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This is a chapter from the book Token Economy (Third Edition) by Shermin Voshmgir. Paper & audio formats are available on Amazon and other bookstores. Find copyright information at the end of the page.
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Decentralized finance is an umbrella term for a set of smart contract-based applications where smart contracts replace many roles of classic financial intermediaries. Token transfers, tokenized credit and lending services, and other financial services are automatically executed by a public blockchain infrastructure. This chapter outlines how the tokenization of more and more asset classes—and a growing body of composable plug-and-play financial products—might challenge our current definition of what constitutes money, finance, and the real economy.
Decentralized finance (DeFi) refers to a collection of Web3-based financial service protocols designed to operate autonomously without a privately operated middleman acting as a clearing institution. The original vision was to build a more efficient, transparent, censorship-resistant, and open decentralized financial system using smart contracts. In a fully decentralized setup, the role of smart contracts is to connect all counterparties to a financial transaction, using conditional rule sets that dictate who is allowed to act and when. The smart contract—or rather a series of smart contracts—computationally formalizes and automatically enforces the rules, thereby replacing many roles of classic financial institutions. When a counterparty initiates a transaction with the smart contract, token transfers, tokenized credit and lending services, and other financial services are automatically triggered. If the conditions of the smart contract are met, the transaction is executed accordingly. The collectively maintained ledger of transactions acts as a permanent record for token ownership and token transactions. The publicly verifiable nature of blockchain networks provides more transparency and accountability than centralized financial services, as well as fast settlement execution. Individuals have full control over their funds if they control their private keys and do not have their tokens stored with a custodial service such as a centralized exchange. In a fully decentralized setup, asset settlement is more frictionless than in traditional financial services (TradFi) or even centralized finance (CeFi) services that only operate at the intersection with Web3.
The foundations of DeFi lie in the invention of Bitcoin in 2008, which introduced a decentralized, peer-to-peer payment system. Ethereum later expanded on the concept of P2P payments by enabling more complex applications, allowing developers to build more versatile financial tools like stable tokens, lending protocols, and decentralized exchanges—from which the term “DeFi” eventually emerged. The concept of DeFi gained mainstream attention during the “DeFi Summer” of 2020, when certain lending protocols that promised high yields drove DeFi adoption and attracted traditional financial players to DeFi applications.
While DeFi holds the promise of empowering individuals with full control over their assets, it also introduces challenges such as usability barriers and information asymmetries related to financial and technological know-how. Misunderstandings about what truly constitutes DeFi, and how it differs from CeFi or TradFi, have led to numerous market failures and scams.
The DeFi space was largely unregulated in its early years. This Wild West environment attracted both developers with serious intentions and all sorts of tech cowboys and scammers. A gold rush atmosphere fostered both productivity and pathology. The lack of explicit regulation and expertise, combined with a high degree of insider trading, untested smart contracts, and the complexities arising from composable protocols—along with a handful of bad actors and power players—led to market asymmetries. A few people made substantial profits, while a considerable number of retail investors suffered significant losses. Nonetheless, the rapid evolution of this space signals a broader shift in how financial systems are conceived and implemented, testing the boundaries of traditional finance.
The main purpose of finance is to bridge capital flows—in the form of loans or credit—between those who have capital (savers and investors) and those who need it (individuals, companies, or governments). The financial instruments we use today—such as money, credit, and more refined forms of capital assets—have evolved over millennia, where credit and lending are often brokered through financial intermediaries such as retail banks, investment banks, and different types of venture capital institutions. Internet-based financial technology companies have been the latest addition to the stakeholder set of financial intermediaries. However, Web2-based financial services were only the vanguard for Web3-based decentralized financial services, which have become the next generation of financial innovation.
Traditional financial institutions work with private systems that are not publicly verifiable and are only audited by third parties. Transparency and interoperability do not exist, and data exchange is process-heavy. At the time of writing this book, the settlement systems used by the classic financial industry often still rely on outdated infrastructure. It is estimated that more than 40 percent of financial institutions today conduct their asset settlement over COBOL-based systems—a programming language from the 1950s that was predominantly used to program mainframe computers. Today, only a few developers still master this programming language and can maintain these systems. Due to the nature of the client-server-based Internet architecture, even modern Web2-based financial service providers are process-heavy and lack transparency regarding how customer funds are actually used. The concept of composability—typical for blockchain networks—is non-existent in traditional financial systems.
While financial intermediary functions also need to be taken care of in DeFi, they are addressed with smart contract-based mechanisms and executed on a publicly verifiable infrastructure with several transformative features:
DeFi applications can be built in a modular way, at least among those that operate on the same blockchain network. They can easily plug into each other like Lego pieces. By combining various DeFi protocols, anyone can create completely new financial products without having to build all the financial components from scratch. Token holders can pick and choose financial infrastructure components to build personalized financial products on top of existing financial components. For example, a stable token protocol can be combined with a decentralized exchange and decentralized lending to produce a completely new real estate product. Any private person could—in theory, and once the regulatory environment allows it—tokenize their real-world apartment and use the tokens as collateral for a P2P lending protocol specialized in real estate assets, all while avoiding the level of bureaucracy that would come with legacy financial systems.
This composability fosters fast-paced innovation cycles based on swarm intelligence, much like APIs did in the Web2 era. However, Web2-based APIs are permissioned, can be revoked, and only allow others to access a restricted set of data that the owners of a Web2 service decide to share. In Web3, composability is the default mode. On the flip side, modularity also adds new levels of complexity, which excludes those who are not tech- or finance-savvy and can be exploited by more knowledgeable players in the market.
Composability also increases complexity, making systems harder to understand and more prone to vulnerabilities. Combining different protocols can create security, sustainability, or privacy challenges, all of which need to be considered when designing sustainable DeFi applications. Exploits often arise when smart contracts are not properly audited or fail to account for unintended interactions between different DeFi components.