Decentralized Finance (DeFi)

This chapter discusses the value and need for trust in economic and financial transactions. We discuss the various definitions of trust, how money functions, and how banks have influenced the development of money. It is our intent to explain the role of banks in the development of money or currency in the European context in order to emphasize that the primary objective of banks is to promote trust among their customers. Further, we explain that trust is a key ingredient for designing and implementing bilateral and multilateral trading, financial, and thereby economic cooperation in the development of the global financial system. As a result of a loss of trust in the financial system, bank runs have occurred and losses have resulted. We explain the impact of technology in enabling a rethink of financial systems and providing innovative solutions by utilizing decentralized finance to democratize banking. This chapter concludes by explaining the motivation and plan of this book.

In this section, we provide an overview of the evolution and development of centralized finance over the last centuries. Building on the historical growth of banking as a sector, we offer a description of banking’s status quo in globalized economies today that are predominantly characterized by dynamic and internationally mobile customers. Furthermore, we provide a brief introduction to the history of banking, which is at the heart of centralized finance. This helps understand the classification of banking licenses, the steps in acquiring such a license, and the authorization processes for these various licenses. We elaborate on the different types of banks, with a discussion on their primary products and services. We hereby summarize their activities and give insights into their operational strategy and their role as an intermediary and bank in the economy. In conclusion, this section provides an overview of the competitive landscape in the financial services industry as a whole.

The purpose of this chapter is to guide you through the mechanics of decentralized finance (DeFi) and its potential applications. As a first step, we will discuss how to implement DeFi by examining smart contracts in order to provide perspectives on the technical foundation required for this type of financing. For a basic understanding of DeFi, we will examine blockchain technology as well as the Ethereum ecosystem on which it will run. We will also illustrate the different categories of DeFi as well as the potential applications of the technology in the future. In conclusion, we will discuss specific aspects of regulation that are necessary for safety and security.

In this chapter, we take a close look at the technology that makes the concept of decentralized finance (DeFi) a reality. We provide insights into the technical mechanics of DeFi and its environment in order to gain a better understanding of the development process of the DeFi ecosystem. We discuss the uses and value of blockchain technology, under which we elaborate on distributed ledger technology and its pioneering role in facilitating DeFi instruments. We discuss the implications of blockchain technology as well as that of Ethereum’s ecosystem in the financial market and explain how these together can create a significant transition—in other words, a disruption—of the overall economic and financial system as we know it today.

We present here an overview of the different types of decentralized finance (DeFi) available in the market today. Currently, there are eight different types that can be identified and classified as functioning tools or products. These include decentralized stablecoins, decentralized payments, decentralized derivatives, decentralized lending and borrowing, decentralized exchanges, decentralized wealth management, decentralized lotteries, and decentralized insurance. A clear delineation of these categories of products and services is currently not possible owing to the similarity of features and/or functions. This is however reflective of the centralized financial markets. Nevertheless, these categories reflect the perception and motivation of different participants in the decentralized financial market, the understanding of which is essential in explaining the formation of the DeFi ecosystem. In conclusion, we elaborate on the six major use cases for the DeFi movement.

Over the past couple of years, DeFi has been growing at a rapid pace. As of January 2022, it is estimated that there are more than USD 237 billion worth of digital assets combined into DeFi projects. There has been a continuous growth of the DeFi movement since the beginning of 2020, and it is most likely that this growth will be sustained in the future. It is becoming more evident that regulators are increasingly aware of DeFi and its rapid growth. Because of this, there are sporadic efforts aimed at creating regulations that will govern the use of DeFi by existing and future participants. In this section, we provide an overview of the potential risks and security concerns that come with DeFi as well as elaborate on the regulatory context in the European Union.

In the context of blockchain technology, it is important to remember that since it gives more power to individuals as opposed to companies or other regulated intermediaries such as banks, there is a greater need for responsibility within the network. DeFi risks can be classified into four different types, namely financial risks, technology risks, procedural risks, and regulatory risks.

Governments and other regulatory agencies are increasingly addressing the question of whether and to what extent the use of decentralized finance (DeFi) services and products should be subject to regulatory requirements in the wake of the rapid visibility, growth, and efficiency of this technology. One of the most important questions for regulators is how to find the individuals or entities who are responsible and liable for the evolving network of anonymous transactions in order to take preventive measures to protect users and beneficiaries. The purpose of this section is thereby to provide an overview of the regulatory context in the area of DeFi services and products and to elaborate on both the international and the European approach to decentralization.

Building on the analyses of the differences in nature and characteristics between centrally controlled and decentralized finance in earlier chapters, in this section, we elaborate on nuanced differences between these systems to point out the advantages and disadvantages of each of these. This exercise will help experts, professionals, and researchers to identify the opportunities and risks associated with each system and will aid them in making decisions accordingly. Overall, the objective is to provide a better understanding of the differences and similarities between traditional and decentralized finance. Furthermore, it provides a status quo and an outlook on future challenges and opportunities regarding decentralized finance and its use cases.

The transition of financial products into the digital economy requires a robust digital infrastructure and an extensive understanding of stakeholders on the value-creating and securing functions of this system as a whole (Friesendorf & Stern, Mangelnde Digitalisierung in der Finanzbranche. In Digitalisierung des Auslandszahlungsverkehrs. essentials. Springer, 2020; Friesendorf & Uedelhoven, Digital transformation of global mobility markets. In Mobility in Germany. Springer briefs in business. Springer, 2021). This chapter provides a comprehensive view of decentralized finance (DeFi) tools and assets. Beginning with the different categories of decentralized stablecoins, we provide detailed insights into decentralized exchanges, decentralized credit, and decentralized assets, which together form the DeFi ecosystem. We provide the most updated information on each of these DeFi classifications of goods to familiarize bankers, entrepreneurs, investors, and government agencies with the DeFi landscape.

Decentralized Finance (DeFi) emerges as a promising field that gives customers control over their finances and has the potential of removing expensive intermediaries and retaining trust in financial systems. Digital technologies are aiding the rapid spread and experimentation of various DApps-based DeFi financial and investment products. Regulatory authorities are yet to frame the development to find out the cases of moral hazard or adverse selection (Friesendorf & Stern, Mangelnde Digitalisierung in der Finanzbranche. In Digitalisierung des Auslandszahlungsverkehrs. essentials. Springer, 2020; Friesendorf & Mir Haschemi, Private equity in Germany. In Venture capital for digital platform start-ups. Springer Business Guides on the Go. Springer, 2023). However, there is much literature produced both in the scientific and practitioner area that we expect national and international regulation to catch up due to this advantage. The question remains whether customers will indeed switch to innovative financing such as DeFi and thereby giving up their familiar experiences with traditional banking. In this chapter, we conduct an empirical analysis using online survey tools to investigate customer ability, willingness, and preferences for and against DeFi. In effect, we illustrate herewith the potential profile of the customer who will appreciate and promote DeFi. We specifically look into trust, technology, and ESG expectations of customers.

In this final chapter of this book, we re-assess the study to filter out key learnings and implications for the traditional financial industry with the entrance of technology and entrepreneurial energy in the face of changing customer preferences and expectations. Furthermore, we will provide an overview of the advantages and disadvantages of decentralized finance as well as the opportunities and challenges that DeFi faces in the future. Given the changes in the environment of finance, we recommend concepts and strategies that enable traditional banks to sustain their customers and position in the market by addressing the topics of regaining the trust of customers and other stakeholders in the industry as a whole. In conclusion, we point out the disruption capacity of dApps and DeFi and how finance can and will change.