2017; https://0x.org/pdfs/0x_white_paper.pdf. 2018; https://github.com/Betoken/Whitepaper/blob/master/BetokenWhitepaper.pdf. The research, penned by Dr. Fabian Schär and published on May 2, has taken a deep dive into the world of DeFi, hinting that if security concerns and risks can be addressed, it may lead to huge changes in the financial industry. Smart contracts can have security issues that may allow for unintended usage, and scalability issues limit the number of users. On the one hand, pseudonymity can be abused by actors with dishonest intentions. As such, DeFi loans are completely permissionless and not reliant on trusted relationships. 1-16; https://doi.org/10.20955/r.2018.1-16. As an alternative, some projects rely on voting schemes, where the respective governance tokens grant their owners the right to vote on the protocol's future. Both Enzyme Finance and Set Protocol allow anyone to create new investment funds. Some of the staking pool owners will likely be other protocols. 1994; http://www.fon.hum.uva.nl/rob/Courses/InformationInSpeech/CDROM/Literature/LOTwinterschool2006/szabo.best.vwh.net/smart.contracts.html. While much of the traditional financial system is trust based and dependent on centralized institutions, DeFi replaces some of these trust requirements with smart contracts. According to Schär, DeFis exist in five layers: settlements, assets, protocols, applications and aggregators. Trading restriction parameters such as maximum concentration, price tolerance, and the maximum number of positions, as well as user and asset whitelists and blacklists, are enforced by these smart contracts. Alternatively, the core team members themselves may be malicious or corrupted by significant monetary incentives. Efficiency. These so-called oracles introduce dependencies and may, in some cases, lead to heavily centralized contract execution. Prof. Dr. Fabian Schär: DeFi steht für «decentralized finance» – für «dezentrale Finanzdienstleistungen». We discuss these aspects in the following subsections. Adams, Hayden. Juliano, Antonio. As described in Section 3.1, some of the most promising features of the DeFi ecosystem are its openness and composability. The shared settlement layer allows these protocols and applications to interconnect. Thus, it remains to be seen if a truly decentralized blockchain can keep up with the demand and provide the foundation for an open, transparent, and immutable financial infrastructure. The unprecedented speed of financial innovation in DeFi is exciting, and the space is home to some of the smartest people I know. The research panel was headed by Dr. Fabian Schar – professor for Distributed Ledger Technologies and FinTech at the University of Basel. 2 For readers who wish to understand the settlement layer better and want to read a general introduction to blockchain and cryptocurrencies, see Berentsen and Schär (2018). It is important to mention that the MakerDAO system is much more complicated than what is described here. Lower trust requirements may come with the additional benefit of reducing regulatory pressure and reducing the need for third-party audits. Moreover, yield farming may lead to centralization creep by allowing an already well-established protocol to assume a significant portion of a relatively new protocol's governance tokens. The most popular implementation is called Augur (Peterson et al., 2019). Just because the data is publicly available does not mean that people – or machines, for that matter – can make sense of it. Fiat on- and off-ramps are the interface to the traditional financial system. Stay current with brief essays, scholarly articles, data news, and other information about the economy Peer-to-Peer Protocols. Also, in his research, Schär used a multi-layered framework to analyze DeFi’s architecture and building blocks. Instead of creating new tokens, it is also possible to borrow existing cryptoassets from someone else. Here, the price is determined by an inverse function of the underlying assets' performance within a given price range. Another point worth mentioning is the fact that many smart contracts are reliant on external data. DeFi may cause a Real disruption of the ecosystem, according to the Federal Reserve bank paper. In this case, the transaction will be invalid and any of its results (including the loan itself) reverted. Yearn Vaults are collective investment pools designed to maximize yield for a given asset. Although the system is mostly decentralized, it is reliant on price oracles, which introduce some dependencies, as discussed in Section 3.2. The smart contract can mitigate many forms of the principal-agent problem and incorporate regulatory requirements by enforcing them on-chain. In many cases, it is tough to find answers to seemingly straightforward questions and the risk of data getting misinterpreted is considerable. These keys allow a predefined group of individuals (usually the project's core team) to upgrade the contracts and to perform emergency shutdowns. A paper published by the Federal Reserve Bank of St Louis has delved into the expansion of decentralized finance and Ethereum’s role in it. Boado, Ernesto. Instead, the two transactions can be settled atomically, meaning that either both or neither of the transfers will be executed. The number of tokens that can be created depends on the target price of the tokens generated, the value of the cryptoassets that are being used as collateral, and the target collateralization ratio. Illicit Activity. Image via Twitter "Decentralized Finance: On Blockchain- and Smart Contract-Based Financial Markets," He shared the details of his extensive research in a 2019; http://dx.doi.org/10.2139/ssrn.3443382. "Smart Contracts." The views expressed are those of the author(s) and do not necessarily reflect official positions of the Federal Reserve Bank of St. Louis or the Federal Reserve System. However, market resolution (and therefore the price) greatly depends on the trustworthiness of the resolution source. Composability. Oved, Michael and Mosites, Don. This will help us to navigate the “Misty Mountains of DeFi” and fulfill the promise of a more robust and transparent financial infrastructure. Instead, prices are set by the liquidity providers. While this does not necessarily constitute a problem, users should be aware that, in many cases, there is much trust involved. Transfer speed and transaction throughput can be further increased with Layer 2 solutions, such as sidechains or state- and payment-channel networks. Composability essentially supercharges the effect and transparency is always lagging behind. The funds of all borrowers are aggregated in a single, smart contract-based lending pool, and lenders start to earn interest right when they deposit their funds in the pool. In a recent research paper I have written together with Matthias Nadler, we analyzed these adjustments, computed ownership tables for many of the most popular DeFi tokens, and introduced the term “wrapping complexity,” which measures the average number of adjustment – or “wrapping” – steps for a given base token. See also: Jesus Rodriguez – When DeFi Becomes Intelligent. A user who wants to exchange token x for token y may send a trade request to the smart contract. "The Idea of Smart Contracts." It seems like the speed of financial innovation is much greater than what data analysts can possibly keep up with. DeFi applications are transparent. Based on Blockchain technology, DeFi leverages smart contracts to replicate traditional financial services while introducing more transparency, efficiency and accessibility. Governance tokens may lead to undesirable consequences. All transactions are publicly observable, and the smart contract code can be analyzed on-chain. Whenever a smart contract depends on data that are not natively available on-chain, the data must be provided by external data sources. For example, some decentralized blockchain applications will ask for permissions to transfer an infinite number of tokens on behalf of the user—usually to make future transactions more convenient and efficient. Surprisingly, this is not always the case, meaning that some people have paid a price premium in the secondary market. © 2021, Federal Reserve Bank of St. Louis. 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While audits, insurance services, and formal verification are partial solutions to this problem, some degree of uncertainty remains. His research focus is on public Blockchains and DeFi protocols. "Token Tracker." Figure 5Weighted Dai Collateralized Debt Market Rates and the MakerDAO Stability Fee. 2018; https://github.com/runtimeverification/verified-smart-contracts/blob/uniswap/uniswap/x-y-k.pdf. In the case of a crisis, the availability of historical (and current) data is a vast improvement over traditional financial systems, where much of the information is scattered across a large number of proprietary databases or not available at all. 2018; https://github.com/ethereum/EIPs/blob/master/EIPS/eip-721.md. Federal Reserve Bank of St. Louis Review, 2018, 100(1), pp. Unfortunately, the average user will not be able to read the contract code, let alone evaluate its security. What I am mainly concerned with is an inherent risk, based on one of the fundamental properties of DeFi. Accessibility. "Havven: A Decentralised Payment Network and Stablecoin." To mitigate counterparty risk and protect the lender, loans must be fully collateralized, and the collateral is locked in a smart contract—just as in our previous example. Fabian Schär is a professor at the University of Basel and the managing director of the University’s Center for Innovative Finance. A paper published by the Federal Reserve Bank of St Louis has delved into the expansion of decentralized finance and Ethereum’s role in it. Whenever someone invests in an on-chain fund, the corresponding smart contract issues fund tokens and transfers them to the investor's account. To illustrate the concept, let us use the example of MakerDAO, a decentralized protocol that is used to issue the USD-pegged Dai stablecoin. "A Non-Custodial Portfolio Manager, Liquidity Provider, and Price Sensor." In particular, it is not possible for a third party to front-run someone accepting an offer by observing the pool of unconfirmed transactions (mempool). Roth, Jakob and Schär, Fabian and Schöpfer, Aljoscha. Zhang, Yi; Chen, Xiaohong and Park, Daejun. Brooks, Samuel; Jurisevic, Anton; Spain, Michael and Wawrick, Kain. Any two or more pieces can be integrated, forked, or rehashed to create something entirely new. DeFi may increase the efficiency, transparency, and accessibility of the financial infrastructure. External Data. CoinMarketCap. Examples include tokenized versions of stocks, precious metals, and alternative cryptoassets. “DeFi uses smart contracts to create protocols that replicate existing financial services in a more open, interoperable, and transparent way,” Dr. Fabian Schär wrote, also hailing its efficiency, accessibility, and composability. The broad categories are P2P and pooled matching. “DeFi offers exciting opportunities and has the potential to create a truly open, transparent, and immutable financial infrastructure,” wrote Fabian Schär, a University of Basel professor who specializes in distributed ledger technologies such as blockchain . We call a derivative event-based when its price is a function of any observable variable that is not the performance of an asset. In particular, the infrastructure requirements are relatively low and the risk of discrimination is almost inexistent due to the lack of identities. Instead, the cryptoassets are locked up in a smart contract. We end up with schemes that create tokens, on top of tokens, on top of tokens. Whenever the market price of an asset shifts, anyone can use the arbitrage opportunity and trade tokens with the smart contract until the liquidity pool price converges to the current market price. The research, penned by Dr. Fabian Schär and published on May 2, has taken a deep dive into the world of DeFi, hinting that if security concerns and risks can be […] "Melon Protocol: A Blockchain Protocol for Digital Asset Management." The leader in blockchain news, CoinDesk is a media outlet that strives for the highest journalistic standards and abides by a strict set of editorial policies. “DeFi offers exciting opportunities and has the potential to create a truly open, transparent, and immutable financial infrastructure,” wrote Fabian Schär, a University of Basel professor who specializes in distributed ledger technologies such as blockchain. Most users do not understand the data payload they are asked to sign as part of transactions and may be misled by a compromised front-end. In this case, the smart contract ensures that asset managers adhere to the predefined strategy and act in the investors' best interest. Just like traditional investment funds, on-chain funds are mainly used for portfolio diversification. It was proposed by Oved and Mosites (2017). He illustrates the nascent industry’s rapid growth with a chart that reflects the rise of DeFi-locked USD and Ether (ETH) assets from 2018 to 2021. If there are coding errors, these errors may potentially create vulnerabilities that allow an attacker to drain the smart contract's funds, cause chaos, or render the protocol unusable. Smart Contract-Based Reserve Aggregation. While it is understandable that some projects want to implement these precautionary measures and remain somewhat flexible, the existence of these keys can be a potential problem. Nevertheless, even when a launch is perceived as being relatively "fair," the actual distribution often remains highly concentrated. Abstract. 2020; https://docs.yearn.finance/. Fabian Schär University of Basel ... DeFi still is a niche market with relatively low volumes – however, these numbers aregrowing rapidly. 2019; https://compound.finance/documents/Compound.Whitepaper.pdf. While this technology has great potential, there are certain risks involved. However, if there is limited or no competition for a given trade pair, the approach may result in collusion risks or even monopolistic price setting. The rules (smart contract code) and actions (transactions) are publicly available, and some additional meta-information (events) may help an observer to make sense of the data. Fabian Schär The term decentralized finance ( DeFi ) refers to an alternative financial infrastructure built on top of the Ethereum blockchain. DeFi uses smart contracts to create protocols that replicate existing financial services in a more open, interoperable, and transparent way. These indexers assume the role of a directory in which people can advertise their intent to make a specific trade. For example, if an investor owns 1 percent of the fund tokens, this person would be entitled to 1 percent of the locked cryptoassets. Some DeFi applications allow users to create collateralized debt positions and thereby issue new tokens that are backed by the collateral. Under certain circumstances, these prediction markets may serve as decentralized oracles for the likelihood of a future outcome. etherscan.io/tokens, accessed January 22, 2021. Escalating gas prices (transaction fees) and long confirmation times adversely affect the DeFi ecosystem and favor wealthy individuals who can conduct large trades. As a countermeasure, reserve aggregation protocols usually have some (centralized) control mechanisms, such as maximum prices or a minimum number of liquidity providers. Suppose the borrower has not returned the funds (plus interest) at the end of the transaction's execution cycle. Betoken operates as a single fund of funds managed by a community of asset managers through a meritocratic system. Second, loans can be fully secured with collateral. Marcia. Please consider using a different web browser for better experience. Event-based derivative tokens can be based on any objectively observable variable with a known set of potential outcomes, a specified observation time, and a resolution source.7 Anyone can buy a full set of sub-tokens for a given event by locking 1 ETH in a smart contract. Consequently we have to assign the tokens once again to the owners of that protocol, who may potentially be further protocols. 6 In practice, the collateralization must be much larger, as any credit position with collateralization below 150 percent is liquidated. MKR is the governance token for the MakerDAO project. A paper published by the Federal Reserve Bank of St Louis has delved into the expansion of decentralized finance and Ethereum’s role in it.. This may create large meta protocols whose token holders essentially control a considerable portion of the DeFi infrastructure. Some projects have tried to mitigate this concentration of voting power by rewarding early adopters and users who fulfill specific criteria, which range from simple protocol usage to active participation in the voting process and third-party token staking (yield farming). On the other hand, moving DeFi to a more centralized base layer does not seem to be a reasonable approach either, as it would essentially undermine its main value proposition. Fabian Schär, a professor at the University of Basel who specializes in distributed ledger technologies and fintech, writes in the paper that while DeFi is still a niche and small market, the industry is growing fast.. Let us assume that a person locks ETH as collateral in the MakerDAO contract to issue Dai stablecoins. Collateralized loan platforms exist in three variations: Collateralized debt positions, pooled collateralized debt markets, and P2P collateralized debt markets. We call a derivative token asset-based when its price is a function of an underlying asset's performance. P2P matching means that the person who is providing the liquidity lends the cryptoassets to specific borrowers. "Aave Protocol Whitepaper (v1.0)." Subsequently, they call a contract function to create and withdraw a certain number of Dai and thereby lock the collateral. While the deterministic and decentralized execution of smart contracts does have its advantages, there is risk that something may go wrong. I used to be quite optimistic that DeFi could improve on the status quo and have spent significant portions of my early DeFi talks elaborating on why the cryptographic transparency may shape the future of finance. Moreover, they heavily depend on price oracles and third-party protocols, mainly for lending, trading, and the inclusion of low-volatility reference assets such as the Dai or USDC stablecoins. The smart contract will compare prices from all liquidity providers, accept the best offer on behalf of the user, and execute the trade. Anyone who provides liquidity to the pool receives pool share tokens that allow them to participate in this accumulation and to redeem these tokens for their share of a potentially growing liquidity pool. The advantage of this approach is that the parties agree on a time period and operate with fixed interest rates. To really understand how everything is connected, one would have to look far beyond the transaction level, analyze internal calls and aggregate the dependencies in a macro model. Research written by Dr. Fabian Schär and was published on May 2, deeply immersed in the world of DeFi, suggesting that if security risks and risks can be addressed, it can … This approach works fine if there is a relatively broad base of liquidity providers. The problem becomes apparent when illustrated by an example. These features allow various smart contracts and decentralized blockchain applications to interact with each other and to offer new services based on a combination of existing ones. "KyberNetwork: A Trustless Decentralized Exchange and Payment Service." But token composability is just the tip of the iceberg or the peak of the “Misty Mountains of DeFi.” In addition to the vast areas that are covered in mist, there is an extensive yet largely unexplored system of caverns below the mountains. DeFi also has certain risks, namely, smart contract execution risk, operational security, and dependencies on other protocols and external data. Cronje, Andre. This is a great advantage over the traditional financial system, where much of the data is scattered across various proprietary databases and, in many cases, not accessible or to be analyzed in any meaningful way. Dependencies. These inverse tokens allow users to get short exposure to cryptoassets. It lays the foundation for the discussion in Section 4. All of the above are important aspects, may cause some havoc and certainly deserve our attention. DeFi protocols are often compared with Lego pieces. Prices are still negotiated P2P. Set Protocol is mainly designed for semi-automated strategies with deterministic portfolio rebalancing triggered by predefined threshold values and timelocks. 4 UTXO-based blockchain implementations such as Bitcoin allow sophisticated unlocking conditions through their scripting language. "Betoken Whitepaper: A Meritocratic Hedge Fund Built on Ethereum." The higher the underlying volatility, the larger the risk of falling below a given collateralization ratio. The implicit bid/ask spread of the constant product model (plus a small trading fee) may lead to the accumulation of additional funds. A researcher for the Federal Reserve Bank of St. Louis, Fabian Schär, suggests that decentralized finance (DeFi) protocols "potentially contribute to a more robust and transparent financial infrastructure." Collateralized debt positions are loans that use newly created tokens, while debt markets use existing tokens and require a match between a borrowing and a lending party. Although DeFi could provide traditional financial services in a "more open, interoperable, and transparent way," Schär notes that DeFi is still a "niche market with certain risks." Fabian Schär is a professor for distributed ledger technologies and fintech at the University of Basel and the managing director of the Center for Innovative Finance at the Faculty of Business and Economics, University of Basel. Fabian Lukas Schär (German pronunciation: ; born 20 December 1991) is a Swiss professional footballer who currently plays as a centre-back for Premier League club Newcastle United and the Swiss national team.. As of September 2020, Dai accounts for almost 75 percent of all loans in the DeFi ecosystem. 2017; https://www.airswap.io/whitepa... Peterson, Jack; Krug, Joseph; Zoltu, Micah; Williams, Austin K. and Alexander, Stephanie. Lending pools have the additional advantage that they can perform maturity and size transformation while maintaining relatively high liquidity for the individual lender. However, if these issues can be solved, DeFi may lead to a paradigm shift in the financial industry and potentially contribute toward a more robust, open, and transparent financial infrastructure. "dYdX: A Standard for Decentralized Margin Trading and Derivatives." However, this may not necessarily be a bad thing, and the situation is more complicated than it may seem at first glance. These tokens represent partial ownership of the fund and allow token holders to redeem or liquidate their share of the assets. DeFi uses smart contracts to create protocols that replicate existing financial services in a more open, interoperable, and transparent way. In a recent research paper published in the Federal Reserve Bank of St. Louis Review, I argued that “DeFi [decentralized finance] has the potential to create a truly open, transparent and immutable financial infrastructure.”. The same is true for the fund's fee schedule. As such, MKR holders have skin in the game, and it should be in their best interest to maintain a healthy system. Operational Security. An alternative to classic exchange or liquidity pool models are peer-to-peer (P2P) protocols, also called over-the-counter (OTC) protocols. Multisig requires M-of-N keys to execute any of the smart contract's admin functions, and timelocks specify the earliest time at which a transaction can be (successfully) confirmed. The research, penned by Dr. Fabian Schär and published on May 2, has taken a deep dive into the world of DeFi, hinting that if security concerns and risks can be addressed, it may lead to huge changes in the financial industry. Berentsen, Aleksander and Schär, Fabian. "Compound: The Money Market Protocol." Prominent examples of smart contract-based liquidity pool protocols are UniSwap, Balancer, Curve, and Bancor. I am concerned that we are in the process of creating a system with a few systemically relevant protocols, some of which have severe external dependencies and are heavily centralized kill switches that may potentially be a threat to the entire DeFi ecosystem. On-chain fund protocols can make use of decentralized exchange protocols or achieve leveraged positions through lending protocols. As such, they are on track to become an essential part of DeFi lending. So essentially, this is a call to action. Whenever this token (or one of its wrapped variants) is locked in a protocol, the wrapping complexity increases. For example, if two parties want to exchange digital assets in the form of tokens, there is no need for guarantees from a CCP. See also: Why DeFi Pulse’s Key Metric Is So Simple It’s Confusing. Once we include negative balances (short selling through lending markets), various sorts of financial derivatives, and realize that there is a potential for recursive effects, we get an understanding of how this seemingly straightforward analysis may pose severe challenges. Similar risks exist in contract execution. The former may provide exciting new possibilities and remove some dependencies, while the latter may essentially introduce the worst of two worlds, that is, de facto dependencies on a centralized operator with limited supervision. Another approach is to consolidate liquidity reserves through a smart contract that allows large liquidity providers to connect and advertise prices for specific trade pairs. In contrast to other protocols, offers can be accepted exclusively by the parties who have been involved in the negotiation. coinmarketcap.com, accessed September 15, 2019. Leshner, Robert and Hayes, Geoffrey. 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