Decentralized Finance (DeFi): Foundations, Applications, Potentials, and Challenges

Bitcoin and other cryptocurrencies built on blockchains have increasingly attracted investors in recent years. Motivated by the opportunities of this technology, blockchain-based applications in various sectors have also been explored. Yet, so far, finance-related applications have arguably remained the most advanced and relevant area of blockchain usage. The resulting financial ecosystem based on blockchains as infrastructure is often referred to as decentralized finance (DeFi). DeFi integrates not only basic payment functionalities, but also provides highly complex applications that interconnect different building blocks and services. These features result in the creation of an open, trustless, composable, and permissionless financial ecosystem. Protocols built on blockchains, i.e., smart contracts, facilitate automation and highly customizable DeFi applications. Thus, smart contracts enable a wide range of financial services such as digital assets (e.g., stablecoins and derivatives), participation mechanisms (e.g., governance in decentralized autonomous organizations (DAOs)), and investment opportunities (e.g., non-fungible tokens (NFTs) and fractional ownership).Proponents of DeFi argue that removing central entities in the value chain of traditional finance (TradFi) improves access to financial services, lowers transaction costs, increases flexibility, and drives innovation. However, the nascent stage of DeFi still poses major risks and challenges: Regulatory bodies are looking for means to prevent money laundering and to hold entities accountable for misbehavior. Also, the transparent nature of blockchains raises questions regarding compliance with data protection and related privacy regulations. Bridging cryptocurrencies, DeFi-based transactions, and the real world is another multi-faced challenge. Furthermore, security and scalability issues hamper the development of promising applications. The current scalability issues, for example, cause high transaction costs that make DeFi less attractive or unusable for non-affluent users, undermining the value proposition of DeFi.Understanding DeFi’s potentials and challenges is a crucial prerequisite to seize business opportunities early on. In addition, it is imperative to educate investors, policy-makers, and users about the principles of DeFi. Moreover, innovation from DeFi has arguably inspired many other sectors. Thus, the technical innovations in DeFi can facilitate decentralized applications (DApps) in various domains, e.g., payments using central bank digital currencies (CBDCs) or verifiable supply chains. Blockchain and smart contracts can allow companies to freely capitalize on composable, trustless, and permissionless DeFi protocols to build and offer innovative products and services.The goal of our study is to shed light on DeFi and provide experts and non-experts with the required knowledge to comprehensively understand this emerging phenomenon. In addition, we discuss potentials, but also existing challenges of DeFi and present solutions and measures for risk mitigation. We hope readers enjoy this study and welcome questions, discussions, and suggestions for improvement.