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2023 | OriginalPaper | Buchkapitel

2. Centralized and Decentralized Finance: Coexistence or Convergence?

verfasst von : Axel Wieandt, Laurenz Heppding

Erschienen in: The Fintech Disruption

Verlag: Springer International Publishing

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Abstract

The financial crisis of 2007–2008 revealed that centralized finance (CeFi), which relies on large, interconnected financial institutions, is easily destabilized. Since the crisis, significant regulatory tightening, monetary easing, and new competitors (e.g., fintechs) have created significant pressure on profit margins and CeFi business models. Recently, a new form of financial intermediation that functions independently of centralized intermediaries has emerged, namely decentralized finance (DeFi). DeFi relies on public, permissionless blockchains and uses so-called smart contracts to perform financial services such as borrowing, lending, and trading in a transparent and automated fashion. This paper gives an overview of DeFi and discusses its advantages and disadvantages compared to CeFi. In it, we analyze different scenarios pertaining to the future paths of CeFi and DeFi, and conclude that a convergence scenario is the most likely.

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Vorheriges Kapitel Fintech and Banking: An Overview

Nächstes Kapitel Fintech and the Digital Transformation of the Banking Landscape

For a systematic review of peer-reviewed DeFi-related publications, see Meyer et al. (2022).

For a summary of the role of banks in the financial system, see Wieandt (2017, p. 43).

For this perspective on money creation, see, e.g., McLeay et al. (2014).

See Diamond and Dybvig (1983) for a model of bank runs and the stabilizing effects of deposit insurance.

FAANG is an abbreviation of the five largest technology companies Facebook (now Meta), Apple, Amazon, Netflix, and Google/Alphabet.

For a comprehensive discussion of Bitcoin and other cryptocurrencies, see Narayanan et al. (2016).

Szabo (1997) illustrates the functionality of a smart contract using the example of a vending machine. A vending machine can interact with a user in three automated ways. If the user inserts the appropriate amount of money, the desired product is delivered. If too much money is inserted, the vending machine recognizes this and dispenses change and the desired product accordingly. If not enough money is inserted, no product is dispensed and the inserted money is returned with the message that the inserted amount was not sufficient.

Turing-complete refers to a machine that, given enough time, memory, and the necessary instructions, can solve any computational problem, regardless of its complexity.

We distinguish between transparency and comprehensibility of the source code since technical expertise is needed to understand the logic of the program.

For a detailed introduction to smart contracts, see Antonopoulos and Wood (2018).

DApp differs from DeFi protocols in that DApp encompasses both the functionality of the protocol and the corresponding user interface (UI). However, since the functionality of DeFi is of primary importance, most of the literature refers to protocols without explicitly discussing the UI. For this reason, in this paper we use the terms DApp and DeFi protocol synonymously.

See the Terra (Kereiakes et al., 2019) and Binance Smart Chain (Binance, 2020) whitepapers for further reference.

Since users can have several addresses, the number of unique addresses only approximates the number of users.

Jensen et al. (2021a) propose a layer system consisting of four layers, in contrast to Schär (2021), combining the protocol and application layer.

This transfer between different blockchains through so-called bridges will be addressed in more detail later in a deeper exploration of the protocol layer.

Non-fungible tokens (NFTs) have recently experienced an enormous boom, as they are used, for example, to represent ownership of unique art objects.

Fungible tokens are comparable to, e.g., traditional fiat currencies, non-unique and divisible. Non-fungible tokens, on the other hand, represent unique and indivisible items, e.g., (digital) artworks or flight tickets.

For example, in the context of a loan agreement, it is problematic if the interest payments fluctuate significantly due to a highly volatile calculation base, as this results in unfavorable situations for either the lender or the borrower.

Some new projects, such as Goldfinch, also provide unsecured loans for a longer period of time.

See Chapter 4 for a detailed comparison between a DEX and a traditional (securities) exchange.

For detailed discussions of liquidity pooling and AMMs, see, e.g., Lehar and Parlour (2021), Schär (2021), and Aramonte et al. (2021).

See Schär (2021) for a discussion of the situation with one or multiple fund managers whose actions are controlled by fixed rules in smart contracts.

In the context of the proof-of-stake consensus mechanism, minting describes the process of validating information and including transactions into a newly created block. To participate in this process, the so-called validators must deposit crypto assets, e.g., Ether, as a security, to ensure their integrity. In return, the validators are compensated in the form of block rewards and transaction fees. Minting is thus the counterpart of the so-called mining, which is used in the proof-of-work consensus mechanism.

Other collateral assets are, e.g., Basic Attention Token (BAT), USDC, Wrapped Bitcoin (WBTC), and Tether.

MakerDAO requires that, for a loan of 1 Dai, at least a value of 1.5 Dai/USD must be deposited, corresponding to a collateral ratio of 150%. In practice, the collateral ratio is currently (01/2022) c.170%.

The stability fee is a compounding interest rate per second, which is used to develop the platform, among other things.

The liquidation ratio is determined for each collateral asset by the governance system of MakerDAO.

For an overview on oracles, see Pasdar et al. (2021), Beniiche (2020), and Liu et al. (2020).

Sharding is a common concept in the context of database systems as it describes the splitting of a database horizontally to achieve a better distribution of the workload across the nodes (Ethereum, 2022a).

Roll-ups execute transactions outside of the main Ethereum network but post the transaction data back to the Ethereum network, thus ensuring the security provided by the Ethereum protocol (Ethereum, 2022a).

See also Gogel (2021) for a list of functional differences between DeFi and CeFi.

The lending protocols Aave and Compound currently use a minimum collateral ratio of 120%, which means that someone borrowing USD 100 must deposit at least USD 120 in assets.

In some cases, the current transaction fees are also considered when deciding on the timing of the disbursement to find the most favorable transaction timing.

In CeFi, the buyer may pay the agreed purchase price immediately, while the seller delivers the securities at the end of the settlement period. Thus, the buyer’s asset position is initially reduced without immediate compensation.

The degree of self-sovereignty between a user and a DeFi protocol must be strictly separated from the dependency of a user on a wallet provider. For example, if a user commissions a wallet provider to store his private key, then a dependency relationship exists between the user and the wallet provider. However, this dependency does not explicitly affect the self-sovereignty of a user when dealing with a DeFi protocol.

Even though the basic idea of DeFi is based on permissionless access, permissions can be set, e.g., by using private blockchains or restrictive smart contract configurations.

At times, transaction fees, e.g., on the Ethereum blockchain, have been very volatile, reaching a high of the equivalent of USD 70 in May 2021.

The Ethereum blockchain can currently achieve a throughput of around 15 transactions per second, which is expected to increase significantly after the transition to Ethereum 2.0 in early 2022. In comparison, Visa states that their systems are capable of handling more than 65,000 transactions per second and the trading system of NASDAQ currently handles approximately 1,300 transactions per second during a trading day. While such a direct comparison of decentralized and centralized systems is an oversimplification, these figures illustrate that DeFi systems require sufficient throughput volumes to compete with CeFi systems.

Miner extractable value (MEV) describes the maximum value that can be generated from mining a block in addition to the block reward and transaction fees by deciding which transactions are added to a block and in which order. Certain market participants try to take advantage of the MEV by trying to find profitable MEV opportunities, e.g., arbitrage opportunities between different DEXes, and use them for their own benefit by submitting profitable transactions with high transaction fees and thus pushing themselves ahead of other transactions. Such actions are referred to as frontrunning (Ethereum, 2022b). See also Auer et al. (2022) for a comprehensive discussion of MEV and associated risks.

The same opinion is shared by Aramonte et al. (2022), who also state that access to overcollaterized credits is limited to asset-rich users.

For an introduction to flash loans in DeFi, see Wang et al. (2021).

Another popular attack that targets the composability of DeFi protocols is the so-called “frontrunning,” described by Daian et al. (2019).

The figures represent the rolling 10-day volatility.

This thought is also shared by Aramonte et al. (2022), who also claim that more information needs to be collected about, e.g., borrowers in lending protocols, albeit that this decreases the degree of decentralization.

See Zetzsche et al. (2020) for a discussion of a potential regulation approach for DeFi. In addition, Auer et al. (2022) argue that there is a need for new regulatory approaches that are more suitable to deal with potential threats of market manipulation in DeFi (e.g., problems related to MEV).

In this context, another interesting example is the cooperation between Aave and RealT which allows user to borrow stablecoins on the Aave platform by using real estate investments made on the RealT platform as collateral.

Aramonte et al. (2022) also state that depositing RWAs as collateral in DeFi lending protocols is important to enable bridges between CeFi and DeFi.

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Titel: Centralized and Decentralized Finance: Coexistence or Convergence?
verfasst von: Axel Wieandt
Laurenz Heppding
Verlag: Springer International Publishing
Buch: The Fintech Disruption
Print ISBN: 978-3-031-23068-4

Electronic ISBN: 978-3-031-23069-1

Copyright-Jahr: 2023
DOI: https://doi.org/10.1007/978-3-031-23069-1_2