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The technology of decentralized finance (DeFi)

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Abstract and Figures

Decentralized Finance (DeFi) is a new financial paradigm that leverages distributed ledger technologies to offer services such as lending, investing, or exchanging cryptoassets without relying on traditional centralized intermediaries. A range of DeFi protocols implements these services as a suite of smart contracts, i.e., software programs that encode the logic of conventional financial operations. Instead of transacting with a counterparty, DeFi users interact with software programs that pool the resources of other DeFi users. DeFi’s programmable and automated technology could foster efficiency and increase transparency. However, it exposes users to idiosyncratic risks, such as smart contract vulnerabilities and complex protocol interoperability. This paper provides a deep dive into the overall architecture, the technical primitives, and the financial functionalities of DeFi protocols. We analyze and explain the individual components and how they interact through the lens of a DeFi stack reference (DSR) model featuring three layers: settlement, applications and interfaces. We discuss the technical aspects of each layer of the DSR model. Then, we describe the financial services for the most relevant DeFi categories, i.e., decentralized exchanges, lending protocols, derivatives protocols and aggregators. The latter exploit the property that smart contracts can be “composed,” i.e., utilize the functionalities of other protocols to provide novel financial services. We discuss how composability allows complex financial products to be assembled, which could have applications in the traditional financial industry. We discuss potential sources of systemic risk and conclude by mapping out an agenda for research in this area.
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Vol.:(0123456789)
Digital Finance (2024) 6:55–95
https://doi.org/10.1007/s42521-023-00088-8
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ORIGINAL ARTICLE
The technology ofdecentralized finance (DeFi)
RaphaelAuer1· BernhardHaslhofer2· StefanKitzler3· PietroSaggese3·
FriedhelmVictor4
Received: 10 March 2023 / Accepted: 21 June 2023 / Published online: 1 August 2023
© The Author(s), under exclusive licence to Springer Nature Switzerland AG 2023
Abstract
Decentralized Finance (DeFi) is a new financial paradigm that leverages distrib-
uted ledger technologies to offer services such as lending, investing, or exchang-
ing cryptoassets without relying on traditional centralized intermediaries. A range
of DeFi protocols implements these services as a suite of smart contracts, i.e., soft-
ware programs that encode the logic of conventional financial operations. Instead
of transacting with a counterparty, DeFi users interact with software programs that
pool the resources of other DeFi users. DeFi’s programmable and automated tech-
nology could foster efficiency and increase transparency. However, it exposes users
to idiosyncratic risks, such as smart contract vulnerabilities and complex protocol
interoperability. This paper provides a deep dive into the overall architecture, the
technical primitives, and the financial functionalities of DeFi protocols. We analyze
and explain the individual components and how they interact through the lens of a
DeFi stack reference (DSR) model featuring three layers: settlement, applications
and interfaces. We discuss the technical aspects of each layer of the DSR model.
Then, we describe the financial services for the most relevant DeFi categories, i.e.,
decentralized exchanges, lending protocols, derivatives protocols and aggregators.
The latter exploit the property that smart contracts can be “composed,” i.e., utilize
the functionalities of other protocols to provide novel financial services. We discuss
how composability allows complex financial products to be assembled, which could
have applications in the traditional financial industry. We discuss potential sources
of systemic risk and conclude by mapping out an agenda for research in this area.
Keywords Decentralized finance· DeFi· Blockchain· Ethereum· DLT·
Stablecoin· Cryptoasset
JEL Classification E42· E58· F31· G19· G23· L50· O33· G12
The views expressed in this document are those of the authors and not necessarily the views of
the BIS. We thank Matteo Aquilina, Rainer Böhme, Andrea Canidio, Emma Claggett, Christian
Diem, Nicola Dimitri, Alexander Eisl, Pirmin Fessler, Jon Frost, Arthur Gervais, Aljosha Judmayer,
Masarah Paquet-Clouston, Krzysztof Paruch, Burkhard Raunig, Andreas Schrimpf, Esther Segalla,
Nicholas Stifter, Martin Summer, Stefan Thurner, Marcus Wunsch, and Teng Andrea Xu.
Extended author information available on the last page of the article
Content courtesy of Springer Nature, terms of use apply. Rights reserved.
... Decentralized Finance (DeFi) has rapidly expanded into one of the fastest-growing cryptocurrency sectors. DeFi platforms enable users to borrow, lend, trade, and stake their digital assets-marking an exciting development in financial services (Auer et al., 2024). ...
... Another off-chain risk management strategy is to utilize financial derivatives such as options and futures to hedge specific risks in DeFi protocols (Auer et al., 2024). Users can buy put options that will let them sell some of the assets at a certain price when the market crashes. ...
... Another area that has been underexamined is regulatory complexities, particularly in cross-jurisdictional settings. The literature acknowledges mounting regulatory pressures and the challenges of enforcing compliance in decentralized networks (Auer et al., 2024). Still, more study is needed of how regional DeFi regulations are enforced or how such enforcement influences platform strategies and user behavior (Koprivec et al., 2021). ...
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Chapter
The rapid growth of the Ethereum ecosystem since 2020 has been driven by the proliferation of several DeFi protocols [10], which are application-layer programs that provide Decentralized Finance (DeFi) services [14, 16] such as the exchange of cryptoassets on decentralized exchanges (DEXs) [2, 7, 15], their lending and borrowing [1, 4, 8], or the creation and trade of related derivative contracts [11].