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…