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The technology of decentralized finance (DeFi)

Decentralized Finance (DeFi) is a new financial paradigm that leverages distributed ledger technologies to offer services such as lending, investing, or exchanging cryptoassets without relying on traditional centralized intermediaries. A range of DeFi protocols implements these services as a suite of smart contracts, i.e., software programs that encode the logic of conventional financial operations.

Instead of transacting with a counterparty, DeFi users interact with software programs that pool the resources of other DeFi users. DeFi’s programmable and automated technology could foster efficiency and increase transparency. However, it exposes users to idiosyncratic risks, such as smart contract vulnerabilities and complex protocol interoperability.

This paper provides a deep dive into the overall architecture, the technical primitives, and the financial functionalities of DeFi protocols. We analyze and explain the individual components and how they interact through the lens of a DeFi stack reference (DSR) model featuring three layers: settlement, applications and interfaces.

We discuss the technical aspects of each layer of the DSR model. Then, we describe the financial services for the most relevant DeFi categories, i.e., decentralized exchanges, lending protocols, derivatives protocols and aggregators. The latter exploit the property that smart contracts can be “composed,” i.e., utilize the functionalities of other protocols to provide novel financial services.

We discuss how composability allows complex financial products to be assembled, which could have applications in the traditional financial industry. We discuss potential sources of systemic risk and conclude by mapping out an agenda for research in this area.

R. Auer, B. Haslhofer, S. Kitzler, P. Saggese, F. Victor, The technology of decentralized finance (DeFi), Digital Finance (2023).

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