What is decentralized finance?
Decentralized finance (DeFi) is the provision of trading, lending and investment services through smart contracts on a public blockchain, without a bank or broker that keeps the records. The code executes the contract, and every transaction is visible on the chain. The German term is dezentrale Finanzen.
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Decentralized finance in brief
| Term | Decentralized finance, short DeFi. German: dezentrale Finanzen. |
|---|---|
| Definition | "The financial applications run by smart contracts on a blockchain, typically a permissionless (ie public) chain" (BIS, ). |
| EU law | Recital 22 of Regulation (EU) 2023/1114 (MiCA): services provided "in a fully decentralised manner without any intermediary" fall outside the regulation. |
| Date of application | MiCA applies from (Article 149(2)). |
| Supervisors | BaFin in Germany, FMA in Austria, FINMA in Switzerland, for the firms that offer crypto services. |
How does decentralized finance work?
Decentralized finance works by replacing the intermediary of a financial service with a smart contract. In traditional finance a bank, exchange or fund manager keeps private records and carries out the contract. In DeFi a protocol, a set of smart contracts on a public blockchain, does both, and the records sit on the chain.
Explained in simple terms, DeFi does the work of banks and exchanges in another way. The Bank for International Settlements (BIS) groups the services into trading, lending and investment. Stablecoins connect them: they let users move funds between platforms without converting to and from fiat money at every step.
What are decentralized finance applications?
Decentralized finance applications are the protocols that offer one service each, such as an exchange or a lending pool. The BIS compares them with their counterparts in traditional finance.
| Service | Traditional finance | DeFi application |
|---|---|---|
| Trading | Exchange with a central limit order book | Decentralized exchange with an automated market maker and liquidity pools |
| Lending | Bank loan after a credit check | Lending protocol with crypto collateral |
| Investment | Investment fund | Decentralized portfolio that shifts funds across lending platforms by fixed rules |
| Means of payment | Bank deposits in euro or dollar | Stablecoins |
Outside data such as market prices reach these protocols through a blockchain oracle.
How does DeFi lending work?
DeFi lending works with collateral worth more than the loan. The BIS gives the reason: lenders cannot trust anonymous borrowers, and crypto collateral is volatile. When the ratio of collateral to loan falls below a threshold, the protocol sells the collateral automatically. The need for crypto collateral "stands in the way of lending to households and businesses", for example for house purchases.
DeFi also offers flash loans. A flash loan has zero duration: the borrower takes the loan, trades and repays principal and interest in the same block. The protocol grants it only if the trade ensures that repayment.
Is decentralized finance really decentralized?
Decentralized finance is less decentralized than its name suggests. The BIS speaks of a "decentralisation illusion" because "the need for governance makes some level of centralisation inevitable". Every DeFi platform has a governance framework. Holders of governance tokens, often the developers, vote on proposals much like shareholders.
The BIS adds that these governance structures give authorities natural reference points for questions of financial stability, investor protection and illicit activity.
Is decentralized finance safe?
Decentralized finance carries the risks of traditional finance plus risks of its own. The Financial Stability Board (FSB) concludes that DeFi "does not differ substantially from traditional finance in the functions it performs or the vulnerabilities to which it is exposed". It names operational fragilities, liquidity and maturity mismatches, leverage and interconnectedness. Crypto-assets "lack inherent value and are highly volatile", and the FSB says this magnifies the impact of these weaknesses (FSB, ).
The European Securities and Markets Authority (ESMA) sees "serious risks to investor protection", among them "the lack of a clearly identified responsible party". It also lists new forms of market manipulation such as maximal extractable value and flash loan attacks (ESMA, ).
Decentralized finance in Germany, Austria and Switzerland
In Germany and Austria MiCA applies directly. Its recital 22 draws the line: MiCA applies to crypto-asset services "including when part of such activities or services is performed in a decentralised manner", but "where crypto-asset services are provided in a fully decentralised manner without any intermediary, they should not fall within the scope of this Regulation". Whether a DeFi service has an intermediary is a question for the single case. A firm that provides crypto-asset services needs an authorization under Article 59. BaFin supervises in Germany, the FMA in Austria.
Article 142 of MiCA asked the European Commission for a report by with "an assessment of the necessity and feasibility of regulating decentralised finance".
Switzerland is outside the EU, so MiCA does not apply there. FINMA judges tokens by their "economic function and purpose", as set out in its ICO guidelines of . This page gives no legal advice.
Sources
- Bank for International Settlements: DeFi risks and the decentralisation illusion, BIS Quarterly Review,
- Financial Stability Board: FSB assesses financial stability risks of decentralised finance,
- European Securities and Markets Authority: Decentralised Finance in the EU: Developments and risks,
- FINMA: FINMA publishes ICO guidelines,
- European Union: Regulation (EU) 2023/1114 on markets in crypto-assets,