DeFi Integrates Technical, Financial, Socio-Economic Complexity in Unprecedented Way: Report

Decentralized finance (DeFi) builds on distributed ledger technologies (DLT) “to offer services such as trading, lending and investing without using a traditional centralized intermediary,” according to finding shared by the Bank for International Settlements (BIS).

The fact that DeFi components can be programmed “may open up new possibilities for more competitive financial markets, and could bring efficiency gains,” the paper shared by BIS noted.

However, DeFi reportedly “introduces enormous technological and economic complexity that makes it increasingly difficult to assess the risks and potential of DeFi financial products.”

But financial institutions and regulators dealing with DeFi need “just such a systematic evaluation of these factors.”

This paper posted by BIS seeks “to provide a comprehensive overview and classification of DeFi.”

It aims “to explain the technical details to a broad audience and to introduce the financial protocols that the DeFi ecosystem builds upon.” It explains “the system’s complexity and reviews how DeFi might be used in the future.” As noted in a blog post, they consider recent findings that help “to clarify the functioning and design of DeFi systems, and how they can interoperate.”

DeFi is “defined here as a competitive, contestable, composable and non-custodial financial ecosystem built on technology that does not require a central organization to operate.”

To explain the functioning, design and interoperability of such systems, the paper “uses a DeFi stack reference (DSR) model to conceptualise the stack-layer components of their technical primitives and financial functions.”

The DSR model “comprises three layers: settlement, applications and interfaces.”

The settlement layer is “responsible for completing financial transactions and discharging obligations.” The application layer “comprises applications implemented through smart contracts, thus combining cryptoassets, DeFi protocols and compositions.” The interface layer provides front-end interfaces that “facilitate user-friendly interaction with the smart contract logic.”

The paper next outlines “the technical primitives such as DLT and smart contracts, the spectrum of cryptoassets used to represent and transfer value, and the design and financial functions of the most prominent DeFi protocol families.”

It also reviews how DeFi protocols “can be combined into compositions. Finally, the paper outlines an interdisciplinary agenda for future research.”

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 a traditional centralized intermediary.”

A range of DeFi protocols “implements these services as a suite of smart contracts, ie software programs that encode the logic of conventional financial operations.”

Instead of transacting with a counterparty, DeFi users thus interact “with software programs that pool the resources of other DeFi users to maintain control over their funds.”

This paper provides “a deep dive into the overall architecture, the technical primitives, and the financial functionalities of DeFi protocols.”

The paper notes:

“DeFi integrates technical, financial, and socio-economic complexity in an unprecedented way. This development could be neglected while DeFi was still a niche phenomenon without ties to the fiat system. However, with the increasing integration of cryptoassets with the traditional financial sector, we require novel methods to identify, investigate, and ultimately understand the risks associated with these developments. The scientific method embedded in a multi-disciplinary setting offers the most promising answer to this challenge.”

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