Decentralized Finance: Automation of Financial Markets

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The expression decentralized finance - often abbreviated as DeFi - describes to an alternative financial infrastructure built on top of the Ethereum blockchain. DeFi uses smart contracts to create protocols that replicate existing financial services in a more open, interoperable, and transparent way. This article highlights opportunities and potential risks of the DeFi ecosystem. I propose a multi-layered framework to analyze the implicit architecture and the various DeFi building blocks, including token standards, decentralized exchanges, decentralized debt markets, blockchain derivatives, and on-chain asset management protocols. I conclude that DeFi still is a niche market with certain risks but that it also has interesting properties in terms of efficiency, transparency, accessibility, and composability. As such, DeFi may potentially contribute to a more robust and transparent financial infrastructure.
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The term decentralized finance - often abbreviated as DeFi - refers to solutions built using internet protocols, using decentralized software solutions, including public blockchains, and web interfaces. DeFi systems deploy 'digital vending machines' created by smart contracts to create automated solutions, resembling those of legacy financial services, without the need of human intervention - in form of middlemen - or a corporate structure. The original concept of a smart contract was developed by Nick Szabo in 1997; he used the example of a vending machine to describe the idea of a "embedded" contract with, in such a way as to make a breach of contract an expensive contract.