DeFi Promise and Pitfalls Fabian Schar

Decentralized finance could support a new financial infrastructure if challenges are overcome

Digital innovation has brought major improvements to the financial system. But the system’s architecture remains essentially the same. It’s still centralized. 

Decentralized finance (DeFi) offers an alternative. It uses public blockchain networks to conduct transactions without having to rely on centralized service providers such as custodians, central clearinghouses, or escrow agents. Instead, these roles are assumed by so-called smart contracts.

Smart contracts are instructions in the form of computer code. The code is stored on public blockchains and executed as part of the system’s consensus rules. DeFi protocols can be designed in a way that prohibits intervention and manipulation. All participants can observe the rules before they engage and verify that everything is executed accordingly. State changes (for example, updates to account balances) are reflected on the blockchain and can be verified by anyone.

In the context of DeFi, smart contracts are used mainly to ensure the atomic (simultaneous and inseparable) transfer of two assets or to hold collateral in an escrow account. In both cases, the assets are subject to the smart contract’s rules and can be released only if the predefined conditions are met.

Making use of these properties, DeFi can mitigate counterparty risk and replicate numerous financial services without the need for intermediaries and centralized platform operators. This can reduce costs and the potential for errors. Lending markets, exchange protocols, financial derivatives, and asset management protocols are just a few examples.

Smart contracts can reference other smart contracts and make use of the services they provide. If, for example, an asset management protocol uses a decentralized exchange, incoming assets can be swapped as part of the same transaction. This concept, of actions across multiple smart contracts that can take place within a single transaction, is referred to as “intra-transaction composability” and can effectively mitigate counterparty risk (the likelihood that other parties will not fulfill their end of the deal).

Benefits of decentralization

Many advantages usually attributed to DeFi—or blockchains in general—can also be achieved via centralized infrastructure. Smart contracts are not limited to decentralized systems. In fact, the same standards and execution environments can be used on centralized ledgers. There are countless examples of the Ethereum virtual machine (a virtual machine that runs on all computers in the blockchain network and executes smart contracts) being employed alongside heavily centralized consensus protocols. Similarly, the same token…