make DeFi less attractive or unusable
for non-afuent users, undermining the value proposition of DeFi.
Understanding DeFi’s potentials and challenges is a crucial prerequisite to seize business opportunities early
on. In addition, it is imperative to educate investors, policy-makers, and users about the principles of DeFi.
Moreover, innovation from DeFi has arguably inspired many other sectors. Thus, the technical innovations in
DeFi can facilitate decentralized applications (DApps) in various domains, e.g., payments using central bank
digital currencies (CBDCs) or veriable supply chains. Blockchain and smart contracts can allow companies
to freely capitalize on composable, trustless, and permissionless DeFi protocols to build and offer innovative
products and services.
The goal of our study is to shed light on DeFi and provide experts and non-experts with the required knowl-
edge to comprehensively understand this emerging phenomenon. In addition, we discuss potentials, but
also existing challenges of DeFi and present solutions and measures for risk mitigation. We hope readers en-
joy this study and welcome questions, discussions, and suggestions for improvement.
Prof. Dr. Jens Strüker
Professor of Information Systems
and Digital Energy Management,
University of Bayreuth
Head of Fraunhofer Blockchain Lab,
Branch Business & Information Systems
Engineering of Fraunhofer FIT
jens.strueker@t.fraunhofer.de
©Hochschule Fresenius/ John M. John ©Björn Seitz – kontender.Fotograe
Prof. Dr. Nils Urbach
Professor of Information Systems,
Digital Business and Mobility,
Frankfurt University of Applied Sciences
Head of Fraunhofer Blockchain Lab,
Branch Business & Information Systems
Engineering of Fraunhofer FIT
nils.urbach@t.fraunhofer.de
Decentralized Finance | 3
Glossary
Glossary
AML anti-money laundering
AMLD Anti-Money Laundering Directive
AMM automated market maker
API application programming interface
BaFin German Federal Financial Supervisory Authority
CARF Crypto-Asset Reporting Framework
CBDC central bank digital currency
CeDeFi centralized decentralized nance
CEX centralized exchange
CFT countering the nancing of terrorism
CFTC Commodity Futures Trading Commission
DAO decentralized autonomous organization
DApp decentralized application
DeFi decentralized nance
DEX decentralized exchange
DLT distributed ledger technology
DSP direct stock purchase
ERC Ethereum request for comments
EU European Union
FATF Financial Action Task Force on Money Laundering
FEC Federal Election Commission
FinCEN Financial Crimes Enforcement Network
GDPR General Data Protection Regulation
IAS International Accounting Standard
ICO initial coin offering
IDO initial decentralized exchange offering
IEO initial exchange offering
IFRS International Financial Reporting Standards
IPO initial public offering
KYC know your customer
L2 layer 2
MEV miner extractable value
MiCA markets in crypto assets
NFT non-fungible token
OECD Organisation for Economic Co-operation and Development
P2P peer-to-peer
PoA proof of authority
PoS proof of stake
Decentralized Finance | 4
Contents
Contents
1 Introduction 8
2 Foundations 12
2.1 Blockchain Fundamentals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
2.2 SmartContracts .......................................... 13
2.3 Tokens, Transfers, and Wallets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
2.4 DecentralizedFinance....................................... 15
3 Application Areas and Use Cases 18
3.1 Stablecoins............................................. 18
3.2 Decentralized Exchanges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
3.3 LendingandBorrowing ...................................... 22
3.4 Derivatives............................................. 23
3.5 Insurances ............................................. 23
3.6 AssetManagement ........................................ 24
3.7 DeFi-related Applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
4 Potentials 27
4.1 Financial Inclusion and Independence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
4.2 Innovative Asset Classes and Funding Opportunities . . . . . . . . . . . . . . . . . . . . . . . 27
4.3 FractionalOwnership ....................................... 29
4.4 Open Systems and Interfaces . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
4.5 Catalyst for New Ecosystems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
5 Challenges 36
5.1 Technical Risks and Security Concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
5.2 ScalabilityIssues .......................................... 37
5.3 Illiquidity.............................................. 38
5.4 Transparency vs. Privacy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
5.5 Lack of Harmonized Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
5.6 Improper Property and Consumer Protection Laws . . . . . . . . . . . . . . . . . . . . . . . . 43
5.7 Inconsistent Taxation and Accounting Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
5.8 Recentralization .......................................... 45
6 Conclusion 48
Decentralized Finance | 6
Introduction
1
1 Introduction
1 Introduction
Since the inception of Bitcoin in 2008, nancial
markets have seen a sharp increase in market cap-
italization for various blockchain-based assets in
recent years. Yet, Bitcoin still represents the most
popular cryptocurrency, with a market capitaliza-
tion amounting to approximately USD 370 bil-
lion as of mid 2022. The recent phenomenon of
blockchain-based applications such as non-fungible
tokens (NFTs) and the emergence of decentralized
nance (DeFi) have also contributed to the mush-
rooming of digital assets. In particular, DeFi has
experienced tremendous momentum, with cryp-
tocurrency investments locked to the Ethereum
blockchain exceeding USD 100 billion by the end
of 2021 (see Figure 1). DeFi has witnessed a rapid
increase in market value in 2021, accompanied by
a growing user base and the emergence of new,
innovative use cases. Against this backdrop, we
believe that exploring and developing a compre-
hensive understanding of DeFi marks a worthwhile
endeavor.
Although blockchains have long been closely as-
sociated with nancial applications, today appli-
cations have evolved into a more general multi-
purpose area. With the advent of the Ethereum
blockchain, it was possible for the rst time to exe-
cute arbitrary, user-dened programming logic (Bu-
terin, 2014). These pieces of code, called “smart
contracts”, built and run on blockchains, provide
new opportunities for the development of more
advanced nancial applications and infrastruc-
tures. As a result of these innovative features, a
new ecosystem has emerged, referred to as DeFi.
It is also conceived to be a movement to develop
decentralized nancial applications that do not
depend on a distinguished central authority and
therefore resist manipulation and censorship to
a certain extent (CoinGecko, 2020). Proponents
of such non-institutional nancial services claim
that DeFi can aid in improving nancial inclusion,
thereby reducing poverty, inequality, government
censorship, and increasing economic growth glob-
ally. In addition, the underlying DeFi protocols
promise to automate processes, specically across
different organizations (Fridgen et al., 2018a), of-
fering the opportunity for higher transaction speed.
Since the code is generally open source and cannot
be altered beyond the established rules once it is
deployed, trust can be placed in the integrity and
functionality of DeFi applications. Moreover, the
modular components of DeFi aim to improve the
building and linking of nancial applications with-
out the need for access to bank-specic application
programming interfaces (APIs). Beyond these po-
tentials, there are further developments around
technologies that do not yet have a direct relation
to DeFi but may have strong interactions with it in
the future. For example, digital identities based on
asymmetric cryptography allow persons, organiza-
tions, and machines to provide machine-veriable
information (Sedlmeir et al., 2021b; Strüker et al.,
2021) and, thus, may facilitate a bridge between
regulated domains and DeFi (Sedlmeir et al., 2022).
Nevertheless, there are still great challenges that
need to be addressed to unleash DeFi’s potential to
the economy and society. For instance, there have
been multiple attacks owing to security gaps in
DeFi applications, often by targeting users through
phishing attacks, hacking or by abusing aws in
smart contract code. In addition, there have been
a lot of attempts to commit nancial fraud through
initial coin offering (ICO) scams, pump and dump
schemes, and other activities that traditional nan-
cial markets have inhibited through regulation over
the last centuries. Regulators are also concerned
that DeFi may undermine nancial stability and
put consumers at risk (Financial Stability Board,
2022). Another challenge of DeFi is caused by the
inherent transparency of blockchain, which can
be problematic with respect to data protection or
antitrust compliance requirements. Worse, trans-
parency grants miners an undue advantage by al-
lowing them to make (arguably) illegitimate prots
by front-running and other activities that would
be prevented in regulated markets. In general, the
large number of unregulated entities involved not
only make it challenging to compensate investors
for losses following such events. The pseudonymity
Decentralized Finance | 8
1 Introduction
0
20
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160
180
Jan 20
Feb 20
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Apr 20
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Aug 20
Sep 20
Oct 20
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Jun 22
TVL (billion USD)
Figure 1: Total value locked in DeFi on Ethereum (data retrieved from DeFiLlama (2022)).
of accounts in DeFi can also make it difcult to
comply with anti-money laundering (AML) and
countering the nancing of terrorism (CFT) regula-
tion. As they represent distributed and decentral-
ized systems that are synchronized to a consistent
state, blockchains typically require multiple devices
to perform the same operation in order to ensure
and uphold data integrity. This leads to a lower
processing capacity in comparison to centralized
databases. Hence, from a technical point of view,
the challenge is to nd solutions to avoid conges-
tion, high transaction latencies, and transaction
costs that arise from scalability issues.
Despite recent developments, the DeFi ecosystem
is currently still in its infancy. However, DeFi com-
ponents are already being connected to central
systems operated by traditional nance (TradFi)
institutions and marketplaces. According to the
“Protocol Sink Thesis”, open, permissionless DeFi
applications will increasingly converge with central-
ized entities in the future (Hoffman, 2020). It also
states that the DeFi ecosystem is the rst nancial
system that provides settlement assurances enabled
by the underlying technology-stack instead of re-
lying on laws or governments to enforce its rule.
Thus, these trustless, permissionless, and unbiased
protocols will “sink to the bottom” and become
the technical infrastructure of new and currently ex-
isting systems. This development would then allow
companies to freely capitalize on these infrastruc-
tures to offer better services and products.
Although the Protocol Sink Thesis still needs to
prove itself in the long term, the nancial indus-
try is already adopting business models towards
DeFi-based services, e.g, custody services for crypto
assets. In addition, centralized crypto marketplaces
such as Coinbase, Binance, and Opensea are en-
gaging in competition with traditional brokers and
exchanges. These exchanges allow users to par-
ticipate in various revenue streams, e.g., staking,
liquidity pooling, lending, or issuing and trading of
NFTs (see Section 3).
The goal of this study is to shed light on the state-
of-the-art of DeFi to comprehensively understand
the technological foundations, the ecosystem as
well as it’s potentials and challenges. First, we
present the technology-stack that powers DeFi
by elaborating on its building blocks in Section 2,
including blockchains, smart contracts, tokens, and
digital wallets. In addition, we present the layers
that compose DeFi. Next, we provide an overview
of core DeFi application areas and use cases in Sec-
tion 3. We then analyze the potentials of DeFi
and evaluate related promises in Section 4. After
that, we discuss current challenges in DeFi and ap-
proaches to possible solutions in Section 5. We
conclude with a summary and an outlook in Sec-
tion 6.
With our study, we hope to reach all those inter-
ested in DeFi, including those who want to use
this work for initial research on the topic. We aim
not only to demonstrate the potential of DeFi, but
Decentralized Finance | 9
1 Introduction
also to provide a dedicated assessment of key chal-
lenges that otherwise received little attention to
date in research on DeFi. We believe that this en-
compassing overview provides a profound under-
standing on the emerging topic of DeFi, partic-
ularly, for investors, users, and decision-makers
across all types of organizations and domains.
Decentralized Finance | 10
Foundations
2
2 Foundations
2 Foundations
This section introduces the technological founda-
tions of DeFi that are essential for understanding
the concepts presented in this study. First, we
delve into blockchains and smart contracts, which
serve as DeFi’s technical backbone. Second, we
introduce further key components of DeFi consid-
ering its main objectives. Third, we present the
DeFi-Stack that describes its different layers.
2.1 Blockchain Fundamentals
A blockchain is a type of distributed ledger tech-
nology (DLT). A DLT typically denotes a database
in which the data storage is distributed across mul-
tiple entities. In a blockchain, the transactions are
aggregated in batches, called blocks, which are
cryptographically linked together, making it in-
feasible to alter transactions in retrospect. In ad-
dition, data on blockchain is stored transparently
to allow for verication on its integrity. Therefore,
blockchains are generally considered tamper-proof
and transparent ledgers. Owing to their properties,
blockchains can be implemented in domains be-
yond nance. In this regard, blockchains can add
value, for example, in the energy (Djamali et al.,
2021; Sedlmeir et al., 2021c), supply chain (Fridgen
et al., 2019), public (Fridgen et al., 2018a; Roth
et al., 2022), or sports sector (Schellinger et al.,
2022a). Blockchains differ from other types of DLTs
in their three main building blocks, i.e., a peer-to-
peer (P2P) network, cryptographic primitives, and
an incentive-based consensus-mechanism (Butijn
et al., 2020). The combination of these building
blocks enables the trustless execution and settle-
ment of transactions in a decentralized setting, i.e.,
without the need for a central authority (Schlatt
et al., 2016; Völter et al., 2021).
Peer-to-Peer Network
A blockchain represents a distributed and synchro-
nized append-only database in which state-updates
(in the form of blocks) are stored in a replicated
way across all participants (Dinh et al., 2018). A
block includes sequentially ordered transactions.
For efciency reasons, computers (nodes) that
maintain their own, synchronized copy of the
database also compute a world state, i.e., a run-
ning aggregation of all previous state updates. By
design, a blockchain is maintained on a multitude
of nodes in a P2P conguration. Redundant data
storage ensures the availability and integrity of the
data, as well as protection against denial-of-service
attacks. Proposed transactions that have not yet
been conrmed by including them in a block are
typically stored in a Mempool. Based on the yet
unconrmed transactions in the Mempool, block-
producers select transactions to be included in the
next block (usually transactions with higher fees).
Cryptographic Linking
Blocks in a blockchain are cryptographically linked
to one another using hash values of data. In addi-
tion to new transactions, a new block requires a
hash-pointer to the preceding agreed-on block in
the blockchain. These cryptographic links are re-
quired to achieve immutability of the blockchain:
Any alteration in previous blocks would change
the block’s hash value and thus render the chain
inconsistent (“tamper-evidence”) (Samaniego et al.,
2016). An ex-post modication that other nodes
accept therefore requires the modication of all
blocks subsequent to the manipulated one. Thus,
consensus mechanisms are typically designed in a
way that makes ex-post modications increasingly
difcult with the growing number of subsequent
blocks (Nakamoto, 2008).
Consensus Mechanisms
The block creation process varies across different
blockchains. Generally, the consensus mecha-
nism relies on combining cryptographic techniques
and economic or social incentive mechanisms to
determine who may propose a new block. By
committing processing-power (e.g., in proof of
work (PoW)-based systems), locked capital (e.g., in
proof of stake (PoS)-based systems) or reputation
(e.g., in proof of authority (PoA)-based systems) to
the network, block-producers or validators have
a specic probability of being eligible to propose
Decentralized Finance | 12
2 Foundations
a new block (Wang et al., 2019). PoA represents
a voting-based consensus mechanism, where a
block is accepted once a (super-)majority of nodes
approves it. A simple approach where each node
has one vote, or the number of votes is connected
to the corresponding entity’s reputation, is only
possible in permissioned blockchains where par-
ticipating identities are restricted and known. Cor-
respondingly, coupling a scarce resource like hard-
ware and energy (PoW), capital (PoS), or storage in
open, permissionless networks to voting weight is
required to counter Sybil attacks. Sybil attacks in-
volve an adversary who would aim to outvote hon-
est participants by registering dummy accounts at
low costs (Sedlmeir et al., 2020). Proposed blocks
are then validated by the network using the spe-
cic consensus-mechanism and – if approved –
appended to all replicas of the blockchain. Usually,
the block-producer earns a reward for an accepted
block in the form of newly created coins and trans-
action fees.
Heterogeneity of Blockchains
Besides these characteristics, blockchains are quite
heterogeneous. They vary, for example, in their de-
gree of openness (public vs. private) and eligibility
to participate in the consensus mechanism (per-
missionless vs. permissioned). Public blockchains
can be accessed, copied, and synchronized by any-
body. In permissionless blockchains, any party can
assume a role within the network and participate
in consensus without needing the approval of one
or several other entities of the network. In addi-
tion, while Bitcoin and other cryptocurrencies have
been criticized for their high energy demand, many
other blockchains – namely those that do not use
a PoW-based consensus mechanism – do not have
a problematic energy consumption (Sedlmeir et al.,
2020). In particular, both PoS-based permission-
less blockchains and permissioned blockchains that
are usually using some voting-based consensus
mechanism require several orders of magnitude
less electricity than Bitcoin. In this regard, Bitcoin
has often been criticized for its enormous energy
requirements that rank among some medium-sized
industrialized countries. Yet, less energy intense
blockchains may even facilitate net energy savings
by leveraging additional opportunities for digitizing
cross-organizational processes (Rieger et al., 2022).
The low energy consumption of PoS blockchains
is one of the core reasons why some DeFi services
decided to launch on PoS-based blockchains like
Cosmos, Polkadot, or Tezos. Also, Ethereum is still
undergoing a transition from PoW to PoS. In this
view, regulators are actively discussing whether
measures against PoW cryptocurrencies’ high
energy consumption should be taken (Gola &
Sedlmeir, 2022).
DeFi applications typically rely on public and per-
missionless blockchains. However, there are appli-
cations built on permissioned blockchains since,
among other reasons, these allow for improved
performance. However, performance improve-
ments come with a trade-off as more sophisticated
and expensive hardware is required to participate in
consensus.
2.2 Smart Contracts
A simple transaction in the blockchain ecosystem is
the transfer of funds from one address to another.
However, many more recent forms of blockchains
have expanded upon that and allow for the ex-
ecution of arbitrary deterministic program code.
These executable programs on blockchains are
referred to as smart contracts (Buterin, 2014;
Szabo, 1996). In a smart contract, a code is de-
ployed on the blockchain and thus available to
audit and call (according to the code’s rules) for
every participant at any time (Buterin, 2014). On
the Ethereum blockchain – arguably the most im-
portant DeFi blockchain at the moment – there are
already many popular standards for the most com-
mon types of smart contracts. These standards are
often specied in the form of Ethereum requests
for comments (ERCs), for instance, the widespread
ERC-20 for fungible and ERC-721 for non-fungible
tokens. Through the asset layer, Ethereum also em-
powers programmers to implement decentralized
applications (DApps), which leverage the Ethereum
Decentralized Finance | 13
2 Foundations
blockchain to record events. In addition, DApps
track the ownership of digital assets that are rel-
evant to the application and for which it should
not depend on the availability or honesty of a
trusted third party. In this light, smart contracts
allow implementing DApps that represent com-
plex applications or organizational structures, e.g.,
decentralized autonomous organizations (DAOs).
The code is run in the creation phase of a new
block. A user can then commit funds and input
variables to a smart contract by sending a transac-
tion. Upon inclusion of the transaction in a new
block, the block creator runs the smart contract
code using the given inputs and commits all result-
ing state updates – including transactions triggered
subsequently according to the smart contract’s
logic – to the world state. Nodes that accept this
new block also perform this computation and up-
date their world state accordingly. Therefore, it
is critical that smart contracts are deterministic.
Given the inputs of a transaction, changes in vari-
ables and the triggering of other methods must
be identical for each node, otherwise the world
states of the different nodes would diverge (Kan-
nengiesser et al., 2021). Consequently, it is not
feasible to simply query data from outside the
blockchain, e.g., a website that provides data on
weather or ight delays, in a smart contract oper-
ation. Thus, DApps require “oracles” which inter-
mediate between the deterministic “blockchain
environment” and the non-deterministic “outside”
by making associated information available “on-
chain”. An entity is then responsible for inserting
outside-world data as payload in transactions that
triggers a smart contract. As it is not possible to
automatically and universally check for the verac-
ity of this information, the blockchain relies on
these agents to perform honestly and to report
the correct information. This dilemma is often re-
ferred to as “the oracle problem” (Caldarelli & Ellul,
2021). Corresponding data is typically checked by
a consortium of incentivized entities, cryptographic
checks of provenance, or removing outliers and
averaging the remaining data. Often, this involves
combinations of incentives and punishments for
inserting “good” or “bad” data.
2.3 Tokens, Transfers, and Wallets
Tokens play a central role in DeFi applications. How-
ever, the design and role of tokens can vary widely.
Smart contracts can, for example, be used to cre-
ate new tokens with a specic supply that follows
a specic logic, and manage the corresponding
ownership relations. Initially, smart contract-based
tokens were often programmed and issued via ini-
tial coin offerings (ICOs), inspired by initial public
offerings (IPOs) in TradFi. ICOs have been used by a
variety of projects to fund early development, mar-
keting, or to obtain initial liquidity (Arnold et al.,
2019). Smart contracts can also be used to man-
age variables that represent control over the smart
contract itself or other key parameters that it was
built for. This is relevant, for instance, to offer the
creator a degree of freedom to update or deacti-
vate the smart contract. This built-in mechanism
becomes handy in the case of implementation er-
rors or extensions. However, it also bears risk, as
the corresponding entity needs to be trusted not to
abuse this power.
Depending on the smart contract’s design, tokens
can resemble units of a currency, equity, fractional
ownership of an asset, voting rights, payments
within an application, or an incentive in a net-
work (Oliveira et al., 2018). The most common
application of a token is that of a currency, where
a fungible token represents a unit of account. Bit-
coin’s “BTC” and Ethereum’s “ETH” are examples
for such native protocol tokens, which are also
central to uphold the corresponding blockchains’
consensus mechanism by incentivizing the honest
contribution of hashrate, capital or some other
scarce resource, depending on the consensus mech-
anism. In this light, the native currency units serve
as “fuel” for facilitating transactions in the form
of fees that are needed to incentivize block pro-
ducers’ activities on the network. In a variety of
blockchain protocols, validators are also rewarded
with freshly minted native tokens once a new block
Decentralized Finance | 14
2 Foundations
has been accepted by the network. This is due to
the fact that malicious behavior cannot be detected
in a pseudonymous system since identities behind
wallet addresses are not known, which makes it
difcult to take legal action. Therefore, incentive
mechanisms are implemented to reward honest
behavior to ultimately maintain the integrity of the
system (Bano et al., 2019).
Tokens in the context of the ERC-721 standard
have been a relatively new development. They are
NFTs, i.e., each token is unique and distinguishable
from each other. Lately, NFTs have garnered attrac-
tion for being used as unique digital assets, e.g.,
digital artwork (Sunyaev et al., 2021; Whitaker &
Kräussl, 2020). In addition, other widely-used stan-
dards have emerged that exhibit extended function-
alities. In this light, the ERC-1155 standard allows
to create a token in a smart contract that incor-
porates properties of both the ERC-20 and ERC-
721 standard. The transfer of one of these tokens
on the blockchain is one of the simplest forms of
transactions: It usually involves saving the sender’s
and receiver’s addresses as well as the amount
of assets to be transferred (additionally, for NFTs
the unique identier is saved). By publishing the
transaction in the next block, it is approved by the
whole blockchain-network, and can be considered
nalized. Tokens associated with an application can
not only be used for the specic application, but
can be freely transferred to many other DApps if
they follow the standard templates (e.g., ERC 20
on Ethereum).
To access and manage these funds represented
by tokens, associated with a unique address, par-
ticipants need so-called wallets. Digital wallets
generate and securely store cryptographic key
pairs that need to be used to access tokens on a
blockchain.“Hot wallets” are essentially clients that
communicate with blockchain nodes in the form of
software applications running on a mobile phone
or a computer. These kinds of wallets also display
account balances and facilitate the interaction with
blockchains. There are also specic tools to address
security requirements. For instance, “cold wallets”
store sensitive information and in particular private
keys on air-gapped storage media, such as ash
drives or QR codes, to prevent leakage to attackers.
2.4 Decentralized Finance
As shown, DeFi is characterized by an open, permis-
sionless, and highly interoperable technology stack
with strong integrity and availability guarantees.
Proponents claim that it promotes nancial inclu-
sion, efciency gains, and exibility (Schär, 2021).
DeFi aims at replicating nancial services and prod-
ucts. Further, it creates entirely new DApps in an
open and transparent way built on blockchains and
smart contracts. Owing to the degree of decentral-
ization of the underlying blockchains, DeFi does
not rely on a single intermediary or centralized in-
stitution, such as banks, brokers, or exchanges
(Feulner et al., 2022a). Instead, agreements are
enforced by code and consensus, which allows
transactions to be executed in a secure, predictable,
and veriable way, with legitimate state changes
persisted on a public, tamper-proof ledger. Note-
worthy, this does not mean that every DeFi applica-
tion is fully decentralized (see Section 3). Yet, the
transparent record of transactions on public ledgers
and publicly available code enable an immutable
and highly interoperable nancial system with un-
precedented transparency, equal access rights, and
little need for custodians, central clearing houses,
or escrow services (Schär, 2021).
According to Schär (2021), the DeFi ecosystem can
be subdivided into ve different layers; Figure 2
illustrates this stack exemplary for Ethereum:
•Settlement Layer: The settlement layer is
represented by a blockchain-based distributed
database that manages basic accounting op-
erations, maintains access to funds, and exe-
cutes transactions. A consensus mechanism
and basic cryptography like digital signatures
and cryptographic hashing algorithms ensure
security and integrity guarantees in a decen-
tralized manner.
Decentralized Finance | 15
2 Foundations
Blockchain (Ethereum)
Native
protocol asset
(ETH)
Fungible token
(ERC20)
Non-fungible token
(ERC721/1155) …
Exchange Lending Derivatives Asset
Mgmt …
Aggregator 1 Aggregator 2 Aggregator 3
Aggregation Layer
Application Layer
Protocol Layer
Asset Layer
Settlement Layer
Figure 2: The DeFi-Stack on Ethereum (based on Schär (2021)).
•Asset Layer: Different digital assets can
be created and traded on top of the settle-
ment layer. Beyond the simple use of such
an asset as a store of value or medium of ex-
change, DeFi also allows users to act as ser-
vice providers. Users can supply assets to DeFi
applications or hold tokens that represent a
share of a project, granting governance rights.
•Protocol Layer: The protocol layer includes
smart contracts that try to provide a standard-
ized solution or service, e.g., a general way
to allow for the exchange of different cryp-
tocurrencies. Protocols represent ubiquitous
services (Sedlmeir et al., 2022) that can be as
sophisticated as DAOs that represent complex
organizational structures. They enable the
execution of general, deterministic code for
a variety of applications, such as exchanges,
lending, or derivatives.
•Application Layer: A combination of smart
contracts as backend and a web-based fron-
tend results in a DApp. These applications
make DeFi services accessible to a broader
user base through user interfaces and may
integrate several of these highly composable
protocols to allow more complete services.
This could, for instance, include a service that
integrates several currency protocols and an
exchange protocol into a single decentralized
or centralized exchange (Tabora, 2021).
•Aggregation Layer: The aggregation layer
enables aggregator applications by integrat-
ing services that can be technically indepen-
dent of one another. However, these DApps
provide more utility if made accessible com-
bined by a single aggregator. For instance,
this could comprise several insurance services
that join one larger DeFi-based insurance plat-
form.
It becomes apparent that these layers build on each
other and that the different DeFi layers are not
strictly separated but interwoven. Owing to the in-
teroperability and composability of smart contracts,
DeFi often uses the notion of “money Legos” (Ka-
tona, 2021; Schär, 2021). In a more narrow view,
the term DeFi primarily refers to upper layers, i.e.,
the protocol, application, and aggregation layers
of the model proposed by Schär (2021). However,
the asset and settlement layer act as a technical in-
frastructure and common foundation. Thus, it is an
essential part in the DeFi-Stack.
Decentralized Finance | 16
Application Areas and Use Cases
3
3 Application Areas and Use Cases
3 Application Areas and Use
Cases
Bitcoin was the rst system that enabled the trans-
fer of value in a decentralized P2P network, there-
fore innovating electronic payment systems beyond
traditional, centralized architectures. Ethereum
then extended the capabilities of blockchain-based
systems far beyond simple payments. In particular,
smart contracts facilitate a broader range of appli-
cations that offer a high degree of customizability
and programmability.
A considerable portion of these applications t
into the category of DeFi, which focuses on the
replication of nancial services. Against this back-
ground, smart contracts have enabled the com-
munity to develop innovative and complex DApps,
DAOs, and digital tokens. DeFi hereby comprises a
wide range of different application areas that have
considerably grown in value locked, most notably
in 2021. Figure 3 summarizes the DeFi applications
presented in this section. The two main sectors
identied are nancial services or markets and gam-
ing or gambling. As explained in section 2, the
DeFi ecosystem is closely interconnected and for
most protocols there is neither a clear-cut between
the two main categories nor between the subcate-
gories. In fact, there are many protocols that cover
multiple subcategories. Also, a multitude of gam-
ing or gambling protocols rely on nancial building
blocks. Conversely, many core DeFi services (i.e.,
nance-related DApps) incorporate gamication
elements to increase user adoption. In the follow-
ing, we will present these relevant application areas
and provide illustrative examples for a better under-
standing of DeFi projects.
3.1 Stablecoins
Owing to substantial nancial speculation, mar-
ket manipulations from large token holders (i.e.,
“whales“), and relatively low liquidity, cryptocur-
rencies typically face severe price uctuations, im-
pairing their ability to be a medium of exchange
and reducing liquidity in cryptocurrency markets
(Grifn & Shams, 2020). A medium of exchange
requires a certain price stability to a broad range of
products, which is a complex task of money sup-
ply and demand management and is usually per-
formed by a central bank. In this light, stablecoins
have emerged, aiming to provide a stable exchange
rate to a pegged value, e.g., at currencies, com-
modities, or gold. Thus, stablecoins constitute a
digital asset whose price is either pegged to the
value of an underlying reserve asset or maintained
by algorithms. Yet, the main goal of stablecoins
resides in providing a cryptocurrency with as little
volatility as possible (relative to established curren-
cies like the USD) to fulll the need for a stable
medium of exchange in economy. In addition, less
volatile crypto assets are important for nancial
products and services in the DeFi ecosystem. Thus,
stablecoins represent a crucial part of DeFi and are
expected to boost widespread adoption of DeFi ap-
plications (Catalini et al., 2021). Figure 4 illustrates
the historic market capitalization of the top ve
stablecoins.
In general, several types of stablecoins exist that
depend on the type of the underlying reserve as-
set – the collateral (Klages-Mundt et al., 2020).
Foremost, there are stablecoins that are pegged
to one or more commodities, at currencies, or
other “stable” real-world assets. Just like within
the origins of at currencies, the value of coins are,
thus, based on the promise of an issuing party that
the amount of circulating stablecoins is backed
by the amount of underlying assets, making them
redeemable for the underlying asset at any time.
Fiat-backed stablecoins, for example, peg each coin
directly to a certain amount of at currency. This
peg is realized off-chain and requires a nancial in-
stitution that serves as a custodian for the currency
used to back the stablecoin. In addition, off-chain
collateralized stablecoins demand trust in central-
ized custodians in terms of backing the asset or at
currency for the stability of the coin. Accordingly,
these stablecoins are often not considered as truly
decentralized crypto assets and are vulnerable to
depreciation if the backing cannot be veried.
Decentralized Finance | 18
3 Application Areas and Use Cases
Stablecoins
Mitigate volatility
Pegged to other assets
Custodial & non-custodial stablecoins
Lending & Borrowing
No credit-worthiness checks
Lend digital assets & earn interests
Collateralization of digital assets to obtain loans
DECENTRALIZED EXCHANGES
Full asset custody
Exchange of digital assets
Frictionless peer-to-peer trading
Derivatives
Hedging
Short & long positions
Speculation or leveraging
Asset Management
Investment maximization via yield aggregators
DeFi applications for fund management
Oversee & manage portfolio
Fair Lotteries
Pooled capital into a smart contract
Earn interests & give it to a winner
Lottery tickets are refunded
Insurances
Insurance covers losses
Hedge against smart contract exploits
Settlement of insurance claims via the blockchain
Prediction Markets
Based on crowd-wisdom
Bet on real-life events
High flexibility
Decentralized Gaming
Monetization of in-game assets
Uniqueness & scarcity (NFTs)
Play to earn
Other DeFi-related Apps
→
→
DeFi-related services
Core DeFi services
Figure 3: Summary of core DeFi and DeFi-related service categories.
The second category includes seigniorage stable-
coins whose stability is based on an algorithm that
maintains the coin price close to an intended peg
(e.g., USD 1). This is achieved by automatically ex-
panding and contracting the coin supply – similar
to how central banks mint or burn money (Sams,
2014). Unlike other categories, Seigniorage sta-
blecoins are therefore the only category which
is not actually backed by any underlying asset.
The missing collateralization poses several ques-
tions and hurdles, e.g,. if the coin will be stable in
value when there are high (alternating) price uc-
tuations. Depending on the denition, it is often
questioned if they can be considered as stablecoins
at all (Crown, 2018). Noteworthy, the algorithmic
stablecoin UST (Terra USD) of the LUNA ecosys-
tem was the fourth largest stablecoin in the DeFi
ecosystem until April 12, 2022. After massive sell-
offs in the wake of a general DeFi downturn (see
Figure 1), UST lost its peg to the USD and its mar-
ket capitalization fell from approx. USD 19 billion
to USD 70 million (Barthere et al., 2022). Conse-
quently, this development lead to downturns in
the whole cryptocurrency market that also caused
nancial turmoil of centralized institutions, e.g., in
the case of Celsius (Blockworks, 2022b) or 3 Ar-
rows Capital (3AC) (Blockworks, 2022a).
Finally, the third type of stablecoins is issued using
other cryptocurrencies as underlying asset. Con-
ceptually, this is similar to at-backed stablecoins,
but with the important distinction that the backing
happens completely on-chain using smart contracts.
This means that stablecoins are minted once a user
locks a cryptocurrency as collateral into a particular
smart contract. Since the value of the underlying
cryptocurrency is exposed to price uctuations,
these stablecoins need to be over-collateralized.
The smart contract then grants the user access to
a certain amount of stablecoins, depending on
the mandatory (over-)collateralization rate and the
value of the (crypto) reserve asset.
A prominent example for a crypto-backed stable-
coin is DAI of the MakerDAO protocol (Brennecke
et al., 2022). We illustrate how these stablecoins
work by introducing an example where Alice wants
to get the equivalent of USD 100 in DAI stable-
coins. As DAI is an Ethereum-based token, the
collateralization occurs completely on-chain. This
means that Alice sends Ether as collateral to a par-
ticularly designed smart contract governed by the
MakerDAO protocol. To ensure price stability, the
DAI rate is pegged to the USD and has to be se-
cured with at least 150 % of the collateral (Ether).
Decentralized Finance | 19
3 Application Areas and Use Cases
0
20
40
60
80
100
120
140
160
180
Jan 20
Feb 20
Mar 20
Apr 20
May 20
Jun 20
Jul 20
Aug 20
Sep 20
Oct 20
Nov 20
Dec 20
Jan 21
Feb 21
Mar 21
Apr 21
May 21
Jun 21
Jul 21
Aug 21
Sep 21
Oct 21
Nov 21
Dec 21
Jan 22
Feb 22
Mar 22
Apr 22
May 22
Jun 22
Market cap (billion USD)
USDT USDC BUSD DAI FRAX
Figure 4: Market capitalization of the most relevant stablecoins (Data retrieved from Glassnode (2022)).
As Blockchains cannot access data outside their
own state, “oracles” are necessary to provide pric-
ing information. Within the collateralization for
on-chain assets, decentralized exchange rates, and
within auctions, order books or automated market
making applications can be used to derive price
information. For Alice, this means that she needs
to send Ether as a collateral within the smart con-
tract. In our example, the provided Ether have to
be worth at least USD 150 based on the current
exchange price (given by the oracles). The contract
then allows Alice to withdraw DAI worth USD 100.
As the DAI is pegged to the USD, the value of the
collateral (i.e., Ether) locked in the smart contract
will be continuously checked and if its value falls
below the mandatory liquidation rate of 150 %, an
automated auction of the reserve asset is enforced.
Alice is obliged to pay a penalty for the auction,
motivating her to secure her coins with a collateral
deposition well above the 150 % ratio. In markets
with high volatility and network congestion, the
liquidation process can carry signicant risks for
users. Nonetheless, this mechanism enables an en-
tirely decentralized and automated self-stabilizing
system.
In general, stablecoins can be used across the
whole DeFi ecosystem as long as they are com-
patible to the underlying blockchain infrastruc-
ture of the coin. For example, DAI is native on
the Ethereum blockchain. Possible use-cases for
stablecoins include exchanging them to another
currency (crypto or at), using them to de-risk with-
out the need of withdrawing the money from the
DeFi ecosystem, offering the possibility of keeping
a long-position on the reserve asset and borrow-
ing against it to still having liquid capital (due to
the collateralized debt position), buying more units
of the reserve asset at a decentralized exchange
in the DeFi ecosystem, leveraging beneciary ex-
change prices, and earning interest using lending
and borrowing platforms. Overall, within all these
areas of application, users are able to make use of
their investments without having to sell the under-
lying collateral. Finally, stablecoins can also be used
for remittance or salary payments to avoid high
intermediation costs or to mitigate volatility and
currency risks of local currencies.
Another type of cryptocurrency that aims to pro-
vide a low-volatility currency that is pegged to a
certain basket of assets, are decentralized reserve
currencies. They can be viewed as a special form
of crypto-backed stablecoins, but instead of keep-
ing a peg to a at currency like the USD, they are
pegged to a basket of assets, mainly composed
of different cryptocurrencies. The performance of
them therefor can be compared to an exchange
Decentralized Finance | 20
3 Application Areas and Use Cases
tradable fund (ETF), which volatility mainly depends
on the volatility of the individual assets, their cor-
relation and its diversication. The main reason
for their emergence was the growing importance
of stablecoins in the ecosystem and the reintro-
duction of centralized institutions behind them.
Decentralized reserve currencies therefore try to
take the autonomy of DeFi one step further to be
independent of centralized institutions holding at
reserves and also to not be limited to low volatil-
ity assets that are pegged to at currencies and
other commodities. The rst protocol to implement
this mechanism was OlympusDAO which reached
a value of controlled assets of up to USD 800 mil-
lion. 1Inspired by the success of Olympus, many
other decentralized reserve currencies emerged
with various asset compositions and different suc-
cess regarding their growth and price stability.
3.2 Decentralized Exchanges
A decentralized exchange (DEX) provides the ad-
vantage of not having to rely on a single, non-
transparent, trusted entity as the market maker
who might work in their own favor, get hacked,
or outright disappear with entrusted funds. It also
avoids problems of re-centralization. Traditional ex-
changes rely on order books. A centralized party
stores demand- and supply-orders and matches
them by pairing a buy with an opposing sell de-
cision for an equal amount and price. In terms
of trading volume and total value locked (TVL),
the value committed to certain smart contracts
– decentralized order book exchanges – play no
signicant role in the DEX space yet: Owing to
the expensive storage space and computation on
a blockchain, and considering that setting and
matching an order results in separate transactions,
the fees of this approach would be very high. Nev-
ertheless, technologies like zero-knowledge proofs
(ZKPs) or layer 2 (L2) solutions used in new appli-
cations on established or entirely new blockchains
(see Section 5) could make order-book DEXes a
more viable option for DeFi in the future. Currently,
Polkadex and Serum are rst growing players run-
1See Market value of treasury assets in OlympusDAO.
ning on-chain order books. This approach is ad-
vantageous – in contrast to the automated market
makers (AMMs) which we discuss below – as or-
ders backed by liquidity can be pooled without the
need for external liquidity providers.
To date, most popular DEXes operate based on
an AMM algorithm. Hereby, a liquidity pool holds
both assets of the trading pair and acts as coun-
terparty to trades. An algorithm determines the
exact amount and price at which an order is exe-
cuted that is based on the ratio of the assets in the
liquidity pool. When trading against this liquidity
pool, that is supplying only one asset and receiv-
ing the other asset, the pool ratio shifts and the
price moves. The size of the price movement de-
pends on the ratio of trade size to liquidity pool
size and the pool’s algorithm. A simple example
is the curve-function Rx
·Ry=mused by the
constant function market maker Uniswap: For
each additional increment of currency xadded to
the Reserve Rx, the marginal amount of units of
currency ybought from the Reserve Rybecomes
slightly less so that the price increases with the
size of the buy order (see Figure 5). The special
curve-function ensures automation and allows for
efcient and fair collaborative pricing without the
need for a centralized order book. Further, liquidity
is created by dedicated “liquidity providers”, who
provide both assets of the trading pair in the cur-
rent ratio to the liquidity pool. While on centralized
exchanges (CEXes), market makers are often a re-
sponsible for keeping even exchange rates on dif-
ferent exchanges, DEXes need arbitrageurs that
use price discrepancies in order to reach price equi-
librium. Since arbitrageurs prot from the price
discrepancies that they balance out, the liquidity
providers are exposed to “impermanent loss” due
to price movements caused by arbitrage trades:
After they have provided their liquidity, their liquid-
ity position can become worth less than it would
have been if they just had held the assets they con-
veyed when the relative value of the two assets
changes. In order to compensate for impermanent
loss, and to incentivize liquidity provisioning, liquid-
ity providers receive a share of the trading fees that
Decentralized Finance | 21
3 Application Areas and Use Cases
Constant
Reserve in asset x
Reserve in asset y
Marginal exchange rate of assets
(assets spent)
(assets gained)
The lower the reserves of an asset,the more valuable it gets (pricing)
Reserves cannot be drained
CFMM formular:
Properties of the function: or
or
For spending asset x for asset y:
Figure 5: Constant Function Market Maker (based on Bartoletti et al. (2021) and Xu et al. (2021)).
are generated from the pool. Most AMMs further
incentivize liquidity suppliers by distributing their
own protocol token to liquidity providers. We lim-
ited our illustration of AMMs to a simple archetype
which shows how an AMM algorithm can be con-
structed. Uniswap, Curve, and Bancor are the most
notable DEXes at the moment, yet, they each use
different interpretations of AMM-algorithms.
3.3 Lending and Borrowing
Similar to how DeFi establishes spot exchanges by
use of AMMs, DeFi also enables the seamless P2P
lending and borrowing of crypto assets. However,
AMMs for lending and borrowing do not price
assets against each other like on DEXes but deter-
mine the interest rate on a given asset, based on its
utilization rate (total loans divided by total deposits
of the asset) (AAVE, 2020; Compound, 2020). The
interest rate function can be either linear, non-
linear (e.g., dYdX), or kinked (e.g., Compound and
AAVE), determining at which rate the interest rate
increases or decreases, which represent the main
incentive for lending and borrowing. Lenders lock
their crypto assets in a smart contract and earn vari-
able interest on locked currencies. These funds can
then be borrowed at xed or variable interest rates.
The assets borrowed need to be backed by a collat-
eral deposit consisting of another asset to ensure
liquidity in the absence of credit-worthiness due to
pseudonimity.
Over-collateralization defeats the nancing purpose
of a loan per se, however, lending and borrow-
ing protocols are important and mainly used for
providing further nancial utility such as decen-
tralized margin trading for borrowers (e.g, short
sells and leveraged longs) and easy, relatively safe,
and trustworthy investment of crypto assets for
lenders (Gudgeon et al., 2020b). Additionally,
these protocols, in conjunction with stablecoins,
play a substantial role in providing the DeFi ecosys-
tem with liquidity. At the time of writing, four
out of the ten biggest Ethereum applications in
terms of TVL are such lending protocols. As of June
2022, Aave is currently the biggest lending applica-
tion, with roughly USD 5 billion locked (DeFiLlama,
2022).
Decentralized Finance | 22
3 Application Areas and Use Cases
3.4 Derivatives
A nancial derivative is a contract which derives its
value from the performance of an underlying as-
set. They are commonly used in the nancial world
to decrease risk (by hedging) or to purposefully in-
crease exposure to an asset without having to buy
the asset itself in hopes of beneting (by leverag-
ing) from the increased risk.
Derivative applications for margin trading are im-
plemented similar to the lending and borrowing
protocols, with the main difference that additional
derivative-specic smart contracts automate and fa-
cilitate the orders for margin trades (e.g., leveraged
longs and short sells). In options trading, a buyer of
a derivative pays a premium to the issuer executed
by a smart contract. In addition, the smart contract
controls the underlying asset. As a last step, the
smart contract issues a new token that represents
the option (Juliano, 2018). This token can then
be sold to others or used to exercise the option,
similar to options in TradFi. These derivatives can
function without time and price feed oracles by
using the Unix time stamp of blocks and decentral-
ized pricing mechanisms of AMMs. However, there
also exists the possibility of a smart contract that
tokenizes, i.e., converts real-world objects into a
blockchain-based form, these nancial derivatives
using oracle price feeds (e.g., Synthetix). This mech-
anism enables the creation of non-crypto assets in
DeFi.
Lately, a growing number of DeFi derivatives on
“real-world” assets can be observed. Price data on
real-world assets is usually provided through ora-
cles, so that any asset for which an oracle exists
can be described by a derivative, while the value
of common crypto assets can also be derived from
lookups on DEXes (Synthetix, 2022). This allows
users to hedge or leverage open positions not only
on crypto assets, but increasingly on real-world
assets in a far easier way than TradFi would allow.
For example, dYdX offers derivatives on cryptocur-
rencies with up to 25x leverage, while Synthetix,
provides derivatives on crypto assets and at cur-
rencies, commodities, stocks, and indices. Proto-
cols like Hegic and Dopex supply more traditional
derivatives like call or put options, as well as future
contracts.
3.5 Insurances
Given the novelty of DeFi applications, the risk of
smart-contract hacks and bugs embedded in the
code is extremely high, creating a need for insur-
ance coverage to protect against such risks. These
risks can have severe consequences on the integrity
and adoption of DeFi applications, e.g., in the case
of the DAO (Dhillon et al., 2017) or Poly Network
hack (Gagliardoni, 2021). Since smart contracts
are publicly available code snippets, anyone can
search for aws and exploit them. Against this
background, users can cover losses resulting from
bugs or attacks in smart contracts by purchasing
dedicated insurance products (Guggenberger et al.,
2021a). For instance, Nexus Mutual and Opium
Finance provide insurances that cover smart con-
tract risks. Other insurance applications in the DeFi
space are gaining traction as well. Through the
use of oracles, virtually any real-life risk can be
insured using DeFi-based insurances. Arbol, for
example, uses oracles for weather-data to insure
farmers against the loss of crop yield, should cer-
tain weather parameters be met. Another example,
Etherisc, automatically compensates customers of
delayed ights. In such cases, the settlement of
insurance claims can be handled digitally and virtu-
ally instantaneously, in contrast to most real-world
insurance procedures. On the other hand, imple-
menting a purely smart-contract based insurances
in DeFi is arguably challenging, as, for instance, a
hack is difcult to prove purely based on transac-
tions that the hack involved. To address this issue,
for example, a DeFi-based insurance platform could
establish a competent contingency committee com-
posed of insurance experts and advised by inde-
pendent IT auditors who assess the claims. Based
on the vote, the insurance claim is either settled
or declined (Guggenberger et al., 2021a). While
this procedure can solve the problem of proving
the occurrence of an insured event, it reintroduces
Decentralized Finance | 23
3 Application Areas and Use Cases
trusted intermediaries. Therefore, it remains un-
clear to which extent the dependence on trusted
intermediaries inhibits the utility of insurance prod-
ucts in DeFi.
3.6 Asset Management
Crypto assets offer an opportunity for port-
folio diversication and, thus, mitigation of
risk (Schellinger, 2020). Additionally, beyond pure
crypto investments, DeFi enables automated digital
asset management. In DeFi, funds can be locked
in smart contracts controlled by DApps that invest
and manage crypto tokens. Asset management
tools come in a plethora of different innovative
approaches and designs. A widespread use case
is the automated investment in existing DeFi pro-
tocols, where the weighting of different positions
is determined by an algorithm or personal prefer-
ences. Asset management in DeFi is largely dened
by yield farming protocols, such as Yearn.nance
and Pickle.nance (Guazzo, 2020). These portfo-
lio management applications offer ”vaults” where
users can deposit their assets. Each vault comprises
different investment strategies for the asset, which
are developed, optimized, and tested off-chain by
strategists (Yearn Finance, 2022b). Usually these
strategies encompass an initial investment of the
original assets into a liquidity pool of a DEX and
then re-invest the tokens awarded for providing
liquidity to another DApp and so on. Hence, yield
farming spans a variety of existing applications of
the DeFi ecosystem. Based on the changing yield
values of these strategies, the vault then routes the
funds through the strategy which currently allows
for the highest return. When interest rates change
on various DeFi platforms, the vault automatically
reallocates its assets to a better strategy, if one is
available (Yearn Finance, 2022a).
Through smart contracts or tokenization, establish-
ing social investing where one investor manages
the digital assets becomes convenient. Moreover,
others can follow or stake these investments – of-
ten for a fee that can amount up to 20 % of the
earnings – by simply engaging with a provided
smart contract. DeFi also offers a lot of potential
for automation, as transactions are only engage-
ments of smart contracts they can be triggered
one after another within one main call. This can be
used to take out a “ashloan” (“ash” due to their
short lifespan) to benet from arbitrage. As such,
ashloans initiate a succession of rapid transac-
tions with the borrowed money and pay back the
loan within a single call. One tool to facilitate such
atomic transactions is Furucombo.app, where users
can easily create their own trading bot through a
drag-and-drop interface.
There are also applications that address the prob-
lem of conditional orders (i.e., stop-loss orders)
within DeFi which are usually individual transac-
tions on most DeFi protocols and, thus, cause trans-
action fees for each change of an order. Services
can manage these conditional orders on their own
layer and only execute them on the main chain
once the condition is met. The landscape of DeFi
protocols is highly fragmented on a technical level
over several blockchains and on an interaction level
over a variety of websites and DApps. Standard-
ization is important to overcome these challenges
arising from a common digital infrastructure with
a multitude of incompatible interfaces. Prevalent
asset management tools try to overcome this lack
of standardization by aggregating important in-
vestment, liquidity, lending, and NFT protocols in
their services and allow users to interact through
a unied interface. Zerion.io for example claims
to be the most extensive aggregation of DeFi-
protocols across chains and platforms. However,
the high volatility and dynamics in DeFi ecosystems
require asset management DApps to be highly ag-
ile (Dedezade et al., 2020; DKCrypto, 2021).
Furthermore, the management of crypto assets in-
cludes taking advantage of “airdrops”. Airdrops
describe the free distribution of tokens to early
users and investors of blockchain projects (Coin-
Bundle, 2018). The rationale behind airdrops
are primarily marketing purposes, as giveaways
of valuable funds generate awareness for the
Decentralized Finance | 24
3 Application Areas and Use Cases
project, while rewarding users and keeping them
invested (Gunther, 2021; Solanews, 2021).
3.7 DeFi-related Applications
In addition, other non-core nancial applications
have emerged and are increasingly growing. These
applications have a non-nancial business logic,
yet, relying on DeFi services and products, e.g., fair
lotteries, prediction markets, and decentralized
gaming.
•Fair Lotteries: Regulators often restrict the
kind of bets that one may place or take sig-
nicant fees for lotteries. DeFi applications
try to mitigate these restrictions by construct-
ing cheap, accessible, and mostly fair lotter-
ies. The most notable lottery is provided by
Pooltogether.com, where locked assets are
invested, and locked coins equal one ticket
for a weekly lottery of the return on invest-
ment. Lotto.nance has a more traditional
approach, where tickets in the form of to-
kens are bought, and each token holder is
automatically debited one token per lottery
drawing, which are held twice a week.
•Prediction Markets: Prediction markets are
created to predict, or rather bet on, the out-
come of real-life events. Virtually any real-life
event can be priced in these markets, e.g.,
applications ranging from predicting future
prices of cryptocurrencies (e.g., omen.eth,
plotx.io), sports-betting (e.g., augur.net) or on
real-life events, for example betting on Poly-
market.com if the rate of ination will reach a
certain threshold. Through crowd wisdom, a
price is found for both options, representing
the sentiment of all betters (Augur, 2018).
•Decentralized gaming: Decentralized gam-
ing describes computer games that are built
on and operated by decentralized technolo-
gies, e.g., blockchain. Especially regarding
the possibility of monetizing in-game assets,
DeFi and decentralized gaming offer a new
paradigm for players often referred to as
“play to earn” (e.g., Ubisoft Quartz). There-
fore, decentralized gaming can provide many
advantages. For instance, players can trade in-
game assets between gaming applications or
exchange them for crypto or at currency. In
addition, users can borrow and lend in-game
assets to other players. Lastly, users can ben-
et from earning passive income on their in-
game assets, e.g., by staking them in liquidity
pools (Krion, 2021). While these opportunities
are specically useful to reduce the depen-
dence on the company that creates the game,
one needs to take into account that owing
to the capacity bottlenecks of blockchains,
games usually do not happen entirely on-
chain and therefore continue to build signif-
icantly on proprietary, closed-source software.
Consequently, it is unclear to which extent
computer game manufacturers will implement
the interaction with blockchain-based gaming
assets in a way that makes them useful also,
for instance, across different versions of the
same game, let alone across different games
built by different manufacturers.
Decentralized Finance | 25
Potentials
4
4 Potentials
4 Potentials
DeFi is still at an early stage of development, yet it
offers a wide range of applications, which we have
highlighted in the previous section. Together, these
aspects suggest considerable economic potential,
which we will discuss in the following section. In
addition, we address the impact that DeFi could
have on various aspects of society and present
other specic business areas that could be affected
by DeFi.
4.1 Financial Inclusion and Indepen-
dence
The main goal of a nancial system is to improve
capital efciency, which is achieved by intermedi-
ation between suppliers and demanders of funds
on different nancial markets using respective -
nancial instruments (Cadete de Matos et al., 2021).
TradFi hereby mainly operates in a hub-and-spoke
structure in order to be efcient, for instance, by
pooling nancial activity and cutting costs (Lipton
& Hardjono, 2021). However, this makes TradFi
an inherently centralized and opaque nancial
ecosystem, where assets are often held in custody
by third parties and access is limited due to geo-
graphic constraints (Derviz et al., 2021; Zetzsche
et al., 2020).
Although online banking has made nancial ser-
vices more accessible, approximately 1.4 billion peo-
ple worldwide are still considered “underbanked”,
especially in developing countries (The World Bank,
2018, 2021). Consequently, nancial inclusion
remains a broad socioeconomic challenge to be
resolved even today. The reasons for this situation
are manifold, e.g., the lack of local branches owing
to overhead costs or efforts to comply with regu-
lations, general distrust in banks and custodians,
or failing minimum fund requirements (The World
Bank, 2021).
As opposed to TradFi, DeFi represents a decen-
tralized and transparent nancial ecosystem that
facilitates access to nancial services. Instead
of relying on a branch ofce to obtain nancial
services or obtaining permissions to operate in
such systems, DeFi applications require an inter-
net connection and a device to interact with the
system (Derviz et al., 2021). By replacing interme-
diaries with smart contracts (e.g., AMMs), DeFi
enables trustless and decentralized (P2P) nancial
markets using blockchains as a source of trusted
settlement (Schär, 2021). Since smart contracts act
as ubiquitous, fully automated service providers,
DeFi provides access to nancial services at any
time. DeFi thereby provides permissionless nancial
services detached from geographical and formal
restrictions, enhancing total self-custody (Qin et
al., 2021a). In addition, reducing intermediaries to
a few protocols has the potential to reduce addi-
tional fees. In this way, DeFi could become more
accessible and benecial to less afuent people
around the world (Schär, 2021). Hence, propo-
nents argue that DeFi could offer a remedy to the
un(der)banked people worldwide, thereby boosting
nancial inclusion and independence (Y. Chen &
Bellavitis, 2020; Katona, 2021; MakerDAO, 2020;
Qin et al., 2021a). For instance, DeFi has seen a
growing increase in usage across developing coun-
tries such as Vietnam, India, and Pakistan and
many other countries in South America, where it
is often perceived as a means to extend nancial
inclusion, open up new job opportunities, or access
more stable (foreign) currencies (Chainalysis, 2021;
Tornaghi, 2022).
4.2 Innovative Asset Classes and
Funding Opportunities
As mentioned in Section 3, DeFi requires digital
currencies, i.e. tokens, which are crucial for storing
value and payments in this ecosystem. In addition
to cryptocurrencies and in particular stablecoins,
DeFi asset classes include governance and security
tokens that are similar to traditional stocks (Oliveira
et al., 2018). Organizations offering these tokens
can range from traditional companies to DAOs.
While DAOs incorporate these tokens by means
of smart contracts, conventional businesses need
to tokenize their shares. In general, these tokens
Decentralized Finance | 27
4 Potentials
grant ownership and voting rights in this entity,
including payouts such as “dividends” (Barbereau
et al., 2022c).
Furthermore, there are tokens that have a specic
use in DeFi, such as paying for services provided
by a DApp. Both asset classes, tokens that repre-
sent ownership and voting right, and tokens that
provide access to services, can be used to fund
projects in DeFi and are often initially launched and
distributed via ICOs and airdrops. However, the
main venues for distributing these tokens are tradi-
tional and decentralized exchanges. In this context,
initial exchange offerings (IEOs) are token launches
on a regular TradFi exchange, while initial decentral-
ized exchange offerings (IDOs) are the counterpart
launched on DEXes (Coinmarketcap, 2022b). A
project that wants its token to be listed on a tra-
ditional exchange typically needs to meet formal
requirements and quality standards in order to get
listed (Anson, 2021). In contrast, IDOs provide the
opportunity for everyone to list and launch their
tokens – which, of course, also bears increased risk.
DEXes provide a market with low entry barriers and
a higher degree of (yet rarely perfect) anonymity,
since users do not need to go through sophisti-
cated know your customer (KYC) processes. In
contrast CEXes offer a broader user base to the
project as well as a certain level of authority and
security with regard to fraudulent projects (Anson,
2021; Aspris et al., 2021). Many projects that end
up getting listed on CEXes start with a DEX listing
and proceed to attempt the cross-listing on a CEX
later on in the project’s life cycle. DEXes hence are
suitable for nancing early stage projects while
CEXes – in line with their integration in regulatory
domains – full a gatekeeper role by certifying the
quality and credibility of nished projects. Thus,
they ensure further nancing possibilities for devel-
oped projects by opening them to more risk-averse
investors (Aspris et al., 2021). In the past, CEXes
offered high amounts of liquidity, however, at
present, the largest share of liquidity and trading
volume for many projects and their respective to-
kens can be found on DEXes. This can lead to the
token only being listed on a DEX, resulting in many,
especially DeFi-native projects.
Analogously to what we described in Subsec-
tion 4.1, DeFi enables the process of nancing
projects to be less costly for anyone involved.
Lower costs can be achieved by cutting the mid-
dlemen and reducing bureaucracy regarding com-
pliance (Arnold et al., 2019). Moreover, given dif-
ferent types of assets, for example, native tokens,
fungible tokens, and NFTs, DeFi funding tools are
highly customizable to individual use cases and can
range from providing utility and ownership such as
shares to a token for crowdfunding (Bachmann et
al., 2019; Fridgen et al., 2018b). In addition, smart
contracts can be used to separate different utili-
ties and authorizations that a token provides to its
owner. For instance, governance tokens’ trading
rights could be traded separately from the token as
a pure means of speculation or investment (Buterin,
2021). Fungible tokens are mostly used for purely
nancial (core DeFi) purposes, while non-fungible
and semi-fungible tokens 2are more widespread
in further use cases. These tokens do not need to
be associated with nance but can also be used in
combination with hobbies. For example, collecting
NFT trading cards (e.g., CryptoKitties and Bored
Apes), enabling fan interaction in sports (e.g., NBA
Top Shot NFTs and Socios Fan Tokens) or even rep-
resenting forms of ownership.
Another interesting opportunity to use DeFi assets
for nancing purposes comprises “liquidity min-
ing”. Liquidity mining is tightly connected to trad-
ing on DEXes. As we described in Section 3, op-
posed to TradFi exchanges, DEXes have no central
intermediary that acts as market maker by main-
taining an order book. Instead, they have to rely
on liquidity providers that provide liquidity for cer-
tain asset pairs to DEX liquidity pools, which in
turn then act as market makers. Liquidity providers
enable AMM DEXes by providing liquidity to the
respective liquidity pool (asset pairs) in return for a
share of the total trading fees that the DEX earns
on every swap. The share can be determined, for
2Semi-fungible tokens can change their fungibility status
between non-fungible and fungible during their life cycle.
Decentralized Finance | 28
4 Potentials
instance, by utility or governance tokens received
for supplying liquidity. This process is also known
as liquidity mining and a protable way to put capi-
tal to efcient use in DeFi. Supplying funds to lend-
ing pools works analogously by supplying an asset
to its respective pool, where it gets loaned out for
a small fee that then gets distributed amongst the
suppliers of the lending protocol as means of a
reward. Many lending protocols also incentivize
lending and borrowing by subsidizing the rates
with an additional distribution of the protocol to-
ken. In contrast to liquidity providers for AMMs,
liquidity providers for lending protocols do not face
impermanent loss.
Tokens in DeFi-based DApps can not only be used
for this specic application, but can be freely
transferred to many other DApps if they follow
one of the common standards (e.g., ERC 20 on
Ethereum) (Cousaert et al., 2022). This mechanism
is, among others, used in yield farming, which is
currently by far the most used practice to invest as-
sets in DeFi, where DeFi’s composability enables the
usage of tokens across multiple layers of DApps,
resulting in multiple yield sources. This compos-
ability is one of the main drivers for the success
of yield farming. Mmoreover, yield farming is a
large contributor to the growth of the DeFi ecosys-
tem (Derviz et al., 2021; Silberholz & Di Wu, 2021;
Wachter et al., 2021).
It is also possible to benet from classic revenue
streams in the cryptocurrency ecosystem by partici-
pating in the network as a validation node. Native
currencies, such as ETH and BTC, originate directly
from the blockchain layer, as they are generated in
the process of the consensus nding as part of the
incentivization mechanism, ensuring the respective
blockchain’s security (e.g., PoW, PoS, etc.). When
having fullled the requirements (e.g., providing
computational power for PoW or locking stake
for PoS), one can participate in the block valida-
tion process, which can also be a protable invest-
ment (Binance, 2022; Vermaak, 2022a). Due to its
origin and the need to use it as a basic payment
currency for the settlement of transactions, native
currencies represent an investment in the overall
performance of the respective DeFi platform. As
the popularity of a blockchain platform increases,
so does the need for transactions, and with it the
demand for native currency and its value (Corbet
et al., 2021). Native tokens can also be of use in
DApps by “shifting” them from the native layer
to the application layer in the course of a wrap-
ping process. Wrapping native assets, e.g., ETH to
WETH, is realized by locking a native cryptocurrency
in a dedicated smart contract and simultaneously
minting the respective amount on the smart con-
tract layer. This process is also an example for split-
ting assets into different functions, as we illustrated
already above with the example of splitting voting
rights from governance tokens. While the native as-
set represents the utility token of the network, i.e.,
as fuel to pay transaction fees, the wrapped version
of this token enables the utilization of the asset for
DeFi applications.
4.3 Fractional Ownership
Ownership in TradFi is a concept of legal possession
and control over an object (tangible or intangible)
that is deemed property of someone or something.
This involves the law and legal system, especially
when determining the status of ownership in case
of a dispute and an authority which certies the
ownership. DeFi is more connected to the concept
of “technical ownership”, enabled by the proof of
ownership based on the blockchain’s immutable
data record and digital signatures (Zetzsche et al.,
2020). A token corresponds to an address on the
blockchain that “owns” tokens until spent. Who-
ever has access to this address – i.e., whoever holds
the corresponding private key – can dispose freely
of this token, resulting in a technical ownership via
blockchain. This mechanism lays the groundwork
for the DeFi ecosystem, making a decentralized -
nancial system possible. DeFi provides accounts on
which value is stored on the settlement layer and
where ownership is veried and transferred by the
rules of the blockchain network. More interesting,
but also signicantly more complex, is tying the
Decentralized Finance | 29
4 Potentials
ownership of off-chain assets to these tokens that
are tradable in DeFi.
The ability to create different types of tokens based
on their level of fungibility allows these tokens to
represent items such as unique artworks, vouchers,
and tickets on the blockchain, which can then be
“owned” by simply storing their digital representa-
tion at the user’s own blockchain address. Because
of the immutable record of the blockchain and its
ownership mechanism, it is possible to check for
the authenticity of the token by creator address.
In this light, the blockchain ensures that the cur-
rent token holder really owns the respective to-
kens (Sunyaev et al., 2021). This is especially inter-
esting for the digital art industry, as digital originals
of artworks are hard to establish because data can
be duplicated and the artworks thus be copied.
NFTs, however, have the potential to enable such
digital originals that can be owned and not dupli-
cated since the ownership track is documented
on the blockchain (Kugler, 2021; McConaghy et
al., 2017). Nonetheless, in this case, the original
creation of an NFT and the certication that this
is in fact the only legitimate tokenization of a spe-
cic real-world asset is a single point of failure and
only works when real-world trust in institutions or
individuals can be transferred to the blockchain
ecosystem (Barbereau et al., 2022a). To this end,
certicate-based digital identities may play a crucial
role (Sedlmeir et al., 2022).
NFTs are also used for decentralized gaming (e.g.,
Ubisoft Quartz), where items earned by playing
can now be owned and traded as tokens on a mar-
ket amongst players instead of just being items
that are rigidly bound to a player’s account (Block-
onomist, 2021). In addition, NFTs offer properties
that could be useful for the ticketing industry by
being a representation of an on-chain ticket with
easily veriable ownership history (Regner et al.,
2019). However, many challenges in the ticket-
ing industry – such as secondary market control –
can arguably not be solved with NFTs alone and
instead require strong identity binding to be en-
forceable (Feulner et al., 2022b).
The concept of fractional ownership can also be
easily realized in DeFi. Ownership is “fractional-
ized” when the underlying asset is split into shares
or other titles. A classic TradFi example would be
the issuance of stock shares for companies or par-
tial ownership of real-estate through several com-
panies or individuals. In the DeFi-space, such an
equal share can be represented by a fungible token.
It represents the partial ownership of the underly-
ing smart contract. This smart contract, in turn, can
be used to represent an asset. These kinds of to-
kens can be traded for value on crypto exchanges,
with their value connected to the company’s suc-
cess, and can often represent voting rights in com-
pany decisions. The associated smart contracts also
offer the opportunity to tokenize assets by incorpo-
rating an asset into the smart contract and subse-
quently creating tokens that represent ownership
of the smart contract and therefore the underlying
asset. The ownership can be sold as a whole, but
smart contracts also offer the opportunity to issue
fungible tokens or NFTs to represent ownership of
fungible or nun-fungible fractions of the tokenized
asset.
Assets that have been tokenized already can be
further fractionalized or conjoined. This is due to
the feature that smart contracts can take over the
role of a token owner. Ownership of an NFT, for
example, can thus be transferred to another smart
contract that releases fungible tokens to fraction-
alize the NFTs it owns (APYSwap, 2021; FundiFi-
nance, 2021). All these features allow for fast and
easy fractionalization, but also the transfer of corre-
sponding partial ownership of digital assets within
the DeFi space.
The ownership mechanisms thus can extend,
support, or maybe even replace legal ownership
through technical ownership, facilitated by crypto-
graphic proofs of ownership based on a decentral-
ized, public ledger. As ownership and possession
are crucial aspects in most industries, DeFi bears
the potential to ease and accelerate the process
of transferring ownership and property (especially
internationally). Smart contracts could reduce the
Decentralized Finance | 30
4 Potentials
bureaucracy involved, particularly, replacing often
lengthy and complex procedures of drafting legal
contracts and documents in form of a transaction.
This transaction includes the ownership-bearing to-
ken that settles instantly, irrevocably, and veriably
on the blockchain (Zetzsche et al., 2020).
4.4 Open Systems and Interfaces
Open systems and interfaces typically refers to
the inherent properties of transparency, modu-
larity, and interoperability of the DeFi ecosystem.
DeFi is mainly enabled by public blockchains, e.g.,
Ethereum, Solana, or Cardano, and allows for the
deployment of individual smart contracts. Since
anyone can deploy smart contracts and create new
services, the development of DeFi is open to the
broad (technically literate) public. Major parts of
DeFi are based on open-source code: smart con-
tract code is even required to be publicly visible
on the blockchain. Otherwise, trustless, replicated
execution would hardly be possible (Schär, 2021).
Although DeFi’s degree of decentralization in terms
of market competition varies on the application
level, the open-source availability and transparency
of the infrastructure layer could help to achieve suf-
cient decentralization in the long run (Schrepel &
Buterin, 2020). The possibility for “copy-paste so-
lutions” prevents the exploitation of monopolies –
for instance, by raising fees – since the opportunity
of just copying the code and deploying the same
service with lower fees always exists. This leads
to competition inherently originating from DeFi’s
foundation, which drives innovation of new appli-
cations. Hence, this can be viewed as a good way
to enforce antitrust by technological means and
help to address antitrust issues. In this light, DeFi’s
infrastructure on which the protocols are stored
and executed can be considered as shared “public
good” that counters infrastructure monopolies.
Nonetheless, considering today’s market domi-
nance of user interfaces like Metamask or CEXes
like Coinbase, where the core software is not smart
contract based, it remains a question whether
there are signicant improvements in decentral-
ization compared to TradFi (see also Section 5).
In any case, decentralization on DeFi markets is
rarely enforced at all cost. Similar to how antitrust
laws accept the outcome of “healthy” centraliza-
tion through competition, the DeFi community
accepts centralization if it is an outcome of market
competition, for example, when a product has an
advantage over the products of competitors.3For
instance, despite the transparency of smart con-
tract code, user interfaces often remain proprietary
and can, therefore, exhibit some degree of user
lock-in. In other cases, incumbent exchanges may
have a signicant competitive advantage when
they have reached a certain amount of liquidity.
Overall, this open ecosystem can make partici-
pating in the markets of DeFi as an enterprise for
nancial services a worthwhile endeavor, since
it presents a leveled battleground for competing
products. In addition, it offers a fruitful ground for
innovations, which can be for the common good of
the enterprise and its customers.
For developing DApps in DeFi, there are API
providers such as Infura, which offer access to
nodes on the respective blockchain network or pro-
vide test nets. In combination with other DApps’
APIs (e.g., the Compound API and the UniSwap
API), this allows developers to create new DeFi
applications on an already existing backend or to
develop their own backend smart contracts. Due
to the modularity of the protocols and applications,
companies can also provide entirely new services
by combining already existing services in a useful
manner. For example, yield aggregators combine
different lending, liquidity, and staking pools.
The open-source development in DeFi naturally also
corresponds to the auditability of the whole ecosys-
tem. Transactions and smart contract protocol code
are published transparently in the P2P network
and can be viewed by everyone4. In addition, there
is the potential of easing and partly automating
processes like taxation and auditing by integrat-
ing them into DeFi, which are often regarded intri-
cate and lengthy processes in TradFi (Bennett et al.,
3See DeFi DApp dominance.
4For example, see Etherscan.
Decentralized Finance | 31
4 Potentials
2020). On the other hand, public visibility of code
also allows attackers to nd and exploit vulnerabili-
ties more easily.
The programmability and modularity of DeFi could
also inuence the traditional nancial sectors with
different degrees of modication of DeFi-native
protocols. A direct usage of DeFi protocols could
be possible where banks would conduct their own
business operations on DeFi platforms. In addition,
they could act as intermediaries between their cus-
tomers and DeFi protocols, therefore, integrating
DeFi directly into their business models. Another
implication of DeFi includes a need for its inherent
programmability, automatability, and modularity.
This does not have to result in banks fully integrat-
ing DeFi protocols into their service offering, but
could initiate a change in banking business mod-
els holistically. In order to stay competitive with
DeFi systems, banks could offer APIs that are more
versatile and allow the user to automate its inter-
action with the bank and its services. In order to
achieve this, banks might take existing DeFi proto-
cols and transfer them to an open or permissioned
systems, which could be managed by the bank or a
consortium of banks. Another possibility would be
for banks to program their own application or ad-
just their services to facilitate the programmability.
No matter whether banks integrate DeFi protocols
directly into their system or just change the acces-
sibility and programmability of their services, DeFi
could be a driver of innovation in TradFi.
4.5 Catalyst for New Ecosystems
As shown, DeFi offers great potential for the future
of nance and will potentially affect the process of
how individuals and businesses engage in nancial
services. In this view, DeFi can be a catalyst for the
creation of a new ecosystem in which DeFi itself is
the main provider of decentralized nancial services
or provides the nancial infrastructure for other
ecosystems.
Building a bridge between TradFi and DeFi will ar-
guably play a vital role in the further development
of nance (Derviz et al., 2021; Lockl & Stoetzer,
2021). Thus, creating such points of convergence
that make moving between the two paradigms of
nance convenient for users and compliant with
regulations, may offer new business opportunities
and allow DeFi to overcome some major challenges
(see Section 5). This new nancial service ecosys-
tem at the intersection is also known as centralized
decentralized nance (CeDeFi) (Coinmarketcap,
2022a). In addition, CEXes offer on- and off-ramps
from TradFi to DeFi and vice-versa, and as such
they are an obvious point for initiating some mo-
mentum of convergence (Qin et al., 2021a). Most
of the big CEXes also started offering services tai-
lored for institutional investors.5CEX are often
licensed in multiple jurisdictions in which they pro-
vide services. For example, these companies may
be registered as money service businesses with
Financial Crimes Enforcement Network (FinCEN)
in the US or the German Federal Financial Super-
visory Authority (BaFin) and need to comply with
AML and CFT regulations. Furthermore, there are
blockchain forensics companies like Chainalysis
and CipherTrace that offer services to crypto busi-
nesses, institutional investors, and governments (Bi-
nance, 2021). Similar to exchanges, DeFi appli-
cations try to become more attractive for institu-
tional investors (e.g., Aave Pro) (101Blockchains,
2021). Considering the Protocol Sink Thesis (see
Section 1), this may offer the opportunity for a new
ecosystem of institutionally embedded nancial
services built on DeFi protocols. These develop-
ments towards the convergence of DeFi and TradFi
could offer a common good for both approaches
to nancial systems (Derviz et al., 2021; Lockl &
Stoetzer, 2021; Meegan & Koens, 2021).
In addition to impacting the nancial service in-
dustry directly, DeFi could be a catalyst for many
more industries by providing a commonly accepted
infrastructure for enabling a decentralized gov-
ernance of digital platforms using DAOs (Wright,
2021). Thus, DeFi may facilitate uid organizations
and the emergence of new forms of business en-
tities (Schirrmacher et al., 2021). Prominent exam-
5For example, see Binance,Coinbase, or Kraken.
Decentralized Finance | 32
4 Potentials
ples for this is BisqDAO, which is a DAO operating
and governing the Bisq DEX on top of Bitcoin. In
addition, the DAI stablecoin ecosystem managed
by MakerDAO on top of Ethereum falls into this
category. These constructs are often not registered
as companies or legal entities. In fact, DAOs con-
sist of a variety of smart contracts that are required
for their business on-chain and smart contracts for
executing decentralized governance (Barbereau et
al., 2022b). These entities enable broadly accessi-
ble digital and transparent cooperation for various
purposes, such as (fractional) ownership and man-
aging complex nancial service operations (Wright,
2021). However, as DAOs and DeFi are relatively
new developments that come along with regula-
tory uncertainty, the convergence of TradFi and
DeFi can be achieved by, for example, registering
the DAO as a legal entity (Mienert, 2021). Indeed,
there are already some DAOs that are legally reg-
istered entities, such as BlocksDAO and American
CryptoFed DAO.6
Furthermore, the fragmentation of TradFi struggles
to provide a solution for a particular challenge in
markets, known as “tragedy of the commons”:
internalizing and pricing negative externalities (In-
ternational Monetary Fund, 2020). This problem
often needs to be corrected later on by govern-
ments via taxation or contingencies. Carbon diox-
ide emissions are such an externality, because the
“cost of pollution” is typically not inherently priced
into products. If tackled by contingencies, carbon
dioxide emissions are regulated by a central author-
ity that imposes a maximum of carbon emissions
via distribution of carbon certicates. These certi-
cates are tradable and offer companies that have
not used up their contingency the option to earn
money by selling them on a carbon credit mar-
ket, while providing others whose needs exceed
their contingency to obtain more certicates (Ger-
man Federal Government, 2020). In TradFi, there
are unsolved issues regarding greenwashing, frag-
mented markets, and double spending of certi-
cates (Miltenberger et al., 2021; Sedlmeir et al.,
6For reference, see Blocks DAO LLC and American
CryptoFed DAO LLC.
2021c). DeFi, with its interoperable and transpar-
ent open-source infrastructure, hereby may pro-
vide opportunities to enable envisioned carbon
credit markets by means of NFTs as carbon cer-
ticates (Khan & Ahmad, 2022). In this context,
uniting various stakeholders on a common neutral
platform may help to resolve issues arising from
system boundaries. For instance, while carbon cer-
ticates are used for the compliance carbon market
(i.e., required by law), KlimaDAO engages in the
voluntary carbon market where carbon offsets are
traded. Carbon offsets are produced when car-
bon dioxide emission is reduced, and as such can
be tokenized and made tradable by carbon offset
credits to offset produced emissions (Carbon Offset
Guide, 2022). KlimaDAO backs their interoperable
and fungible “Klima-token” with these offset cred-
its, and thus integrates the negative externalities
directly into an alternative currency. In addition, Kli-
maDAO incoproates it into DeFi markets, which is
envisioned to be a promising way to internalize the
negative externality of carbon emission (D. B. Chen
et al., 2019; KlimaDAO, 2022). On the other hand,
as we already indicated in Section 3 and as we will
further elaborate on in Section 5, the feed-in of
reliable information to create tokenized represen-
tations of emissions will unlikely be solved through
a DeFi-powered approach. Also, the challenge to
make large international stakeholders participate
despite obvious nancial obligations will be difcult
to achieve even with a DeFi-based approach.
Eventually, DeFi comprises the potential of creating
an integrative virtual world, also often referred to
as the “Metaverse”. The Metaverse is expected to
be the next mega-phase of the internet by merging
physical, augmented, and virtual reality in a shared
online space in which users can interact with
each other and software applications in a three-
dimensional virtual space (Haihan et al., 2021). The
goal is to provide a fully edged economy that of-
fers unprecedented interoperability. This means
that users can take their avatars and items from
one place in the Metaverse to another without any
frictions, no matter who runs that particular plat-
form (Ball, 2021). DeFi might enable this embod-
Decentralized Finance | 33
4 Potentials
ied internet to be independent of centralized plat-
forms and software providers, as DeFi-based tokens
and other possibilities may enable the operation
of the metaverse in a decentralized way (Newton,
2021; Ning et al., 2021). For example, NFTs could
be used to provide dedicated property rights in in-
frastructures driven by interactive and intelligent
avatars. This means that NFTs-based avatars may
be able to represent interactive media objects with
personality traits and preferences while providing
real-time interaction capabilities (Lau, 2022).
Decentralized Finance | 34
Challenges
5
5 Challenges
5 Challenges
Although, DeFi has the potential to improve ex-
isting or facilitate novel and disruptive nancial
products and services, it is still in its infancy and
therefore faces great challenges. The emerging
ecosystem is highly vulnerable from a technological,
nancial, and regulatory perspective. It remains an
open question whether DeFi will overcome current
challenges and evolve into a mature ecosystem that
can be benecial to the economy, businesses, and
society. The following section highlights the main
risks and challenges that DeFi is currently facing. It
also suggests potential or pursued approaches to
address these problems.
5.1 Technical Risks and Security Con-
cerns
Most importantly, DeFi needs to address several
technical and particularly security concerns that
are closely related to its layered architecture and
infrastructure. Technical risks are one of the most
fundamental issues and endanger the entire DeFi
ecosystem if not addressed properly.
As DeFi is an open and permissionless environ-
ment, everybody can deploy their smart contracts.
Consequently, the quality of protocols might dif-
fer substantially between different services. Even
when smart contracts have been tested and quality-
assessed, experience shows that there is always the
possibility of errors and bugs in the code, even
in smart contracts of big DeFi services, as illus-
trated by the infamous “DAO hack”. This hack
exploited a coding error that affected the wallet
smart contract of the DAO. In detail, when ex-
ecuting the split function of the DAO in a rst
step, the ETH was withdrawn and only in a sec-
ond step the internal balance was updated accord-
ingly (Daian, 2016; Dhillon et al., 2017). In 2016,
this aw allowed a hacker to siphon off multi-
ples of the initial deposited funds by recursive call
exploits.73,641,694 ETH (approximately 14 %
of all ETH in circulation at the time) were stolen,
7See Open letter of the attacker.
which ultimately led to a hardfork of the Ethereum
blockchain by excluding the malicious transac-
tions (Cryptopedia, 2022; U.S. Securities and Ex-
change Commission, 2017). Another severe ex-
ample of a hack affecting wallet smart contracts
is represented by the recent hack of the cross-
chain network “Poly Network”, in which approx.
USD 600 million (value in cryptocurrencies) were
stolen by gaining control over the wallet smart con-
tracts through awed code (Gagliardoni, 2021).
However, in this example, several blockchains were
attacked in a cross-chain network, which is one of
the reasons why the attack could not be reverted,
like in the case of the DAO hack. Yet, it is not clear
whether a hard fork would be accepted even on a
single major chain nowadays. There are a plethora
of examples across different DeFi services exhibiting
smart contracts aws and bugs that have been ex-
ploited over the years. Hence, loopholes and aws
in code pose a real, costly, and persistent risk in the
DeFi space.8
Another security-related aspect is end users’ cryp-
tographic key management. As funds are stored
on the blockchain and are only accessible by the
corresponding private key, the access to these
keys should be well secured. There are two main
categories of wallets: custodial wallets and non-
custodial wallets. In non-custodial wallets, end-
user control their private keys. In custodial wallets,
a third party manages the private key and main-
tains account balances of the end-users. End-users
typically authenticate with such services through
usernames and passwords. Typical custodial wal-
lets are accounts at a CEX, which manage a lot of
funds, making them an attractive target for attacks
(Merkle Science, 2019; Song, 2017). CEX wallet se-
curity is an important step towards minimizing risks
for a signicant amount of funds in DeFi, which
needs yet to be sufciently addressed (Huili et al.,
2021; Suga et al., 2020). However, custodial wal-
lets provide access to funds in case of a forgotten
password. In contrast, users storing their private
keys by themselves are independent of centralized
8For further information, see Balancer attack,Bisq attack
and bZx attack.
Decentralized Finance | 36
5 Challenges
service providers. Noteworthy, these users take the
responsibility for their keys, implying much higher
risk in case of losing access to the wallet and funds
become forever inaccessible (CBC/Radio-Canada,
2021).
Being unable to rescue funds is a common risk
in DeFi due to its decentralization, which leaves
no single authority that could possibly reorganize
the database to rescue funds. The reorganization
needs to be decided in a complicated process by
the whole network and often ends in a fork of the
blockchain, since not everyone agrees, as in the
example of Ethereum and Ethereum Classic. In ad-
dition, DeFi comprises an adversarial environment
and even transactions aiming to rescue threatened
funds can be frontrunned (typically by automated
bots) and the funds still stolen (Robinson & Kon-
stantopoulos, 2020; Werner et al., 2021). Even-
tually, the transparency of the blockchain is only
useful to a certain degree for tracing attackers. The
DeFi ecosystem provides sophisticated services such
as mixers, e.g., Tornado Cash, or other anonymity-
enhancing tools to obfuscate the origin of transac-
tions (see Subsection 5.4).
DeFi is also exposed to “ashloan attacks” (Ver-
maak, 2022b). As explained in Section 2, primar-
ily, ashloans are not meant as a means of at-
tack, but rather to carry out trades more efciently.
Nonetheless, they can represent a tool for attackers
to reduce the entry barriers for conducting attacks
on smart contracts to which they would be vulner-
able even without involvement of ashloans, e.g.,
oracle attacks, pump and arbitrage, bug exploits,
or frontrunning (Cao et al., 2021; Gudgeon et al.,
2020a). As a tool for attacks, ashloans provide
two important features: First, they are atomic, i.e.,
they execute a series of transactions that cannot be
interrupted. Second, the money that one has to in-
put is reduced to the ashloan’s service fee, which
in turn provides the necessary amount of funds to
conduct the attack. Overall, it is observable that
oashloans allow attacks to be more protable and
less risky (Qin et al., 2020; L. Zhou et al., 2021).
Since ashloans are a tool for particular purposes,
such as arbitrage, they are a double-edged sword
in DeFi. However, DeFi services can protect them-
selves from being attacked through ash loans,
e.g., by prohibiting ashloan functionality or con-
sidering potential attack vectors and implementing
measures to eliminate them, such as a maximum
ashloan amount (Gudgeon et al., 2020a; Qin et
al., 2020).
5.2 Scalability Issues
Scalability issues have a direct impact on the DeFi
ecosystem. Most DeFi platforms can only process a
few transactions per second, e.g., approximately
15 tx/s on Ethereum. In times of high through-
put, this leads to congestion and, consequently,
higher transaction conrmation latencies. Specif-
ically for small investments, high transaction fees
could make DeFi’s declared goal of improving -
nancial inclusion unattainable. Further, many DeFi
transactions that are appealing for institutional in-
vestors are more complex than a simple payment
and therefore can be prohibitively expensive. To
mitigate the risk of being frontrunned or to avoid
large slippage in AMMs that would make a trade
less favorable, large trades often need to be split
into many smaller trades distributed over a larger
period of time. This splitting further increases scal-
ability requirements, transaction fees, and latency
concerns. However, there are several approaches
to address scalability challenges:
• Move the application to another blockchain
that does not prioritize decentralization. By
demanding high-performance hardware and
high bandwidth, these systems can reach a
much higher throughput and sub-second
latencies (Sedlmeir et al., 2021a). A popu-
lar example is Solana. However, such sys-
tems are also more centralized and empiri-
cally seem to have frequent issues with net-
working incidents and denial of service at-
tacks (Reguerra, 2022). Often, moving to
other blockchains comes along with trade-
offs in terms of throughput, transaction fees,
latency, and decentralization. In addition, it
Decentralized Finance | 37
5 Challenges
requires creating bridges to other DeFi plat-
forms like Ethereum. Bridges are needed so
to exchange assets cross-chain and leverage
liquidity of established DeFi platforms. How-
ever, this bears considerable security risks, as
bridges are complex and, thus, error-prone.
Hackers can target the bridge smart contracts
on either side. They can also directly attack
the consensus on the more vulnerable chain
involved, as for example, the recent Poly Net-
work hack illustrates (Gagliardoni, 2021).
• Increasing the performance of the base layer
by optimizations of computation and storage
costs and by introducing scalable side-chains.
In this view, concepts like sharding reduce the
degree of redundancy in transaction storage
and execution. For example, Ethereum 2.0
will presumably have 64 shards for data avail-
ability, which helps to increase the through-
put by around the same factor (Ethereum
Foundation, 2021). Since sharding carries a
tradeoff in terms of the degree of redundancy
and, thus, cross-checks on a blockchain, the
number of shards needs to remain rather lim-
ited. Therefor, shards can only add a small
factor in terms of throughput.
• Implementing so-called ”layer two” (L2) so-
lutions to increase transaction speed and
scalability. L2 systems do not store or pro-
cess all relevant information on the under-
lying blockchain and, therefore, reduce the
overall capacity requirements of the DApps
connected to the L2. Nonetheless, the L2 solu-
tions are designed in a way that makes them
benet from full integrity and availability guar-
antees of the underlying blockchain (Mono-
lith, 2021). The most popular variant are
rollups that use domain-specic optimizations
to reduce the required storage. In addition,
rollups take some of the transaction-related
information and a major share of the com-
putational effort off-chain. On the one hand,
there are optimistic rollups where presum-
ably “wrong” computation can be challenged
and punished on-chain; this approach is con-
ceptually easier but also implies longer laten-
cies (typically, a week) or additional services
(liquidity providers that accept a small risk)
for withdrawals. Consequently, liquidity is
used less efciently. On the other hand, zk-
rollups prove the correctness of the off-chain
accounting through cryptographic proofs,
usually ZKPs (Gluchowski, 2019). This short
(“succinct”) proof is then checked by a smart
contract. This approach is more complex, but
an increasing number of initiatives are suc-
cessfully launching zk-rollups that cover in-
creasingly complex transactions: While early
zk-rollups only supported payments in the
native currency, more recent implementa-
tions cover transfers of ERC-20 tokens. There
is ongoing work to support arbitrary smart
contract functionality. Both optimistic and
zk-rollups face centralized operations, but pre-
vent the need for centralized trust. The secu-
rity of funds is as good as the security of the
blockchain settlement layer, and withdrawals
can be made even if the operator ceases to
provide its service. With rollups, depending
on the required condence in data availability
guarantees, throughput can be increased by a
factor of several hundred to tens of thousands
of the base throughput (Schaffner, 2021). At
present, various rollups are already live on the
public Ethereum blockchain; and while they
are not yet operating at their capacity limit,
they already offer reductions in transaction
fees by one to three orders of magnitude.
Thus, rollups have experienced an increasing
rate of adoption, lately.
5.3 Illiquidity
Providing sufcient liquidity poses a major chal-
lenge for all kinds of nancial markets. These mar-
kets play a key role in ensuring their usability and
efciency. While most traditional markets solve this
problem by having centralized intermediaries act-
ing as counterparties or market makers, the DeFi
ecosystem needs to rely on other mechanisms to
attract liquidity. Liquidity ensures the functionality
Decentralized Finance | 38
5 Challenges
of and enables further adoption in DeFi, especially
from institutions.
In general, liquidity plays a particularly important
role for exchanges, as their usability and the vol-
ume of trades that can be settled depending on
the available liquidity on the exchange and in the
market. Traditional exchanges and brokers hence
use market makers that ensure sufcient liquidity
and act as a counterparty for incoming trades to
provide users with fast trade execution and low
spread. Since DeFi, by its nature, lacks these cen-
tralized parties, most trades are executed through
AMMs. In addition, DeFi protocols provide instanta-
neous trade execution owing to the existing liquid-
ity pool acting as a counterparty. Thus, the spread
that is paid by users mainly depends on the ratio
between the trade size and the size of the liquid-
ity pool (Pourpouneh et al., 2020). This is why the
size of liquidity is one of the most important crite-
ria in the competition among AMMs: the higher
the liquidity, the lower the trader’s spread. Further-
more, liquidity is not only an important competitive
factor for AMMs but also for stablecoins. Since
the goal of a stablecoin is to maintain its value, a
big spread, especially when trading one stablecoin
against another, can be very inefcient. Conse-
quently, large amounts of liquidity can also act as
a (short-termed) mechanism for stablecoins to hold
their peg.
Moreover, especially in DeFi, liquidity is not only
important for trading efciency but also for the
functionality of other applications such as lending
protocols. To ensure the usability and efciency
of lending protocols, sufcient liquidity on both
the supply and the demand side is required. A lack
of demand results in low interest rates for suppli-
ers, while a lack of supply can result in suppliers
not being able to withdraw funds (Gudgeon et al.,
2020b).
While some risks are isolated and only affect one
DeFi application, others can spread through dif-
ferent ecosystems although limited to one DeFi
application (e.g., the hack of the cross-chain net-
work). Specically, wrapping and collateralization
processes can amplify risks through liquidation pro-
cesses that occur in the case of an incident, or can
make risks more difcult to trace. Similar to how
the cross-chain network acts as an oracle between
different blockchains, there are oracles that inter-
mediate between different DeFi applications on
one blockchain (e.g., AMMs as price oracles for
other protocols). Exploits of these channels be-
tween different protocols already exist, where aws
in the code of one protocol are exploited to attack
another that relies on its functionality (e.g., bZx
pump and arbitrage attack, the bZx oracle attack,
the balancer attack, etc.) (Cao et al., 2021).
Another dimension of this “composability problem”
becomes apparent when considering that these
protocols are not only connected by their functions
for each other but also by their assets (e.g. through
wrapping or relying on collateral). For example, if
a stablecoin which is used in a variety of DeFi pro-
tocols fails to maintain its peg and faces a drop in
value, all linked protocols that are affected likewise.
An example for this may be a chain of liquidations
spanning throughout the DeFi ecosystem, resulting
in undercollateralization of lending pools (Gudgeon
et al., 2020a; Meegan & Koens, 2021). Channels
and mechanisms like wrapping through liquidity
mining and yield farming can therefore help to
spread the risk to various DeFi applications and
platforms, leading to the downfall of the whole
DeFi ecosystem. This is often referred to as system-
atic risk. For example, the initial de-peg of the UST
stablecoin and the downfall of the Terra ecosystem
lead to exchange rate losses of other currencies,
liquidations, and illiquidity of multiple DeFi service
institutions. The UST example provides a foretaste
on how these inhibit risks can affect the entire DeFi
ecosystem (CoinDesk, 2022a, 2022b, 2022c). In
addition, problems can arise from code aws that
is typically copied and used as building block for
new DeFi services in an open source environment
(e.g., Sushi Swap as a fork of Uni Swap). Hence,
aws in the original code would be duplicated mul-
tiple times, contributing to destabilization and in-
creasing systematic risks in DeFi (Schär, 2021).
Decentralized Finance | 39
5 Challenges
Additionally, there is also a systemic risk in DeFi’s
infrastructure layer, i.e., in case the blockchain is
compromised (Schär, 2021). Each risk that men-
aces the integrity and functionality of the settle-
ment layer endangers the functionality of the DeFi
services on top of it, thereby, leveraging systemic
and creating systematic risk. For example, exploit-
ing or breaking the consensus mechanism using
sophisticated technology like quantum computing
or a centralized block production can facilitate a
51 % attack on the network (Aponte-Novoa et al.,
2021; Fedorov et al., 2018; Guggenberger et al.,
2021b).
It is important to recognize the interplay between
these technological and economical risks: To pre-
vent illiquidity in protocols, it may be necessary
to further increase incentives to supply liquidity.
These incentives might have detrimental effects on
currency-based consensus mechanisms, e.g., PoS,
and thus undermine the security of the blockchain
(ConsenSys, 2020; Stevens, 2020). Yet, nding a
healthy balance in this trade-off represents a crucial
challenge.
5.4 Transparency vs. Privacy
As we described in Section 2, one of the funda-
mental properties of a blockchain is the redundant
storage and execution of transactions. Besides pro-
viding transparency and trust in the correct process-
ing of transactions, this property implies two major
challenges.
The publicly visible transaction history impairs in-
dividuals and organizations, as sensitive informa-
tion is stored transparently (Sedlmeir et al., 2022).
For example, CEXes can use metadata based on
KYC processes, patterns, habits, and business in-
formation to establish a link to a person despite
the pseudonymization that most blockchains of-
fer (Biryukov & Tikhomirov, 2019; Hickey & Harri-
gan, 2021). This also bears the risk of breaching
data protection regulations (e.g., the General Data
Protection Regulation (GDPR)) for personal data,
or anti-trust regulations for business data (Rieger
et al., 2019; Schellinger et al., 2022b; Sedlmeir et
al., 2022). For example, competitors can observe
an organizations’ nancial transactions and risks
involved when acting on a DeFi platform. These
challenges can generally be addressed using cryp-
tographic privacy-enhancing technologies like ZKPs.
ZKPs are already being used for anonymizing trans-
actions, e.g., in the Ethereum-based mixer Tornado
Cash (Sun et al., 2021). Consequently, blockchain-
based applications, such as data markets, speci-
cally require privacy-enhancing technologies (Mu-
nilla Garrido et al., 2021).
Apart from privacy issues, there are direct economic
challenges that are caused by the transparent ex-
ecution of transactions. Through the initial distri-
bution of all transaction information in the mem-
pool (see section 2), block-producing nodes can
automatically check whether they can make ad-
ditional prot from inserting own transactions in
front or thereafter (Eskandari et al., 2019). This
phenomenon is called ”extractable value” and one
of the most popular examples are frontrunning at-
tacks. For example, an arbitrage trader identies
a large transaction order on a DEX that is to con-
siderably increase the price of a specic token and
can frontrun by initiating a transaction in which
the block producer buys the same asset. Simultane-
ously, the arbitrageur sells the asset after the “big”
transaction, receiving a prot in the form of the
margin. These ”sandwich attacks” have been ob-
served frequently in DeFi (Werner et al., 2021). Not
surprisingly, they are legally forbidden for brokers
in TradFi (Financial Industry Regulatory Authority,
2013). Usually, these attacks lead to a competitive
game of transaction fee bidding between the at-
tackers, which may render the attack unprotable
if there is a large amount of attackers participating
(Qin et al., 2021b). However, if the extractable rev-
enues are higher than the ”normal” block reward,
there are incentives for block producers to benet
from this situation. Block producers can circumvent
the fee bidding by just including their transaction in
front of the target transaction, resulting in a com-
petitive game of reorganizing the blockchain. Ef-
fectively, frontrunning weakens the consensus and,
Decentralized Finance | 40
5 Challenges
thus, represents a systemic risk (Daian et al., 2020;
Qin et al., 2021b). Several approaches to solving
this problem are currently being explored. One ap-
proach, brought by organizations like Flashbots.
This company aims to reduce information asymme-
tries through tools that users can use to check if
and to what extent they can be frontrun. An alter-
native is the conditional operation of transactions
by putting restrictions (“slippage tolerance”) on
the market price clients are willing to pay in a DEX
transaction. While both of these approaches have
limitations regarding the generality of transactions,
they offer a remedy to these “value extraction at-
tacks” (Qin et al., 2021b).
“Gradual decryption” is a viable solution to miner
extractable value (MEV) and represents a rather
generic approach in systems where a set of val-
idators (potentially pre-selected in PoW or PoS)
is responsible for consensus: transactions are en-
crypted with an aggregate epoch public key in the
mempool and also remain encrypted during the
block production process. They can only be de-
crypted gradually after being committed on the
blockchain and partially conrmed (and partly de-
crypted) by validators, so the block producer can-
not see the transaction details and is unable to de-
velop a way to “sandwich” the transaction (Bebel
& Ojha, 2022; Kursawe, 2021).
Despite the fact that many transactions can be
traced back to an individual or organization (e.g.,
companies like Chainalysis offer such services),
there is also a need to address AML and CFT reg-
ulation; specically when privacy is enhanced as a
response to the previously mentioned challenges.
DeFi and alternative digital assets in general will
also require audit trails so that organizations can
prove compliance with regulation or disclosure of
all transactions in their tax declaration. Overall, we
see two major implications of this tension between
privacy considerations on the one hand and regu-
latory demand for transparency on the other hand:
There is a need for “selective privacy”, where only
the minimum information needs to be disclosed for
regulatory compliance is stored on-chain. In this
light, ZKPs can prove the legitimacy of transactions
while only selectively disclosing inputs and outputs
or properties derived from them. Therefore, ZKPs
can be a viable cryptographic tool for achieving se-
lective privacy (Barbereau et al., 2022a). Moreover,
for interactions with real-world identities from the
regulated domain, a certicate-based digital ID will
need to interact with on-chain smart contracts to
prove legal age or an authority’s conrmation of
approval of a certain transaction. For this purpose,
again, selective privacy is crucial, for example, to
hide the identity of the individual or organization
that proves the possession of a certicate attest-
ing the legality of the transaction. In this context,
certicate-based digital identities with predicate
proofs through zero-knowledge technology may be
particularly helpful (Sedlmeir et al., 2021b).
5.5 Lack of Harmonized Regulation
Regulatory uncertainty refers to a set of problems
resulting from the circumstance that many existing
nancial regulations cannot just be transferred
from existing nancial systems and products to this
new evolving ecosystem, but instead adjustments
have to be made, or new regulations have to be
elaborated from scratch. Indeed, many illegitimate
activities that have been banned from nancial
markets through regulation in the last centuries
can now be seen in DeFi as it catches up to the
century-long development of traditional nancial
markets.
There are already many proposals and laws aimed
at regulating virtual assets in different jurisdictions
that also concern DeFi services. These legislations
can be divided into two categories. The rst cate-
gory includes supranational law, such as markets
in crypto assets (MiCA) and anti-money launder-
ing directives (AMLDs) of the European Union (EU),
Crypto-Asset Reporting Framework (CARF) of the
Organisation for Economic Co-operation and De-
velopment (OECD), and guidelines of the Financial
Action Task Force on Money Laundering (FATF),
that instituted by transnational organizations. The
second category are national laws, such as differ-
Decentralized Finance | 41
5 Challenges
ent tax (e.g., income tax and value-added tax) and
supervisory laws (e.g., banking acts and payment
services acts). Often, the supranational proposals
are adopted in the individual member countries
by incorporating them into national laws. Yet, the
implementation might vary between different coun-
tries.
For example, the FATF is an institution that sets
international standards aiming to ght money-
laundering, terrorist nancing, wash trading, and
other market manipulations in virtual asset mar-
kets (Financial Action Task Force, 2022). Every legal
or natural person, that offers services that involve
virtual assets, is thereby considered a virtual asset
service provider (VASP). Even the technology (e.g.,
smart contracts, DAOs, or DApps) and everyone
that is involved with this “intermediary technol-
ogy” (e.g., owners, operators, and founders) may
be classied as VASP (Financial Action Task Force,
2021). The classication requires reporting KYC
and other information to national authorities, the
authorization by licensing and registering its service
within every of its jurisdictions, and further com-
pliance with regulations like the “traveler’s rule”9.
Although the guidance of the FATF does not ex-
hibit a legally-binding character, it is expected that
a multitude of nations will adopt versions of the
proposal in their national laws (Ferreira, 2021).
The implementation of these proposals and the re-
sponsible authority depends on the type of token.
For example, businesses issuing security tokens can
be registered with the Securities Exchange Comis-
sion (SEC), while activities concerning commodity-
and future-like tokens may be registered with the
Commodity Futures Trading Commission (CFTC),
whereas stablecoin businesses may be overseen by
the FinCEN (U.S. Securities and Exchange Commis-
sion, 2019). A similar distinction can be observed
with MiCA (European Union, 2019). Therefore,
lawmakers and regulators in many cases can ex-
pand existing laws to include new types of nan-
cial service providers by linking them to standards
that apply to traditional nancial institutions. Thus,
9See Guide to the FATF Travel Rule.
some tokens can be designated as direct stock pur-
chases (DSPs) and respective service providers regu-
lated by securities exchange commissions, e.g., the
SEC and Federal Election Commission (FEC) (U.S.
Securities and Exchange Commission, 2022).
However, regulatory obligations can only apply if
the activity, i.e., the credit business, is regulated.
For example, the German Banking Act refers exclu-
sively to the granting of loans in at currencies and
not to the lending of crypto assets. Individuals that
provide loans on dedicated DeFi lending platforms
will probably not be subject to licensing since they
do not know the identity of their counterpart (Auf-
fenberg, 2022). An administrator of the smart con-
tract could, however, be subject to authorization as
a crypto custodian on an individual basis as a result
of the receiving, holding, and managing of crypto
assets. Cryptocurrency custody businesses include
the custody, management, or the safeguarding of
private keys and thus are required to be authorized
by the German nancial supervisor. In this light,
staking providers meet the legal denition by the
German Banking Act of managing crypto assets
for others. Hence, they are subject to authoriza-
tion provided that users delegate their rights to the
staking provider service (Auffenberg, 2021).
Owing to the difculty of overseeing the complex
DeFi system from a regulatory perspective, nancial
institutions like the Financial Stability Board are also
afraid that the intertwined components of DeFi
could introduce new systematic risks (Catalini et
al., 2021). These risks may spill over into the TradFi
sector through the growing inter-connectedness (Fi-
nancial Stability Board, 2022). Beyond systematic
risks, protection of nancial risks and crime has
not yet been implemented in DeFi (Catalini et al.,
2021). As a result and besides technical issues
associated with this enforcement, the currently
fragmented and continuously developing regula-
tory patchwork contributes to DeFi still operating
with minimal KYC, AML, and CFT checks, thereby
exhibiting a signicant decit in compliance. Regu-
lation can only be enforced on centralized parts of
DeFi because identifying and grasping the majority
Decentralized Finance | 42
5 Challenges
of individuals governing such entities is inherently
difcult owing to the pseudonymous and decentral-
ized nature of public blockchains (Schär, 2021). En-
tities that have on- and off-ramp links (e.g., CEXes
or non-custodial stablecoin providers) need to inter-
act with TradFi (e.g., commercial banks) and thus
are required by law to be compliant. In addition,
they need to ensure accountability before being
able to start their businesses operations. Bridging
the gap between DeFi and TradFi by integrating
trusted nancial supervisory bodies on a technical
level to centralized endpoints in DeFi poses a po-
tential solution. For example, the introduction of
central bank digital currencies (CBDCs) as a com-
pliant form of stablecoins (Bank for International
Settlements, 2022; Derviz et al., 2021) or increas-
ing pressure on centralized points, e.g., by demand-
ing admin keys or obtaining voting power (Ushida
& Angel, 2021; Zetzsche et al., 2020) can reduce
regulatory burdens.
Many current laws are not applicable for DeFi ser-
vices. In addition, the simplication of tokens into
three main categories fails to account for the broad
variety of nancial instruments in DeFi (Goforth,
2018; Maia & Vieira dos Santos, 2021). With re-
gard to DeFi-based services, traditional regulation
through laws is also often unfeasible, since the
pseudonymity and decentralization of DeFi of-
ten inhibits the enforcement in case of violations.
Eventually, DeFi services on a public blockchain
are globally accessible and thus stretch over mul-
tiple jurisdictions. The process of complying with
multiple regulation regimes is a costly burden, fur-
ther increasing the risk of regulatory arbitrage, and
escape of service providers towards more decentral-
ized and difcult-to-regulate platforms (Wright &
Meier, 2021).
5.6 Improper Property and Consumer
Protection Laws
Prevailing legal frameworks for rights and claims
(i.e., legal ownership and possession) as well as
for contractual obligations and rights do not suf-
ciently address DeFi’s specic requirements. The
classication in common law systems for personal
property, i.e., things in possession (TIP) and things
in action (TIA), leads to problems, especially regard-
ing cryptocurrencies. They do not classify as TIP
because they are data strings recorded on a public
ledger and cannot be physically possessed. In addi-
tion, they do not classify as TIA, since they do not
represent an entitlement to payment against a le-
gal entity (Bolotaeva et al., 2019). An example for
a TIA is money in a bank account, as it is an enti-
tlement to payment of tangible money against the
bank, while tangible money itself, like banknotes,
classies as a TIP.10 A cryptocurrency which is tech-
nologically owned and possessed by the private
key of the address, hence, is neither considered
TIP nor TIA. The consequence of crypto assets not
being able to be subsumed under one of these cat-
egories is that they are not legally recognized as
personal property. Consequently, legal methods of
protecting property, settling claims of contracts, or
enforcing obligations may not apply (Fox, 2018).
However, although legal uncertainty is still the
dominating status quo, there have been efforts to
reduce this uncertainty, e.g., by Liechtensteins’s
Tokens and Trustworthy Technologies Service
Providers Law (TVTG). The TVTG classies tokens as
a new construct at the intersection of the physical
world and digital rights. A token is dened as “a
piece of information on a TT System which [...] can
represent claims or rights of memberships against
a person, rights to property or other absolute or
relative rights [...]” (Government of the Principality
of Liechtenstein, 2021).11 The token is designated
as a container for rights, which makes various civil
rights and property laws in particular applicable,
i.e., there is now a legal basis for transactions, trad-
ing, ownership or custody (Nägele, 2020). Due
to the uncertainty created by the lack of regula-
tions (and their lack of enforceability), scams and
other illegal activities are still widespread, as it is
difcult for users to distinguish between legitimate
products and scams. In addition, the pseudonymity
of the system helps scammers in this regard. This
10Balance on a custodial wallet represents a TIA against
the custodian.
11TT stands for ”trusted technology”.
Decentralized Finance | 43
5 Challenges
is detrimental to the user-friendliness of DeFi, as
users could face severe losses of their investments
through scams and fraud. The transparency of
smart contracts, which in theory could prevent
most of the scams and attacks, has no substan-
tial effect in practice, as end users typically do not
have the time and knowledge to verify their legit-
imacy. In particular, losses have increased owing
to the growing threat of rug pulls that accounted
for 37 % of all scam revenues in 2021, amounting
to USD 2.8 billion. Rug pulls exploit investors that
purchase the scam project’s token or provide liquid-
ity to a pool of the token on a DEX. The scammers,
which either hold a large percentage of the token
or still have control over the entire liquidity pool,
then dump all their tokens, thereby siphoning the
entire pool (Malwa, 2021). Another widespread
danger for users are phishing attacks that aim at
acquiring the seed phrases of users wallets and
thus obtaining control over the assets in their wal-
let.
With increasing interest in DeFi, criminals are get-
ting smarter in exploiting the system. For example,
the online application Antinalysis allows criminals
to check their own Bitcoin wallets and see whether
they have any sort of association with criminal ac-
tivity. One of the most private cryptocurrency used
for money laundering in ransomware is Monero. It
is estimated that around 10 to 20 % of ransoms
are paid in Monero (Ciphertrace, 2021). At the
same time, an increasing number of marketplaces
that are on the dark web are exclusively accepting
cryptocurrencies.
Considering aforementioned regulatory challenges,
it is important to nd a suitable approach to reg-
ulate DeFi without inhibiting its development. Re-
search on DeFi regulation thus proposes multilat-
eral multi-stakeholder approaches, where different
parties (e.g, regulators, service providers, and users)
of different jurisdictions should be involved in nd-
ing a fair solution to the DeFi regulation dilemma
(Hughes, 2021; Matsuo, 2020; Takanashi, 2020).
5.7 Inconsistent Taxation and Ac-
counting Rules
Due to the authoritative principle, the term “eco-
nomic good” under German tax law is identical
to the term “asset” under German commercial
law. Both terms include not only objects and rights
within the meaning of the German private prop-
erty law, but also actual conditions and possibilities.
These terms thus include cryptocurrency, which
makes taxation and accounting laws applicable to
virtual assets (German Federal Ministry of Finance,
2021). More or less the same applies to other
countries, i.e., the US, where cryptocurrency is de-
clared as property for the sake of tax purposes (U.S.
Internal Revenue Service, 2022). Regarding taxa-
tion of cryptocurrency and gains made in DeFi such
as lending and staking, the tax treatment differs
from country to country. Often there is no clarity
on which category of assets cryptocurrencies be-
long to, on how critical matters such as taxation of
cryptocurrencies gained by hard-forks and staking
are treated, and, overall, if and how current laws
apply to virtual assets (PricewaterhouseCoopers,
2021).
As crypto assets are not a TIA, they cannot be
classied as equity instruments in accounting,
and they are not classied as cash because they
are not regarded as a medium of exchange and
unit of account (International Financial Reporting
Standards Foundation, 2019). According to the
International Financial Reporting Standards (IFRS),
cryptocurrencies, thus, are intangible assets, to be
accounted for under International Accounting Stan-
dard (IAS) 38 (general intangible assets) and IAS 2
(inventory) depending on different kinds of tokens.
The answer to whether asset custody should be re-
ported on or off the balance sheet is not clear. For
entities issuing crypto assets (e.g., through ICOs)
there may also apply different guidelines based
on different kinds of tokens (e.g., IFRS 9 and 15
and IAS 32) (Ernst & Young, 2019; Pricewater-
houseCoopers, 2019). Further, accounting prin-
ciples do not provide clear guidance for reporting
Decentralized Finance | 44
5 Challenges
of the many varieties of crypto assets (Association
of Chartered Certied Accountants, 2022).
5.8 Recentralization
DeFi is based on redundant data storage using
blockchains, thus distributing the responsibility
of maintaining system integrity among multiple par-
ticipants in the network. But this does not directly
imply that crypto assets and DeFi applications are
decentralized at their core. Thus, it is vital to dif-
ferentiate between the degree of decentralization
that is related directly to the blockchain infrastruc-
ture and on-chain distribution of tokens coupled to
DeFi application’s use and governance.
The settlement layer involves two crucial dimen-
sions to be considered to assess the degree of de-
centralization, namely protocol-level and mining-
level decisions. Protocol-level decisions are au-
tomatically made by the set of protocols imple-
mented in the client software, while mining-level
decisions are decoupled from the protocol and
are related to how a new block can be created (P.
Zhou, 2020). The former can be evaluated by the
number of running full nodes and their geographi-
cal distribution. The latter plays a key role in main-
taining blockchain security, thus preventing double-
spending attacks. It also ensures functionality to
avoid censorship of the processing of pending
transactions. To achieve a high degree of decen-
tralization, it is important to distribute and disperse
the power of producing new blocks. The increasing
competition and technological advancement lead
to the emergence of numerous mining pools, ag-
gregating hashing power to validate new blocks.
In the example of Bitcoin, the combined hashrate
for the four largest mining pools (Antpool, Foundry
USA, F2Pool, and ViaBTC) over the past year aggre-
gate over 50 %12 of the hashing power required to
attack the network. In total, there were on average
13,911 reachable full nodes in Bitcoin dispersed
globally (53.4 % unknown, 12.8 % United States,
8.4 % German).13 A recent report further empha-
12See Bitcoin’s hashrate distribution.
13See Bitcoin node distribution and Ethereum node distri-
bution.
sized the strong centralization of public blockchains
and particularly Bitcoin on multiple levels, including
the distribution of hashrate, messaging (concen-
tration on few hosting services, internet service
providers and countries), which can become par-
ticularly problematic owing to unencrypted mes-
saging and the vulnerability of consensus to in-
creased latency or even package loss (Sultanik et
al., 2022).14 For a comprehensive systematic study
of centralization tendencies in cryptocurrencies, we
suggest readers to refer to the taxonomy by Sai et
al. (2021).
In addition, blockchain-based cryptocurrencies,
such as Tether or XRP, have a high degree of cen-
tralization owing to their governing bodies. Thus,
centralized power results , for example, in manip-
ulations scandals, and can negatively affect the
ecosystem as a whole (Grifn & Shams, 2020; U.S.
Securities and Exchange Commission, 2020). In
contrast, PoS-based blockchains, such as Polkadot
or Tezos, seem to be more decentralized, as the
integrity of the network relies on the amount of
validator stakes. However, the degree of decentral-
ization in PoS-based blockchains considerably de-
pends on the distribution of voting weights and the
required hardware components to operate nodes.
The DeFi ecosystem composes applications run by
smart contracts that use proprietary tokens to gov-
ern protocol decisions and thus set the course of
these projects. The governance of DeFi protocols
demands a balance between broad token distri-
bution, encouragement of user activity, and the
alignment of nancial incentives for token hold-
ers, users, and the protocol itself (Jensen et al.,
2021). Against this backdrop, it is imperative to
pay attention to the token ownership distribution
of on-chain DeFi applications.
In addition, the control of the team or the proto-
col over the assets supplied by users plays an im-
portant role. For example, in the context of DeFi
lending protocols, six degrees of decentralization
exist. The degree of control of a project’s team be-
14See assessment of this report.
Decentralized Finance | 45
5 Challenges
hind a protocols can be measured by evaluating
various components, including custody, price feeds,
initiation of margin calls, provision of margin call
liquidity, interest rate determination, and proto-
col development (Kistner, 2019). So far, no DeFi
protocol is truly decentralized. In general, the dis-
tribution of governance tokens among key DeFi
applications shows a high concentration, increas-
ing the risk of aggregated power controlling the
project (Jensen et al., 2021). Moreover, token hold-
ers rarely exercise their voting rights (Barbereau et
al., 2022c). What may be even more critical is the
current design to grant multiple rights combined
and implemented in one token, particularly, eco-
nomic interests in revenues and voting rights. The
combination of these rights makes DeFi protocols
prone to governance attacks. Thus, these rights
should be decoupled from each other to mitigate
risks (Buterin, 2021). To address this issue there are
four potential solutions:
• Limit coin-driven governance to reduce the
vulnerability of the system being compro-
mised by determined attackers. Instead, use
on-chain governance for applications, add
time delays, or allow a more fork-friendly pro-
tocol. However, governance itself needs to
be improved since public good funding, i.e.,
valuable projects without dedicated business
models, is prone to be exploited through bad
decisions.
• Use governance techniques that are not coin-
voting-driven. Rather base weights on alter-
native measures, e.g., on veried accounts
per human, proof of participation in a sys-
tem, or a hybrid version of the former two like
quadratic voting.
• Increase individual responsibility in voting to
break the decision that applies to all. In ad-
dition, align individual decisions to their de-
sired outcomes. For example, coins will be
destroyed in an attack if an individual votes
for the attack.
• Combine aforementioned solutions to move
away from coin voting based decentralized
governance.
Decentralized Finance | 46
Conclusion
6
6 Conclusion
6 Conclusion
In light of the presented arguments, we can con-
clude that DeFi carries great potential as it is built
on a neutral platform. DeFi unites a global pool
of investors, service providers, and developers that
benet from relatively low entry barriers and poten-
tially high network effects, especially compared to
TradFi institutions and services. Potential applica-
tions within the DeFi ecosystem offer a signicant
variety of use cases such as yield farming, insur-
ances, lending and borrowing, collecting and trad-
ing NFTs. Therefore, DeFi provides a technology
stack that adds new features and opportunities in
nance, and moreover, enables the combination of
existing and emerging nancial services and prod-
ucts, making DeFi highly composable.
Nonetheless, there are still various challenges re-
garding DeFi’s technical implementation, regula-
tory uncertainties, and the various intersections of
these elds. Especially to enable mass-adoption
of DeFi, the ecosystem needs to overcome these
challenges to fully unleash its potential. In partic-
ular, it is necessary to assure that participants can
be held accountable to integrate DeFi-based ser-
vices in existing regulation. In addition, solving eco-
nomic constraints like ensuring sufcient liquidity
as well as technological issues especially regard-
ing scalability is crucial. Besides further advances
in blockchain technology, it is imperative to nd a
balance between on-chain and off-chain process-
ing of information and transactions. In this light, it
is important to align the replicated execution with
scalability requirements as well as trade-offs be-
tween transparency, auditability, and privacy. The
spectrum between highly decentralized DeFi ecosys-
tems and more centralized ones allows address-
ing different stakeholders’ and use cases’ require-
ments. Moreover, the differences and interactions
between the public and individuals as well as per-
missionless and permissioned blockchains create an
even broader range of alternatives to choose from
to nd the best t for individual applications and
stakeholders.
DeFi is a new paradigm that may have a strong in-
uence on the future of the nancial sector and
how people interact with it. While DeFi is a highly
innovative space, only the future will tell which of
its new applications will remain. Nonetheless, the
impact that DeFi already has on the TradFi system
is undeniable and cannot be expected to vanish
any time soon. DeFi exhibits issues in the TradFi
sector in an indirect manner by forming a more ef-
cient and trustless system, therefore highlighting
aws and inefciencies in TradFi and promoting
changes to improve them. We believe that DeFi
with its underlying technology and fundamentals
will not remove TradFi, but instead will become a
trustless and decentralized foundation to the ex-
isting nancial sector, following the protocol sink
thesis. Along the way, the two sectors will keep
converging creating a more mature ecosystem with
a more complete regulatory framework. Moreover,
we might see TradFi-based service providers start-
ing to adopt concepts of DeFi or provide customers
with dedicated access to DeFi-based services.
In addition to the inuence on the TradFi sector,
DeFi acts as a catalyst for a broad range of research
and development in blockchain technology. Ad-
vances, for example in zero-knowledge technology,
have been strongly driven by DeFi projects and are
likely to be transferred to other application areas,
e.g., in blockchain-based supply chain manage-
ment. DeFi propelled a high degree of innovation,
but the different dimensions of DeFi still require
thorough research. In this context, the role of DeFi
in the Metaverse might also be a worthwhile en-
deavor for further analysis. The most important
challenges of DeFi, however, involve its complex
technical foundations, the legal environment, eco-
nomic consequences, business opportunities, and
user-friendliness. Like many applications in the area
of blockchain, interdisciplinary research and close
collaboration between academia and practitioners
are key.
Decentralized Finance | 48
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Decentralized Finance | 57
Who we are
Branch Business & Information
Systems Engineering
The Branch Business & Information Systems En-
gineering of Fraunhofer FIT unites the research
areas of Finance and Information Management
in Augsburg and Bayreuth. Its special characteris-
tics include expertise at the interface of nancial
management, information management, and in-
formation systems engineering as well as and the
ability to combine methodical know-how at the
highest scientic level with a customer-, target- and
solution-oriented approach. Currently, our team
consists of about 80 research assistants and more
than 140 student assistants. Our research activities
are thematically bundled in different research areas.
This gives us extensive expertise in different areas
of business informatics and enables us to transfer
timely research results into practical solutions in ap-
plied research projects with numerous companies
from different industries, thus creating long-term
“win-win situations”. Additionally, we are able to
incorporate the knowledge gained into our numer-
ous courses, so that we can provide our students
with theoretically sound and practically relevant
and up-to-date content. Our goal is to synergisti-
cally complement our range of topics with suitable
research areas in the future as well.
Fraunhofer Blockchain Lab
Based on these overarching principles of the
Branch Business & Information Systems Engineer-
ing, the Fraunhofer Blockchain Lab was founded,
which is characterized by the interdisciplinary com-
bination of economic, legal, and technical com-
petencies. The Blockchain Lab designs, develops,
and evaluates innovative solutions and is known
for that far beyond national borders. Together with
numerous partners from business and science, we
work hard to comprehensively investigate the po-
tential of blockchain technology and to make it
accessible. At our location in Bayreuth, we have
been supporting companies and public institutions
in the context of applied research projects as well
as in the development of individual and demand-
oriented solutions in the eld of blockchain tech-
nology since our foundation in 2016. Even though
blockchain technology became known through
its initial application as the basis of the cryptocur-
rency Bitcoin, it quickly became apparent that the
actual potential of the blockchain extends much
further. For example, in addition to business logic,
mapped by so-called smart contracts, digital and
self-managed identities are now also often im-
plemented with the support of the blockchain.
In 2016, we were one of the rst organizations
in Germany to publish a white paper15 in which
we examined the fundamentals, applications and
potential of blockchain technology as well and
the role of intermediaries in various contexts. We
have also received several awards for our work –
including the Reallabore Innovation Prize from the
German Federal Ministry for Economic Affairs and
Energy and the eGovernment Prize for our project
with the Federal Ofce for Migration and Refugees.
15See here.
Decentralized Finance | 58
