DeFi operations are based on smart contracts
Decentralised finance (DeFi) aims to decentralise many of the financial activities that we typically associate with the financial system. In the traditional financial system, much of the operations are based on or intermediaries and central nodes in the form of different technical systems. For example, banks are financial intermediaries in that they accept deposits in order to then lend money to other customers.
In DeFi, the concept is rather that there should not be any intermediaries or central entities. OECD (2022), “Why Decentralised Finance (DeFi) Matters and the Policy Implications”, 19 January 2022, Organisations for Economic Co-operation and Development. Instead, services are are provided through decentralised apps, known as dApps, which are built on top of a blockchain, primarily the Ethereum blockchain. To perform various activities on the blockchain, programmable, self-running contracts – known as smart contracts – are written to describe what will happen, for instance which transactions will be conducted, and the terms governing this process. J. Javeus (2021), “DeFi – en jättetrend fortfarande i sin linda (del 1)” [DeFi – a megatrend still in its infancy, part 1], 12 November 2021, Veckans tanke, SEB Research. The contracts cannot be changed retroactively once they have been added to the blockchain. Stablecoins and other cryptoassets are used within DeFi to execute transactions. A common activity within DeFi is lending collateralised by different types of cryptoassets.
The DeFi market has expanded rapidly in 2021 and 2022. In total, cryptoassets worth almost USD 110 billion are used within DeFi (as of the middle of May 2022). This is, however, a decrease since the beginning of December 2021 when cryptoassets worth roughly 250 billion dollar were used within DeFi.
DeFi is currently unregulated while at the same time it is growing rapidly. S. Aramonte et al. (2021), “DeFi risks and the decentralisation illusion”, BIS Quarterly review, December 2021, Bank for International Settlements. Because stablecoins and other cryptoassets are used within DeFi, the same risks are present in the various DeFi activities as those in cryptoassets generally. The degree of transparency is very low and consumer and investor protection is minimal. If DeFi continues to grow at the same rate, its interconnectedness with the rest of the financial system might increase, for instance through the link between stablecoins and the traditional financial system. Risks in DeFi could therefore spill over onto the latter. It is therefore relevant for authorities to follow developments in DeFi.