The official website of the Federal Reserve Bank of St. Louis recently published a report called "Decentralized Finance: Financial Market Based on Blockchain and Smart Contracts". The report details the main application scenarios of DeFi and future opportunities and risks. Analysis.

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The author of the report, Fabian Schär, professor of distributed ledger technology and financial technology at the University of Basel, introduced the related concepts of DeFi and smart contracts, and proposed a five-layer conceptual framework, including settlement layer, asset layer, protocol layer, and application layer And the aggregation layer, and introduced some of the current main DeFi application scenarios, such as asset tokenization, decentralized transaction protocol, decentralized lending platform, decentralized derivatives, and on-chain asset management.

He believes that the current DeFi ecosystem has 4 major opportunities and 6 major risks . In terms of opportunities, the report claims that DeFi can improve the efficiency, transparency and availability of financial infrastructure. In addition, the composability of the DeFi system allows anyone to combine multiple applications and protocols to create new and exciting services.

Efficiency . Most of the traditional financial system is based on trust and relies on centralized institutions, while DeFi replaces some of these trust requirements with smart contracts. These contracts can assume the roles of custodian, escrow agent and CCP. For example, if both parties want to exchange digital assets in the form of tokens, CCP guarantees are not required. On the contrary, the two transactions can be atomically settled, which means that either of the two transfers will be executed. This greatly reduces the credit risk of the counterparty and greatly improves the efficiency of financial transactions. Lower trust requirements may bring additional benefits, namely reducing regulatory pressure and reducing the need for third-party audits. Almost every area of financial infrastructure is likely to achieve similar efficiency improvements.

In addition, token transfers are much faster than any transfers in traditional financial systems, and the transmission speed and transaction throughput can be further improved through the second-tier solution.

Transparency . DeFi applications are transparent. All transactions are public, and the smart contract code can be analyzed on the chain. Observability and certainty of execution can provide unprecedented transparency, at least in theory.

DeFi's financial data is also public and can be used by researchers and users. However, much information in the traditional financial system is scattered in a large number of proprietary databases or is not available at all. Therefore, the transparency of DeFi applications can reduce the impact of malicious events before they occur, and help to understand their sources and potential consequences when they occur more quickly.

Accessibility . By default, anyone can use the DeFi protocol. Therefore, DeFi has the potential to create a truly open and accessible financial system. In particular, its infrastructure requirements are relatively low, and there is almost no risk of discrimination.

If regulatory requirements restrict access to securitized tokens, this restriction can be implemented in the token contract without affecting the integrity and decentralization properties of the settlement layer.

Composability . DeFi protocols are often compared to Lego bricks. The shared settlement layer allows these protocols and applications to connect with each other. On-chain fund agreements can use decentralized transaction agreements, or leveraged positions can be realized through lending agreements.

Any two or more functions can be integrated, forked or refactored to create brand new products. Anything that has been created before can be used by individuals or other smart contracts. This flexibility has made the possibility of open financial engineering expanding and has aroused unprecedented interest.

The author of the report also mentioned the risks of DeFi, including smart contract execution risks, operational security, and dependence on other protocols and external data.

Execution of smart contracts . Although the certainty and decentralized execution of smart contracts do have their advantages, there is also the risk of errors. If there are coding errors, these errors may create loopholes that allow attackers to exhaust the funds of the smart contract, cause confusion, or make the protocol unusable. Users must realize that the degree of security of the protocol depends on the underlying smart contract. Unfortunately, it is generally impossible to read the contract code, let alone evaluate its security. Although auditing, insurance services, and formal verification are part of the solution to this problem, there is still a certain degree of uncertainty.

Similar risks exist in contract execution. Most users do not understand the data required to be submitted as part of the transaction. Unfortunately, there seems to be an inherent trade-off between usability and security. For example, some decentralized blockchain applications will require users to obtain permission to transfer an unlimited number of tokens on behalf of the user, usually to make future transactions more convenient and efficient. However, this authority puts the user's funds at risk.

Operational safety . Many DeFi protocols and applications use management keys. These keys allow a predefined set of individuals (usually the core team of the project) to upgrade contracts and perform emergency shutdowns. Although it is understandable that some projects wish to implement these preventive measures and maintain a certain degree of flexibility, the existence of these keys may be a potential problem. If key holders do not securely create or store their keys, malicious third parties may obtain these keys and compromise the smart contract. In addition, the core team members themselves may be malicious or corrupted by a large amount of money.

Most projects try to reduce this risk through multiple signatures and time locks. Other projects rely on voting schemes that grant their owners the right to vote on the future of the agreement through their respective governance tokens. However, in many cases, most governance tokens are held by a small group of people, which actually leads to similar results as managing keys. Some projects try to mitigate this concentration of voting rights by rewarding early adopters and users who meet certain criteria.

Governance tokens can also lead to undesirable consequences. In fact, when these rights are tokenized, the high concentration of power may cause greater problems. In the absence of a vesting period, a malicious founder can cause a large-scale supply shock by dumping all the tokens he holds and damage the credibility of the project. In addition, liquidity mining may lead to more centralization, as it allows an already mature protocol to distribute a large portion of the governance tokens of a relatively new protocol.

Dependence . Some of the most promising features of the DeFi ecosystem are its openness and composability. These features allow various smart contracts and decentralized blockchain applications to interact with each other and provide new services based on a combination of existing services. Conversely, these interactions can introduce severe dependencies. If there is a problem with a smart contract, it may have a broad impact on multiple applications in the entire DeFi ecosystem. In addition, Dai stablecoin problems or severe ETH price shocks may cause a chain reaction in the entire DeFi ecosystem.

External data . Another point worth mentioning is that many smart contracts rely on external data. Whenever a smart contract relies on non-native data on the chain, the data must be provided by an external data source. These so-called oracles introduce dependencies and, in some cases, may lead to a high degree of centralization of contract execution. In order to reduce this risk, many projects rely on a decentralized oracle network and use a large number of data providers.

Illegal activity . The general concern among regulators is that encrypted assets may be used by individuals who want to evade recording and surveillance. While the inherent transparency of DeFi is a deterrent to this use case, the pseudonymous nature of the network may provide some privacy. On the one hand, pseudonyms can be abused by dishonest actors. On the other hand, privacy may be a desirable attribute for some legitimate financial applications. Accordingly, regulators should act very cautiously and try to find reasonable solutions so that they can intervene when necessary without stifling innovation. In addition, we must also realize that regulating a decentralized network may not be feasible.

Scalability . Blockchain faces the ultimate trade-off between decentralization, security, and scalability. Although the Ethereum blockchain is generally considered to be relatively decentralized and secure, it is difficult to keep up with the huge demand for block space. Rising Gas prices (transaction fees) and long confirmation times have adversely affected the DeFi ecosystem and benefited wealthy users who can conduct large transactions.

Potential solutions to this problem include fragmentation and various two-layer solutions. However, in many cases, scalability efforts weaken composability and the atomicity of general transactions, which are the two most prominent features of DeFi. On the other hand, moving DeFi to a more centralized base layer does not seem to be a reasonable approach, because it will essentially undermine its main value proposition. Therefore, it remains to be seen whether a truly decentralized blockchain can keep up with demand and provide a foundation for an open, transparent, and immutable financial infrastructure.

In its conclusion, the report believes that DeFi provides exciting opportunities and has the potential to create a truly open, transparent and immutable financial infrastructure. Since DeFi is composed of many highly interoperable protocols and applications, everyone can verify all transactions, and users and researchers can analyze the data at any time.

DeFi has set off a wave of innovation. On the one hand, developers are using smart contracts and decentralized settlement layers to create trustless versions of traditional financial instruments. On the other hand, they are creating brand new financial tools, which would not be possible without the underlying public blockchain. Atomic swaps, autonomous liquidity pools, decentralized stablecoins, and lightning loans are just a few of the many examples that show the great potential of this ecosystem.

Even so, users should be aware that there are many risks and problems in DeFi applications. However, if these problems can be solved, DeFi may lead to a change in the financial industry's model, and may contribute to the establishment of a stronger, open and transparent financial infrastructure.

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