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A majority of decentralized finance (DeFi) apps have been built on Ethereum, and DeFi's explosion has rippled across the network. DeFi has pushed Ethereum to its limits but is also accelerating the pace of innovation and experimentation. In this piece we look at how four DeFi token launches affected Ethereum and how the network is evolving as a result. We conclude that DeFi will undoubtedly continue to push Ethereum's limits, as new dapps and tokens launch. But Ethereum is changing as well, and Layer 2 scalability could open up new doors for what is possible in DeFi and beyond.

"The crypto market is relatively small, and CeFi and DeFi are intertwined in an almost paradoxical way. While the DeFi infrastructure was able to sustain the recent market shocks, the collapse of CeFi institutions has put a lot of pressure on DeFi protocols. Simply put, DeFi blossomed in a market that doesn't exist anymore. To fully realize its potential in the new reality of crypto, DeFi needs to evolve. But that evolution can translate into massive opportunities. For DeFi to find its place as the financial services foundation of the crypto space, there are five key areas where it needs to improve."

"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. This article highlights opportunities and potential risks of the DeFi ecosystem. I propose a multi-layered framework to analyze the implicit architecture and the various DeFi building blocks, including token standards, decentralized exchanges, decentralized debt markets, blockchain derivatives, and on-chain asset management protocols. I conclude that DeFi still is a niche market with certain risks but that it also has interesting properties in terms of efficiency, transparency, accessibility, and composability. As such, DeFi may potentially contribute to a more robust and transparent financial infrastructure. "

This article discusses some of the new types of risks introduced by DeFi that are inherent to blockchain systems along with traditional types of financial risks in DeFi that manifest in new ways: (i) interconnections with the traditional financial system, (ii) operational risks stemming from underlying blockchains, (iii) smart contract-based vulnerabilities, (iv) other governance and regulatory risks, and (v) scalability challenges. In an effort to remove humans and automate as much as possible through smart contracts, DeFi has introduced or amplified these risks. The growth of DeFi will depend on its ability to navigate and build compatibility with traditional finance and on how laws and regulations respond. Perhaps the biggest challenge of all is that the DeFi ecosystem continues to grow while its underlying base layer (public infrastructure such as Bitcoin or Ethereum) faces growing pains.

DeFi faces technical and economic challenges. Technically, the ability of protocols to support large-scale adoption is very much in question, not only because of the costs associated with supporting the technology, but also because of its ability to handle large volumes of transactions. From an economics point of view, large-scale adoption would require a profound philosophical change in the way risk is evaluated. For example, DeFi lending markets are completely anonymous and, as such, do not support credit screening, a service traditional banks provide. Furthermore, smooth functioning of many DeFi applications requires arbitrageurs to step in and realign prices. However, arbitrage as an economic mechanism may face limitations as availability of capital becomes scarce, especially when markets are under stress. Another salient issue facing the acceleration of DeFi is inherent in its structure. Most DeFi applications adopt a widespread governance structure in which users and original developers share control of rights to the future of the application. For projects that become relatively large, dispersed governance might become a limiting factor. How much DeFi protocols can, or are allowed to, integrate with a noncrypto economic landscape will depend on whether, and how efficiently, these types of problems can be solved. [Dallas Fed]

"We believe a version of decentralized finance (DeFi) called "Institutional DeFi", which combines the innovations of DeFi protocols with the safeguards of today's finance industry, has the potential for growth and transformative impact. The aim of this joint report by the Oliver Wyman Forum, DBS, Onyx by J.P. Morgan, and SBI Digital Asset Holdings is to help business executives understand the potential benefits of adapting decentralized finance (DeFi) protocols in the finance industry using tokenized real-world asset. This paper explains what industry participants need to do to achieve regulatory clarity, drive commercial adoption, and get the greatest benefits out of Institutional DeFi for their clients and themselves."

"As of August 2022, blockchain-based assets boast a combined market capitalisation exceeding one trillion USD, among which the most prominent are the decentralised autonomous organisation (DAO) tokens associated with decentralised finance (DeFi) protocols. In this work, we seek to value DeFi tokens using the canonical multiples and Discount Cash Flow (DCF) approaches. We examine a subset of DeFi services including decentralised exchanges (DEXs), protocol for loanable funds (PLFs), and yield aggregators. We apply the same analysis to some publicly traded firms and compare them with DeFi tokens of the analogous category. Interestingly, despite the crypto bear market lasting for more than one year as of August 2022, both approaches evidence overvaluation in DeFi."

"Decentralized finance (DeFi) is composed of a variety of heterogeneous sectors that are interconnected through an input-output network of its tokens. We first use a panel data set to empirically document the evolution of the DeFi network across its different sectors. Instead of looking at the misleading measure of total value locked, we then employ a standard, theoretical production-network model to measure the value added and service outputs of the different DeFi sectors. Finally, based on a calibrated version of our model, we study which factors drive DeFi token prices and predict the equilibrium effects when network interconnectedness increases." [Bank of Canada]

Decentralized finance (DeFi) is expanding into the world of interest rate swaps (IRS), a derivative instrument for exchanging fixed and variable interest rates, which account for more than $1 quadrillion in exchanged value per annum in traditional finance. DeFi firm Voltz Labs has launched a non-custodial automated market making (AMM) IRS trading platform based on the Aave and Compound DeFi USDT, USDC, DAI and ETH lending markets. However, IRS AMMs are challenged by DeFi markets' lack of fixed-rate products off which to price swaps. (Traditional markets offer both variable- and fixed-rate products.)

Brian Brooks, Acting Comptroller of the Currency, argues that decentralized finance (DeFi) could pave the way for a kind of "self-driving bank." With a set of new regulations in place, he says that national bank charters might one day be granted to DeFi protocols. DeFi protocols are automated, algorithmically-governed money management systems that essentially skip out on the need for human moderation in financial services and products.

Opium Finance has released collateralized debt obligation products (CDOs) for Compound Finance's automated lending markets. Opium is a decentralized finance (DeFi) protocol that allows for creating, settling, and trading decentralized derivatives. Compound Finance is an algorithmic, autonomous interest rate DeFi protocol that allows for the creation of money markets on the Ethereum blockchain. Investors can put up the Compound debt token cDai - and soon Uniswap tokens - to diversify exposure to DeFi lending markets. Opium's product pays out structured returns to both a senior and junior risk tranche in exchange. The former tranche offers a 7% fixed return on DAI (a crypto-backed USD-pegged stablecoin) at maturity, while the latter pool offers a variable rate paid out after filling up the senior tranche's return.

The sudden growth of DeFi on Ethereum has pushed the blockchain to its limits, leading to transaction delays and inordinately high fees - making many Ethereum DeFi platforms simply unusable to regular users. As a result, many developers are opting to build their DeFi applications on other Platforms such as Polkadot. Polkadot is highly interoperable other blockchains (including Ethereum). Also, Polkadot has a block time of just six seconds and most transactions are considered final after less than a minute, and it can currently handle more than 1,000 transactions per second (tps).

Preston Byrne, a partner at law firm Anderson Kill: "Generally speaking, incorporating DeFi into a web application with the intent that the SaaS provider become a pass-through for the decentralized backend is fraught with legal and compliance issues. Because DeFi tries to replicate financial services, and financial services is regulated, providing services to interact with DeFi is likely to be captured by financial services regulation." For example, decentralized exchange providers such as EtherDelta have run afoul of the Exchange Act "arising from the use of a DeFi platform to trade coins which in the SEC's view were not coins but rather 'digital asset securities.'"

Of all of the disruptive possible uses of blockchain, decentralized finance (or DeFi) might be the one most likely to bring this technology to a wide audience - and challenge the established finance industry in the process. By using self-executing contracts on newly formed marketplaces, DeFi allows users to stand in place of large institutions to loan and borrow money to each other, and to earn interest and fees by doing so. DeFi offers new opportunities to make money, such as "yield farming," which often resemble traditional finance strategies. But it also offers a large-scale update to the basic plumbing of financial markets such as NASDAQ and the NYSE, offering more efficiency, transparency, and trust. There is significant risk inherent these crypto markets, but DeFi offers a less volatile and more accessible point of entry than other markets - and may just have enough appeal to bring blockchain into the mainstream.

DeFi (decentralized finance) encompasses anything that provides loans, borrowing, staking or some reward to the user for putting in capital to the system. It removes all the layers of intermediaries and middlemen that would normally be involved through the use of smart contracts. The DeFi space remains heavily reliant on the Ethereum blockchain (which has famously struggled to scale to onboard mass users). However, once Ethereum transitions to ETH 2.0 using the Proof of Stake consensus mechanism, the number of users it can onboard will be potentially without limitation. Moreover, other serious contenders are further building out the space, such as Compound, and Maker DAO, propelling DeFi to more and more users.

The speculation surrounding YAM draws natural comparisons to 2017's ICO mania. But this is a more complex version, where speculators need to interact with an increasingly complicated system of DeFi smart contracts. This can lead to unexpected risk and sudden surges in fees, which can make it prohibitively expensive to get in and out of speculative positions quickly. Ultimately, escalating fees can cause mass congestion and lead to cascading effects throughout the network. But speculation often helps drive innovation. DeFi will push Ethereum towards scalability solutions, and developers will likely continue to push the boundaries of what's possible in decentralized finance. But there will likely also be a lot of damage along the way, especially if DeFi applications continue to launch without proper auditing and precautions.

As the DeFi sector continues to grow and we seek to track the burgeoning sector, questions often arise as to what exactly constitutes DeFi. In order for a token to constitute "DeFi" it must satisfy the following requirements: (i) the protocol must be explicitly geared towards financial applications, (ii) the code is open-source, (iii) users do not need to reveal their identity, (iv) assets are not custodied by a single third-party, and governance is decentralized (upgrade decisions and administrative privileges are not held by a single entity or at least a credible path exists towards removing them).

DeFi-focused blockchain Algorand is launching smart contract capabilities that will allow DeFi solutions and dApps to be created that are more scaleable than on Ethereum. Specifically it is implementing stateful smart contracts within layer-1. These are more flexible than stateless smart contracts, which require all conditions to be met at once before the funds are unlocked. Stateful smart contracts, one of Ethereum's strengths, can release funds when a sequence of interactive steps have been taken or conditions met, allowing for more sophisticated DApps and DeFi solutions. Algorand already supports stateless contracts, atomic swaps, and Algorand Standard Assets within layer-1. Algorand also says that its blockchain provides "negligible" transaction fees, a pointed reference to "first-generation" networks such as Ethereum.

The OECD published a report that analyzes the connection between decentralized finance (DeFi) protocol liquidations and price volatility in decentralized exchanges (DEXs). The analysis employs transactional data of three of the largest DeFi lending protocols and suggests a positive relation between liquidations and post-liquidations price volatility across the main DEX pools. It also shows a positive correlation among borrowing rates and across different assets, which indicates that the liquidity in DeFi lending pools is connected, and that at extreme events, when investors pursue the same strategy at large numbers, liquidity of a particular asset may dry up in each of the pools across protocols. This implies that the liquidations mechanism might be limited in its ability to restore liquidity, as liquidators themselves rely on the liquidity available in the pools to repay underwater loans.

"DeFi trading volume has more than halved; the total value of crypto tokens locked in DeFi protocols has been mostly flat for months; and DeFi's once lofty returns are nowhere to be found. Investors both at the retail and institutional level are less willing to look past security risks and regulatory uncertainty. And with solutions to those problems still years away, a number of DeFi projects may not survive the downturn."