## DEFI’S PROMISE AND PITFALLS

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**Canonical URL:** [DEFI’S PROMISE AND PITFALLS](https://www.imf.org/-/media/files/publications/fandd/article/2022/september/schar.pdf)

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### Smart contracts and DeFi architecture
- DeFi uses public blockchain networks to conduct transactions without relying on centralized service providers such as custodians, central clearinghouses, or escrow agents; these roles are assumed by smart contracts.
- Smart contracts are instructions in the form of computer code stored on public blockchains and executed as part of the system’s consensus rules.
- State changes (for example, updates to account balances) are reflected on the blockchain and can be verified by anyone.
- In DeFi, smart contracts are used mainly to:
  - ensure the atomic (simultaneous and inseparable) transfer of two assets; and
  - hold collateral in an escrow account.
- Smart contracts can reference other smart contracts and make use of their services; actions across multiple smart contracts within a single transaction is referred to as “intra-transaction composability,” which can mitigate counterparty risk.

### Benefits of decentralization
- Public blockchains provide transparency: code is stored and executed on an open system; all data are available and verifiable, allowing researchers and policymakers to analyze transactions, run empirical studies, and compute risk metrics in real time.
- Access is not restricted, yielding two implications:
  - A neutral foundation that cannot discriminate between use cases nor stakeholders, avoiding the politicization and access-control risks of permissioned ledgers.
  - A layered infrastructure: restrictions can be implemented at the smart contract level without compromising the general neutrality of the base infrastructure; if the ledger itself were centralized, credible decentralization of layers above would be impossible.
- Intra-transaction composability requires assets and financial protocols to be on the same ledger; strong network effects make composable infrastructure compelling for payments, tokenized assets, exchanges, and lending markets.
- Decentralization can mitigate holdups from lack of cooperation that arise when participants expect potential politicization or exclusion on permissioned ledgers.

### Comparisons with centralized systems
- Many advantages attributed to DeFi or blockchains can also be achieved via centralized infrastructure; smart contracts and token standards can be used on centralized ledgers, and composability can work on such systems.
- Well-managed centralized systems are typically more efficient than public blockchains.
- Centralized systems rest on a very strong assumption: trust in intermediaries and institutions that are largely opaque; history shows corruption and errors within institutions.
- The transparency and neutrality of public blockchains make a strong case for decentralization when benevolence of intermediaries cannot be assumed.

### Challenges and risks
- Decentralization theater: many protocols labeled DeFi are often heavily centralized, relying on centralized data feeds, admin keys, or concentrated governance token allocations; differentiating true decentralization from centralized disguises is important.
- Immutability risks:
  - Harder enforcement of investor protection.
  - Smart contract programming errors can have devastating consequences.
  - Composability and complex token wrapping schemes that resemble rehypothecation of collateral contribute to shock propagation and may affect the real economy.
- Privacy and rent extraction:
  - Blockchain transparency and decentralized block creation can be problematic for privacy.
  - Generalized front-running (miner/maximal extractable value, MEV) enables observers to front-run or sandwich transactions and profit at the expense of original transaction issuers; potential mitigations exist but involve trade-offs.
- Scalability trade-offs:
  - Decentralized block creation imposes severe costs; hardware requirements to run a node cannot be arbitrarily high without pricing out stakeholders and compromising decentralization.
  - Limits on-chain scalability push up transaction fees; the trade-off between security, decentralization, and scalability is often portrayed as a trilemma.
  - Layer 2s are a potential solution to move burden off-chain while allowing enforcement on-chain, but in many cases they still require trust and various forms of centralized infrastructure.

### Outlook and policy implications
- DeFi can 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; many academics and practitioners are working on the challenges described.
- If solutions can be found without undermining the unique properties at the core of DeFi, it could become an important building block for the future of finance.

*Fabian Schär, September 2022.*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2022/september/schar.pdf_