Cryptocurrencies and Decentralised Finance (DeFi)

BIS Working Papers  |  No 1061  | 
16 December 2022



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 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.


The economic forces that allow intermediaries to hold market power in traditional finance might still exist in the DeFi world. Moreover, the current design of DeFi applications generates formidable challenges for tax enforcement, aggravates money laundering issues and other kinds of financial malfeasance, and as a result creates negative externalities on the rest of the economy. Finally, if the ties between traditional finance and DeFi grow, DeFi could contribute significantly to systemic risk.


The paper provides an overview of cryptocurrencies and decentralized finance. The discussion lays out potential benefits and challenges of the new system and presents a comparison to the traditional system of financial intermediation. Our analysis highlights that while the DeFi architecture might have the potential to reduce transaction costs, similar to the traditional financial system, there are several layers where rents can accumulate due to endogenous constraints to competition. We show that the permissionless and pseudonymous design of DeFi generates challenges for enforcing tax compliance, anti-money laundering laws, and preventing financial malfeasance. We highlight ways to regulate the DeFi system which would preserve a majority of benefits of the underlying blockchain architecture but support accountability and regulatory compliance.

JEL classification: G12, G15, F38

Keywords: Decentralized finance, blockchain technology, financial intermediation, system risk

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