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The Bank of Canada published a paper that uses a simple stylized model of collateralized lending to analyze the value proposition and limitations of decentralized finance (DeFi). DeFi uses a decentralized ledger to run smart contracts that automatically enforce the terms of a lending contract and safeguard the collateral. DeFi can lower the costs associated with intermediated lending and improve financial inclusion. Limitations are the volatility of the crypto collateral and stablecoins used for settlement, the possible incompleteness of smart contracts and the lack of a reliable oracle. A proper infrastructure reducing such limitations could improve the value of DeFi.

"DeFi still faces many challenges. However, it can also create an independent infrastructure, mitigate some risks of traditional finance, and provide an alternative to excessive centralization. The open-source nature of DeFi encourages innovation, and there are many talented people-academics and practitioners alike-working on these challenges. If they can find solutions without undermining the unique properties at the core of DeFi, it could become an important building block for the future of finance."

The International Organization of Securities Commissions published a report on DeFi, highlighting a wide array of risks associated with it. "As DeFi continues to expand, both a granular and holistic understanding of the DeFi market will improve authorities' ability to understand the regulatory implications of this emergent market with respect to their own jurisdictions."

Can investors obtain better protection when crypto firms fail if activities migrate from centralized crypto entities to DeFi protocols? Decentralization provides some clear benefits to investors, by preventing misuse of customer funds and providing more transparency surrounding data and code. Governance procedures are also more transparent, though voting power can be highly concentrated and thus subject to manipulation. Moreover, the technology in DeFi allows different types of financial services to interact with few frictions. For instance, a flash loan allows users to simultaneously (or atomically) conduct and fund an arbitrage trade-something that would not be possible on a centralized platform. However, the technology also facilitates the creation of excessive leverage due to the repeated use of the same collateral for borrowing and lending. Further, bugs in smart contract codes, as well as hacks to oracles and smart contracts, resulted in an estimated loss of more than $1.3 billion in 2022:Q1. DeFi protocols may also introduce novel legal risks. In particular, the legal obligations of DeFi platforms are often opaque, and users may have little recourse should they seek to modify a transaction as the parties involved are anonymous and may be located anywhere in the world.

The OECD published a paper that provides evidence of increased concentration of decentralized finance (DeFi) liquidity provision in decentralized exchanges (DEXs) and automated market makers (AMMs). A low trade count is observed in liquidity pools where DeFi liquidity provision is concentrated, with 20% of the pools of some of the DEXs examined accounting for more than 90% of the trading volume of these DEXs. Also, a small number of liquidity providers participating in the examined pools represent a significant part of the trading activity. This could exacerbate DeFi vulnerabilities, with possible impact on market functioning, price discovery, and competitive dynamics.

The Journal of Financial Regulation (JoFR) published a paper that offers a framework to assess the factual decentralization of blockchain-based decentralized finance (DeFi) financial infrastructures, which is crucial for regulatory assessments. It explores various potential sources of centralized control, either endogenous or through inherited dependencies on other projects ("centralization vectors"). It finds that many DeFi projects are subject to such vectors that are likely critical, and taking them into account substantially reduces the number of DeFi projects that are genuinely decentralized. The paper argues that if a project has significant centralization vectors it can and likely should be regulated. On the other hand, for truly decentralized projects, the regulatory focus should remain on the on- / off-ramps to / from the spheres of on-chain centralized finance (CeFi) and (traditional) CeFi.

DeFi platforms aim to improve upon the traditional financial system by combining two innovations: a "smart contract" transaction technology and a "token holder" governance model. Although DeFi's transaction technology promises to reduce costs in some applications, it cannot, on its own, redistribute these economic gains to users. To achieve their goal, DeFi platforms must be governed in a way that is consistent with users' interests. So far, however, DeFi has not decentralized decision-making power to users in the way its proponents had hoped. Future progress in DeFi will require not only technical advances in smart contract and distributed ledger design but also economic solutions to the governance problems faced by these platforms.

Avalanche works. Really really well. So what is Team Prospero going to build with it? For starters, we've already mini-pivoted from the basic "turn your credit card change into crypto" play into social DeFi portfolio management. In order for DeFi to reach its full mainstream potential, we believe that engagement with crypto markets needs to be as intuitive as using Robin Hood. That's why we're building DeFi Portfolios for the People.

The Association for Financial Markets in Europe (AFME) published a paper on decentralized finance (DeFi), including the impact of policy and emerging regulatory proposals within Europe on DeFi regulation and its intersection with capital markets. It calls for further research and global cooperation to determine the appropriate, proportionate, and comprehensive regulatory solutions for the unique challenges posed by DeFi. In that regard, it is crucial to leverage existing processes and frameworks to create a holistic regulatory perimeter.

The BIS published a paper that provides a deep dive into the architecture, technical primitives, and financial functionalities of decentralized finance (DeFi) protocols. It analyzes and explains the individual components and how they interact through the lens of a DeFi stack reference model featuring three layers: settlement, applications and interfaces. Then, it describes the financial services for the most relevant DeFi categories, i.e., decentralized exchanges, lending protocols, derivatives protocols and aggregators. It discusses how composability allows complex financial products to be assembled, which could have applications in the traditional financial industry.

A Bank for International Settlements (BIS) paper explains decentralized finance (DeFi) miner extractable value (MEV) and why it arises, documents the amounts involved, and draws regulatory implications for cryptocurrencies, DeFi and other blockchain-based applications. Cryptocurrencies and DeFi protocols built on them rely on validators or "miners" as intermediaries to verify transactions and update the ledger. Since these intermediaries can choose which transactions they add to the ledger and in which order, they can engage in activities that would be illegal in traditional markets such as front-running and sandwich trades. The resulting profit, or MEV, is an intrinsic shortcoming of pseudo-anonymous blockchains.  [Read more]

The Bank of Canada (BoC) published a paper that develops a dynamic model of decentralized finance (DeFi) in which borrowing and lending are backed and overcollateralized by crypto-assets and contract terms are pre-specified and rigid. It identifies a price-liquidity feedback loop in which expectations of future higher lending volumes and prices lead to more lending and higher prices in the current period. This feedback loop and smart contract rigidity leads to multiple self-fulfilling equilibria where DeFi lending and asset prices move with market sentiment. This highlights difficulty of achieving stability and efficiency in a DeFi environment without a liquidity backstop.

The OECD published a paper that assesses the role of centralised finance (CeFi) and decentralised finance (DeFi), and the disproportionate impact the crypto market turmoil has had on retail market participants. It examines learnings of the recent crypto-asset market downturn, including high interconnectedness within the crypto-asset ecosystem; elaborate mechanisms of financial engineering that heavily use leverage and are built on the composability offered by DeFi (i.e., components of DeFi are pieced together to create new products); and increased market concentration. The paper also highlights the urgency for policy action and provides policy recommendations.

The Bank for International Settlements (BIS) published a paper that uses granular, transaction-level data from Aave, a leading player in the distributed finance (DeFi) lending market, to study investor motivations. The theoretical and empirical findings reveal that the search for yield predominantly drives liquidity provision in DeFi lending pools, whereas borrowing activity is mainly influenced by speculative and, to some extent, governance motives. Both retail- and large investors seek potential high returns through market movements and price speculation, however the latter engage in DeFi borrowing relatively more than the former also to influence protocol decisions and accrue more significant governance rights.

The problem with smart contracts is that by design they're hard or impossible to alter, which requires the most painstaking code review and analysis so that you don't lose money to an exploit, but you make more money by being quick to market. DeFi apps that use chains of smart contract programs to automate complex financial transactions enable attacks to be chained too. Unsurprisingly, it's a continuing dumpster fire, reliably delivering comedy gold. The problem with DeFi is not the technology, though that's bad too - it's that people are greedy and foolish.

Decentralized finance, also referred to as "DeFi" or open finance, aims to recreate traditional financial systems (such as lending, borrowing, derivatives, and exchange) with automation in place of middlemen. Once fully automated, the financial building blocks of DeFi can be composed to produce more complex capabilities. Today, the primary venue for decentralized finance is Ethereum, but in principle these ideas can be implemented on any smart contract platform.

Volume on decentralized finance (DeFi) platforms was at an all-time high in 2020 - and so were the number of attacks and thefts in that arena, according to blockchain analysis firm CipherTrace's Crime Report. Over 50% of crypto thefts in 2020 stemmed from DeFi attacks, adding up to $129 million. That's more than 25% of the year's total volume from hacks and other incidents.

"MakerDAO and DeFi more generally are helping to provide an answer to the question that hangs over crypto. After the bubble, then crash, of 2017 and 2018, it's natural to ask, 'What do we use this stuff for?' DeFi is the first legitimate answer to the question. DeFi is starting to have its moment because it's the next chapter for crypto."

Should global leaders come together to create a crypto-friendly global blockchain framework, the DeFi market is poised to become an integral part of the financial industry of the future. Should lawmakers struggle to formulate a conducive regulatory framework, we could still see DeFi flourish in markets where traditional financial institutions have failed large pockets of the population.

DeFi potentially offers much higher returns to savers than high-street institutions. Compound, for example, has been offering an annualized interest rate of 6.75% for those who save with stablecoin Tether. Not only does a user gain interest, but it also receives Comp tokens, an added attraction. With two-thirds of people without bank accounts in possession of a smartphone, DeFi also has the potential to open up finance to them.