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.
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.
History of Finance & Potentials of DeFi
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:
- Self-custody & full control: Users have the option to control their funds directly through private wallet management, removing the need for custodial services like banks or centralized exchanges. However, this also means users are solely responsible for securing their private keys. If you lose them, you lose access to your assets.
- Instant asset settlement: Transactions on blockchain networks are executed within minutes (depending on block creation times and network congestion), compared to the days it can take in traditional finance. Once the smart contract is deployed, DeFi applications self-execute with less human and institutional intervention—except for infrastructure maintenance such as code upgrades, bug fixes, and dispute resolution.
- Transparency, accountability & open source business logic: Blockchain networks provide a publicly verifiable ledger of transactions, increasing institutional accountability and reducing the possibility of hidden dealings. The trading mechanisms of a DeFi application are encoded as open-source code, which means that anyone can inspect how the system works. Loopholes can be fixed collectively, and systems can be built on top of each other, making the applications highly composable—at least in theory. In reality, however, one needs to be able to read the code and understand the economic dynamics of a market in order to contribute to collective code maintenance.
Modularity & Composability
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.
DeFi vs. CeFi
In theory, DeFi services grant more control and sovereignty over one's assets and introduce more transparency, but only if one uses self-hosted wallets and the public-private key infrastructure of blockchain networks. The information on the state of all tokenized assets that are held in collateral of the smart contracts, and information about how much these collaterals are leveraged to purchase other crypto assets, is publicly verifiable at all times. This means that all market participants can understand the current dynamics of the financial markets because there are no backdoor deals.
The reality, however, for the vast majority of token holders today is far from sovereign. Most token holders use the services of financial intermediaries that have emerged around Web3—most predominantly, centralized exchanges. These exchanges do not operate on public blockchain infrastructure, only at the intersection of Web3. They are privately operated companies that manage their customers' tokens via private server infrastructure. Centralized exchanges offer custodial services, managing customer tokens with so-called hosted or custodial wallets. Their customers have no control over their tokens. Centralized exchanges are the “new banks” of Web3, prone to the same systemic risks as traditional financial institutions, with the added risk that, until recently, they have been poorly regulated in many countries.
CeFi users depend on the disclosure tactics of their financial services providers and cannot identify potential threats. For example, CeFi services often accept short-term tokenized deposits, which they lend to others, leveraging tokenized positions of their customers at times up to 20-to-1 ratios, a practice typical in traditional finance. Their operations are secured by business deals with counterparties that act as investors, based on paper contracts whose terms are not publicly verifiable. Customers rely on market rumors and inside know-how, as they do not have insight into the balance sheets of their banks or centralized token exchanges. They do not know how their collateral assets are being managed or whether they might have been under-collateralized in backdoor financial deals.
Most cases of embezzlement and mismanagement in the crypto space were a result of CeFi services, not DeFi services. The collapse of the centralized exchange FTX and its market-making company Alameda Research in 2022 is the best example of the lack of transparency and control over one’s funds when using legacy financial infrastructure and the resulting systemic risks of traditional finance. The same is true for the aftermath of the Terra (LUNA) stable token collapse in 2022, which led to a temporary plunge in crypto asset prices. CeFi service providers such as Celsius, Three Arrows Capital, Nuri, Voyager Digital, BlockFi, and Genesis went bankrupt. These companies, which were venture-backed or bank-funded financial technology startups, had over-leveraged crypto asset positions—essentially the funds of their clients—a strategy that is typical for traditional financial institutions. However, unlike standard practice in traditional finance, these over-leveraged CeFi operators could not restructure or renegotiate their tokenized liabilities after the fact for the crypto assets they had over-leveraged due to the nature of crypto assets.
In a smart contract world, such backdoor deals—which require a change of the terms and conditions—are not possible unless they are provisioned for in the contract. In that case, the rules are transparent to everyone, and no investor gets preferential treatment over another.
Most people today still have problems distinguishing real DeFi from CeFi to assess the strengths and weaknesses of both systems, which would be a prerequisite for educated financial decisions and diligent financial reporting. This has led to the public misconception that “DeFi has failed.” Regulatory oversight advocates argue that better government regulation can mitigate these systemic risks—which has been true to a certain extent for traditional finance. The whole point of DeFi was to use public blockchain infrastructure to prevent such risks in the first place by baking the regulation into the smart contract.
ReFi, MachineFi & DeSci
Decentralized Finance is not limited to conventional financial assets and applications. It can extend into specialized areas that utilize tokenized assets and usage rights, opening up the possibility for completely new data-driven asset classes and new types of applications. Examples include Regenerative Finance (ReFi), Machine Finance (MachineFi), and Decentralized Science (DeSci).
- Regenerative Finance, or ReFi, integrates the principles of regenerative economics with decentralized financial tools. Regenerative economics promotes practices that consider both negative and positive externalities of individual economic activities while producing or consuming goods and services, aiming to balance private and public interests. It acknowledges the impact economic activities have on shared resources such as clean water, clean air, forests, or public infrastructure. ReFi initiatives seek to leverage blockchain networks and tokenization to tackle climate change, support conservation efforts, and foster a more equitable financial system. By tokenizing carbon emission reductions or biodiversity protection, ReFi initiatives try to align economic incentives with environmental and social sustainability. On-chain mechanisms like Proof-of-Carbon-Emission-Reduction and Proof-of-Biodiversity-Protection can offer real-time accountability and transparency for carbon credits and other sustainability initiatives.
- Machine Finance, or MachineFi, explores the integration of machine intelligence and resources into Web3 environments. Decentralized physical infrastructure networks enable machines to autonomously interact with DeFi applications. This approach envisions a decentralized machine economy where devices, powered by blockchain networks and other Web3 protocols, become active participants in financial ecosystems. As described in the previous chapter analyzing the example of KWh tokens, MachineFi relies on a combination of internet-connected devices, blockchain networks, and AI applications. Any industrial machine (such as a solar power plant) or consumer device (such as cars, home appliances, etc.) that is connected to the internet and assigned a unique blockchain identity can settle token transactions autonomously based on predefined rules within DeFi protocols. As discussed in the previous chapter, KWh tokens exemplify how tokenized energy resources can create new opportunities for both investors and operators, but the tokenization of machine resources has many more applications.
- Decentralized Science (DeSci) is a movement within the crypto community that uses blockchain networks and other Web3 protocols to generate higher institutional accountability over the funding, research, dissemination, and rights management processes for scientific research and its outputs. Among other things, DeSci allows for more diverse funding sources and mechanisms and an open funding process with less time lag. Examples of new tools and tokenized incentive mechanisms that are being experimented with include alternative voting concepts such as “quadratic voting” and alternative forms of investment funding such as “retroactive public goods funding.”
Bankable Funds & the Future of Finance
By tokenizing assets of both the real and digital worlds, property rights to these assets can become easily exchangeable using DeFi services. Tokenized certificates that have already been issued over a blockchain network can be easily used as collateral in a range of DeFi applications, effectively converting assets or access rights of the real world—previously considered “non-bankable”—into “bankable funds.” Bankable funds are forms of payment that are accepted at financial institutions and can be easily liquidated into local currencies, such as checks and money orders.
Once the swapping of tokens becomes easily possible across blockchain networks, anyone will be able to exchange any token peer-to-peer, wallet to wallet, without an intermediary. Art NFTs, real estate NFTs, energy NFTs, or data NFTs could become a potential medium of exchange, provided that they can be converted into cash on short notice using a DeFi protocol or if they become increasingly accepted by online merchants as a direct method of payment.
The tokenization of real-world assets and their subsequent collateralization in DeFi protocols could, therefore, contribute to the merging of the money system with the financial system and the real economy, making their distinctions increasingly difficult. It could also impact the role of central banks as geographic monopolists of money. However, this will only be feasible if the regulatory environment of international financial markets supports the process, mass adoption of crypto occurs, and the necessary network effects take hold.
Challenges of DeFi
While promising transformative potential, DeFi applications also present numerous challenges, such as wallet usability, secure inter-blockchain token transfer, and vulnerabilities in smart contracts. The following list of challenges highlights the need for thoughtful approaches to improve DeFi's inclusiveness and security while preserving its decentralized ethos.
Wallet usability: The reliance on centralized services for token management undermines the decentralization efforts that define DeFi. Making wallets more accessible and intuitive is a critical step toward expanding DeFi's reach.
- Blockchain interoperability: As previously explained, Bitcoin tokens cannot be sent over the Ethereum network because only the nodes within the Bitcoin network have the necessary data to verify token ownership. Efforts to enable interoperability aim to bridge these silos, allowing tokens and data to move securely between different blockchain networks. This would empower DeFi applications to incorporate tokens from multiple networks, enhancing accessibility and reducing lock-in effects that conflict with the principles of decentralization. Until interoperability becomes reliable and secure, DeFi applications will remain confined to their native ecosystems.
- Exploitable smart contracts: When smart contracts are poorly written or misaligned with their intended purposes, they become vulnerable to unintended use. These exploits are often leveraged by individuals or institutions with advanced technical and financial expertise, leaving less competent market participants, such as retail investors, at a disadvantage. To build a sustainable and inclusive DeFi ecosystem, smart contracts must undergo rigorous auditing and testing; otherwise, consumer harm will remain high.
- Complexities resulting from composability: The ability of DeFi protocols to interact and integrate seamlessly also introduces significant complexity, which most market participants lack the ability to understand. This creates an environment where a small number of knowledgeable individuals or institutions can economically exploit vulnerabilities for their own benefit. This dynamic mirrors the issues that contributed to the 2008 global financial crisis, where the cascading effects of complex and entangled financial instruments were poorly understood by most homeowners and credit default swap investors. A similar scenario unfolded in 2022 following the collapse of the TerraUSD stablecoin, which triggered widespread failures among CeFi institutions that had over-leveraged their positions. While advancements in AI and data analysis may eventually level the playing field, the current state of DeFi favors those with the resources and expertise to navigate its complexities.
- Oracle problems: Oracle services play a critical role in DeFi by supplying external data to smart contracts, such as real-time asset prices. This external data enables DeFi applications to adjust lending rates, trigger transactions, and manage financial processes. The reliance on centralized oracle services introduces counterparty risks, as the authenticity and security of the data provided can be compromised. For DeFi to achieve full decentralization, decentralized and consensus-based oracles must replace centralized third-party providers.
- Maximum Extractable Value (MEV): Unlike traditional finance, where transactions are processed on a first-come, first-served basis, blockchain networks handle transactions differently, making them prone to MEV attacks. While the crypto community is working hard to develop solutions, the underlying issue remains unresolved. MEV continues to redistribute value in ways that disadvantage less-informed participants. Addressing these dynamics is essential for ensuring fairness and inclusivity in DeFi systems.
- DeFi governance: Many DeFi projects transitioned their governance from centralized companies or foundations to decentralized organizations. MakerDAO was among the first to shift governance responsibilities to its token holders. Even some CeFi services, like centralized exchange, adopted DAO governance models in an effort to decentralize decision-making and involve their user community. However, the reality of DAO governance often falls short of its ideals. Power structures frequently emerge, concentrating policymaking powers around protocol founders and early investors rather than the broader community using a DeFi protocol. This issue will be discussed in greater detail in the use case chapters presented in the third part of this book.
Footnotes
[1] Bankable funds refer to forms of payments that are accepted at financial institutions and easily liquidated into local currencies such as checks and money orders. Non-bankable funds refer to assets that are not accepted as a method of payments in a bank.
[2] “DeFi summer” refers to the summer of 2020, when the decentralized lending protocol “Compound” released their COMP token as a reward for providing tokens to their liquidity pool. This incentivized many token holders to provide desperately needed liquidity to the liquidity pools by depositing their tokens and earning financial rewards. COMP was also designed to reward users for borrowing on Compound. While DeFi protocols were already gaining traction well before DeFi summer, this incentivization model opened investor floodgates and pulled many new users into crypto, driving market volumes and prices, especially after other DeFi protocols also adopted similar mechanisms.
[3] Futures Exchange (aka FTX) was a centralized tokenized futures exchange that was founded in 2019, which had to file for bankruptcy in 2022 as a result of a solvency crisis that unfolded when it became public that their assets were worth a fraction of what they pretended or deluded themselves into thinking. As a result, their customers could not withdraw their funds, and the issue is subject to current investigation. A public outcry followed when it became known that FTX's partner company – a hedge fund called “Alameda Research'' – held a significant portion of its assets in FTT (FTX's native token) and that customer funds might have been misappropriated. Following this revelation, the CEO of Binance, a rival centralized exchange, announced that Binance would sell all its FTT tokens. This announcement initiated a run on FTX – FTX customers started to withdraw their funds and FTX had to admit that it was unable to meet customer demands.
[4] Sandwich trading refers to trades that are executed both before and after a transaction of a particular user. Sandwich attacks commonly occur on decentralized exchanges. They combine the front-running of an order to manipulate the price against that particular order, and is then followed by a so-called “back run,” where an attacker can profit at the expense of a victim. More here: https://info.zeromev.org/terms#toxic-mev
[5] Externalities in economics refers to the costs or benefits that affect a person or community who did not choose to incur that cost or benefit. “Negative externalities” are a result of activities of people and institutions that cause an indirect cost (negative effect) on other people or institutions. Pollution, as a result of producing goods with a negative CO2 footprint, is an example where everyone is affected, but the costs are often not included in the pricing of the goods. Manufacturing can cause air pollution, imposing health and clean-up costs on the whole of society. “Positive externalities” can arise if, for example, two neighboring farmers have positive ecological effects on each other. Incentivizing CO2 emission reduction with a token could be another example of a positive externality that could contribute to a public good, like better air quality in a city. Even though the collective production of public goods can result in positive externalities, it does not necessarily exclude other negative externalities.
[6] The term “digital twin” has a longer history and dates back to spacecraft system design and other complex infrastructure design. BlockScience uses "digital twin" to denote a simulated environment of an operational environment (like a blockchain network) to test and validate assumptions, or to test effects before bringing them onto a live platform (similar in idea to testnets, but a very different way of doing it). Similarly, digital twins can be created to replicate highly sensitive industrial plants, where data flows into the twin from the operational system, allowing to replicate digitally what is happening for tests, etc. “A digital twin is a dynamic virtual copy of a physical asset, process, system or environment that looks like and behaves identically to its real-world counterpart. A digital twin ingests data and replicates processes so you can predict possible performance outcomes and issues that the real-world product might undergo […] The concept of using a digital twin as a means of studying a physical object was first introduced by NASA in the 1960s. NASA replicated its spacecraft at ground level to match the systems in space for exploration missions." (Source: https://unity.com/solutions/digital-twin-definition)
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