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Decentralized Finance (DeFi): A Functional Approach

Author

Listed:
  • Matteo Aquilina
  • Jon Frost
  • Andreas Schrimpf

Abstract

‘Decentralized finance’ (DeFi) refers to a range of applications in the crypto-asset space that seek to disintermediate the provision of financial services through reliance on self-executing computer code (‘smart contracts’). DeFi has so far been mainly self-referential in that it has largely facilitated the financing and trading of crypto-assets rather than providing intermediation services to support real economic activity. Yet this may change in the future, should asset tokenization or the use of DeFi applications by existing financial institutions lead to greater interconnections with traditional finance (TradFi). We argue that many of the functions that DeFi tries to mimic are similar to those in TradFi, and so are many of the risks that this intermediation entails. The same economic rationale that has guided financial regulation for decades can hence be applied to the crypto and DeFi world as well. Risks in DeFi are often exacerbated by the severity of market failures (externalities and information asymmetries). Having compared the functions performed in TradFi and DeFi, we show how regulation to protect consumers, maintain market integrity, and ensure financial stability applies to DeFi. Finally, we sketch a possible approach to the regulation of DeFi that takes into account its specificities and functions.

Suggested Citation

  • Matteo Aquilina & Jon Frost & Andreas Schrimpf, 2024. "Decentralized Finance (DeFi): A Functional Approach," Journal of Financial Regulation, Oxford University Press, vol. 10(1), pages 1-27.
    • Handle: RePEc:oup:refreg:v:10:y:2024:i:1:p:1-27.
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    File URL: http://hdl.handle.net/10.1093/jfr/fjad013
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    Keywords

    DeFi; cryptocurrencies; blockchain; distributed ledger technology; regulation;
    All these keywords.

    JEL classification:

    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • E51 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Money Supply; Credit; Money Multipliers
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • L50 - Industrial Organization - - Regulation and Industrial Policy - - - General
    • O32 - Economic Development, Innovation, Technological Change, and Growth - - Innovation; Research and Development; Technological Change; Intellectual Property Rights - - - Management of Technological Innovation and R&D

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