Historically, financial intermediaries have been the key nodes in the financial system that control the accuracy of customer accounts, perform bookkeeping functions and ensure that unauthorised persons do not have access to an account. But recent advances in technology have enabled, in the form of decentralised finance (DeFi), a new form of intermediation in crypto markets that aims to cut out the middle men and reduce transaction costs. The key elements of the DeFi ecosystem are novel automated protocols on blockchains, ie forms of permissionless distributed ledger in which details of transactions are held in the ledger in the form of blocks of information.
The BIS paper discusses the different ways in which security of transactions is achieved under different protocols of the blockchain technology on which DeFi is based. It also examines the economic incentives built into these protocols. It provides an overview of the current crypto landscape and the main DeFi applications such as decentralised crypto exchanges, borrowing and lending markets, and yield farming. Finally, it compares this new DeFi architecture with traditional financial market solutions and lays out how these two regimes solve some of the most important problems in financial systems, such as data privacy and transparency, extraction of rents, transactions costs, governance issues and systemic risk.