Decentralized Finance (DeFi) remains a niche market, but its efficiency, transparency, accessibility, and composability make for interesting characteristics, enabling it to potentially contribute to a more robust and transparent global financial infrastructure, according to a study published by the St. Louis branch of the US Federal Reserve (Fed).
However, it is written not by the Fed but by Fabian Schär, Professor of distributed ledger technologies and fintech and Managing Director of the Center for Innovative Finance at the Faculty of Business and Economics of Switzerland’s University of Basel.
“DeFi still is a niche market with relatively low volumes — however, these numbers are growing rapidly. The value of funds that are locked in DeFi-related smart contracts recently crossed 10 billion USD,” the author said.
“The spectacular growth of these assets alongside some truly innovative protocols suggests that DeFi may become relevant in a much broader context and has sparked interest among policymakers, researchers, and financial institutions.”
(In fact, the total value locked stands above USD 36bn today, per defipulse.com data.)
Also, in his research, Schär used a multi-layered framework to analyze DeFi’s architecture and building blocks. These include token standards, decentralized exchanges, decentralized debt markets, blockchain derivatives, as well as on-chain asset management protocols. The framework enabled him to highlight the opportunities and potential risks within the DeFi ecosystem.
“DeFi has unleashed a wave of innovation. On the one hand, developers are using smart contracts and the decentralized settlement layer to create trustless versions of traditional financial instruments. On the other hand, they are creating entirely new financial instruments that could not be realized without the underlying public blockchain,” according to the paper. “Atomic swaps, autonomous liquidity pools, decentralized stablecoins, and flash loans are just a few of many examples that show the great potential of this ecosystem.”
This said, the researcher recognized that, while “this technology has great potential, there are certain risks involved. Smart contracts can have security issues that may allow for unintended usage, and scalability issues limit the number of users.”
“Moreover, the term ‘decentralized’ is deceptive in some cases. Many protocols and applications use external data sources and special admin keys to manage the system, conduct smart contract upgrades, or even perform emergency shutdowns. While this does not necessarily constitute a problem, users should be aware that, in many cases, there is much trust involved,” according to the author.
Schär concluded by forecasting that “if these issues can be solved, DeFi may lead to a paradigm shift in the financial industry and potentially contribute toward a more robust, open, and transparent financial infrastructure.”
Meanwhile, the paper is already echoing through the cryptosphere, triggering the enthusiasm of various industry representatives, including Jay Hao, CEO of crypto exchange OKEx who called the study “the gem of the day”. Others, such as a DeFi investor who tweets as Arthur, admitted they “didn’t expect it to come this early”.
Some industry observers even claimed that the study’s publication could indicate a forthcoming re-orientation in the Fed’s conservative approach to DeFi.
“Someone at the Fed had to accept the article for publication. Someone at the Fed decided it was adequately reviewed. The St. Louis Fed is promoting the article through its Twitter feed. Don’t downplay it too much,” a user who goes by the name Notorious PtG, replied to a remark that the Fed is not the author of the report.
Also, Maya Zehavi, a blockchain-focused entrepreneur and Founding Board Member of the Israeli Blockchain Industry Forum, added that she thought this was “the fastest they’ve recognized & researched a crypto trend, probably [because] they realize what a paradigm shift DeFI poses to financial infrastructure”.