DeFi Promise and Pitfalls Fabian Schär

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DeFi uses public blockchain networks to conduct transactions without relying on centralized service providers such as custodians, central clearinghouses, or escrow agents.
Smart contracts are instructions in the form of computer code, stored on public blockchains and executed as part of the system’s consensus rules.
Smart contracts are used mainly to:
- ensure the atomic (simultaneous and inseparable) transfer of two assets, and
- hold collateral in an escrow account, with assets released only if predefined conditions are met.
Intra-transaction composability: actions across multiple smart contracts can take place within a single transaction (for example, an asset management protocol using a decentralized exchange to swap incoming assets as part of the same transaction), effectively mitigating counterparty risk.

Public blockchains provide a transparent, neutral, independent, and immutable infrastructure:
- Code is stored and executed on an open system; all data are available and verifiable.
- Researchers and policymakers can analyze transactions, run empirical studies, and compute risk metrics in real time.
Open access implications:
- Absence of access restrictions provides a neutral foundation that cannot discriminate between use cases nor stakeholders, unlike permissioned ledgers whose rules are set by a centralized entity.
- Layered infrastructure: a decentralized ledger does not require everything deployed on top of it to be equally decentralized; restrictions can be implemented at the smart contract level without compromising the neutrality of the base infrastructure.
Network effects and composability rationale:
- Intra-transaction composability works only if assets and financial protocols are on the same ledger.
- It is very likely we will see a move toward ledgers that combine payments, tokenized assets, and financial protocols, such as exchanges and lending markets.
- Centralized composable infrastructure is possible but would be risky and difficult to govern given the challenges associated with permissioned ledgers, strengthening the case for decentralization.

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.
Well-managed centralized systems are much more efficient than public blockchains, potentially implying public blockchains and DeFi could be inferior on efficiency grounds.
Centralized systems rely on trust in intermediaries and institutions that are largely opaque; public blockchains mitigate this reliance by providing transparency and verifiability.

Decentralization theater:
- Many projects labeled as DeFi are often heavily centralized (centralized data feeds, admin keys, concentrated governance token allocations).
- Important to differentiate true decentralization from companies providing centralized infrastructure while claiming to be DeFi.
Immutability risks:
- Harder enforcement of investor protection.
- Smart contract programming errors can have devastating consequences.
- Composability and complex token wrapping schemes can resemble rehypothecation of collateral, contributing to shock propagation and potential spillovers to the real economy.
Privacy and extractable rents:
- Transparent blockchain data and decentralized block creation can be problematic for privacy.
- Generalized front-running (miner/maximal extractable value, MEV): observers can front-run or sandwich transactions to profit at the expense of original transactors; potential solutions exist but involve trade-offs.
Scalability trilemma:
- 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 and pushes up transaction fees.
- Layer 2 solutions: designed to move burden off the blockchain while allowing enforcement on-chain if needed; promising but often still require trust and forms of centralized infrastructure.

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 addressing its challenges.
If solutions are 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, F&D Magazine, September 2022

DeFi's Promises and PItfalls
- DeFi's Promises and PItfalls (Markdown version)
- DeFi's Promises and PItfalls (PDF)