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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Sprache: Englisch
A Practitioner's Guide to Decentralized Finance (DeFi), Digital Assets, and Distributed Ledger Technology In Decentralizing Finance: How DeFi, Digital Assets and Distributed Ledger Technology Are Transforming Finance, blockchain and digital assets expert Kenneth Bok offers an insightful exploration of the current state of decentralized finance (DeFi). As distributed ledger technology (DLT) increasingly optimizes and democratizes financial ecosystems worldwide, this book serves as a comprehensive guide to the most salient aspects of the ongoing transformation. The text delves into both crypto-native DeFi and DLT applications in regulated financial markets, providing: * Comprehensive analysis of crypto-native DeFi across key areas such as its competitive landscape, infrastructure, financial instruments, activities, and applications * Coverage of key risks, mitigation strategies, and regulatory frameworks, analyzed through the perspective of international financial standard-setting bodies * Insight into how DLT is reshaping traditional financial systems through innovations like central bank digital currencies (CBDCs), tokenized assets, tokenized deposits, and institutional-grade DeFi platforms In a world where financial technology is rewriting the fundamental code of digital currency, the future of money is undeniably DLT-centric. How will this seismic shift interact with existing financial infrastructures? Can decentralization and traditional banking coexist and potentially synergize? This book endeavors to answer these pressing questions for financial professionals navigating these transformative times. Authored by a former Goldman Sachs trader, past Head of Growth at Zilliqa, and an early Ethereum investor with extensive experience in both traditional finance and the crypto ecosystem, Decentralizing Finance provides you with an insider's perspective on the revolution that is DeFi.
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Table of Contents
Cover
Table of Contents
Additional Praise for
Decentralizing Finance
Title Page
Copyright
Dedication
Acknowledgments
Glossary
Foreword
Introduction
I.1 Who Am I?
I.2 How This Book Is Organized
I.3 Scope of This Book
I.4 Disclaimers
I.5 Corrections
Part I: Crypto‐native DeFi
1 What Is DeFi?
1.1 The Role of Intermediaries in TradFi
1.2 Definitions
1.3 Other Characteristics of DeFi
1.4 The DeFi Stack
1.5 Size of DeFi
1.6 Key Participants in DeFi
1.7 DeFi and FinTech
1.8 How Can I Try DeFi?
1.9 Where Does DeFi Meet TradFi?
1.10 What are the Risks of DeFi?
1.11 Chapter Summary
Notes
2 Infrastructure and Instruments
2.1 The Infrastructure of DeFi
2.2 Basics of Blockchains
2.3 Bitcoin and Ethereum
2.4 Permissioned vs Public Blockchains
2.5 L1s and L2s
2.6 Accounts, Keys, Wallets, and Addresses
2.7 Transactions
2.8 Smart Contracts
2.9 Clients and Nodes
2.10 Block Explorers
2.11 Custody
2.12 Oracles
2.13 RegTech
2.14 Identity
2.15 Bridges
2.16 DeFi Instruments
2.17 Stablecoins
2.18 Derivatives
2.19 Chapter Summary
Notes
3 Activities and Applications
3.1 Trading / DEXs
3.2 Overcollateralized Lending / Borrowing
3.3 Governance / DAOs
3.4 Undercollateralized Lending
3.5 Investing
3.6 Payments
3.7 Insurance
3.8 Prediction Markets
3.9 Chapter Summary
Notes
4 Risks and Mitigation
4.1 Types of Losses
4.2 Basic Terminology
4.3 Endogenous DeFi Risks
4.4 Exogenous DeFi Risks
4.5 Chapter Summary
Notes
5 Regulation
5.1 Introduction
5.2 Global Nature of Crypto and DeFi
5.3 What Regulators Want
5.4 Are Tokens Securities?
5.5 The Travel Rule
5.6 Prudential Treatment of Crypto‐asset Exposures
5.7 SSBs, United States and European Union
5.8 European Union – MiCA
5.9 United States
5.10 DeFi Specific Regulation
5.11 Chapter Summary
Notes
Part II: DLT in Traditional Finance
6 Central Bank Digital Currencies
6.1 Introduction
6.2 Prologue: Libra
6.3 Role of the Central Bank
6.4 Structure of the Monetary System and a View Towards the Future
6.5 Central Bank Motivations and Considerations around CBDCs
6.6 Retail vs Wholesale CBDCs
6.7 Wholesale CBDCs
6.8 Case Study: Project mBridge
6.9 Retail CBDCs
6.10 Benefits and Risks of R‐CBDCs
6.11 R‐CBDC Design Choices
6.12 Types of R‐CBDCs
6.13 Examples of R‐CBDCs
6.14 Case Study: Nigerian eNaira
6.15 Case Study: United States
6.16 Case Study: eCNY 数字人民币
6.17 Chapter Summary
Notes
7 Asset Tokenization
7.1 What Is Asset Tokenization?
7.2 Benefits of Asset Tokenization
7.3 How is Tokenization Performed?
7.4 Considerations for Tokenization
7.5 DLT in Capital Markets
7.6 Asset Servicing
7.7 Chapter Summary
Notes
8 Deposit Tokens
8.1 What Are Deposit Tokens?
8.2 Benefits of Deposit Tokens
8.3 Deposit Token Projects
8.4 Chapter Summary
Notes
9 Institutional DeFi
9.1 Considerations for Institutions to Participate in DeFi
9.2 Institutional DeFi Examples
9.3 AMMs and FX
9.4 Considerations for AMMs and Tokenized Assets
9.5 Unified Ledger
9.6 Chapter Summary
Notes
10 Conclusion
10.1 The Crypto–Fiat Innovation Dialectic
10.2 Future Scenarios for DeFi: The Wild West, the Citadel, and the Bazaar
10.3 The Future of Money
Notes
Bibliography and Online Resources
Crypto and DeFi
CBDCs
Payments and FinTech
Monetary History
Online Resources
Index
End User License Agreement
List of Tables
Chapter 2
Table 2.1 Layer 1 comparisons.
Table 2.2 Validator node specifications.
Chapter 3
Table 3.1 Uncollateralized lending to crypto institutions – comparisons.
Table 3.2 Smart bond issuances (as of August 2021).
Chapter 4
Table 4.1 DeFi contagion events, 2022.
Table 4.2 International finance regulators and key DeFi reports.
Table 4.3 Cryptocurrency‐focused malware types.
Chapter 6
Table 6.1 Types of retail CBDC.
Chapter 8
Table 8.1 Types of digital currencies.
List of Illustrations
Chapter 1
Figure 1.1 Total value locked‐up in DeFi (2019–2023).
Figure 1.2 Market capitalization of all cryptocurrencies (2016–2022).
Figure 1.3 Decision tree to differentiate between DeFi and CeFi.
Figure 1.4 The DeFi stack.
Figure 1.5 Total value locked‐up in DeFi (2019–2023).
Figure 1.6 Total number of global crypto owners (in millions).
Figure 1.7 DEX to CEX volumes.
Figure 1.8 DEX volumes.
Figure 1.9 Web3 active developers since 2009.
Figure 1.10 Web3 active developers since launch.
Figure 1.11 Crypto / blockchain deals in 2017–2022 by category.
Figure 1.12 Comparisons of DeFi, FinTech and TradFi.
Chapter 2
Figure 2.1 Blockchain structure.
Figure 2.2 Merkle Tree in a blockchain.
Figure 2.3 Encryption and decryption using public‐private key pair.
Figure 2.4 Digital signing and verification with a public‐private key pair....
Figure 2.5 The blockchain trilemma.
Figure 2.6 Hierarchical deterministic wallets.
Figure 2.7 Custody types.
Figure 2.8 WBTC minting process.
Figure 2.9 Total stablecoin supply.
Figure 2.10 USDC reserves.
Figure 2.11 USDT reserves.
Chapter 3
Figure 3.1 Constant production function in AMMs.
Figure 3.2 Interest rate model in Aave.
Figure 3.3 DAI / USD price history in 2022.
Figure 3.4 MakerDAO governance structure and process.
Figure 3.5 Credix market and process.
Figure 3.6 Maple and TrueFi total loan outstanding.
Figure 3.7 NAV model.
Figure 3.8 Tinlake epochs – investment and redemption execution.
Figure 3.9 SocGen – MakerDAO vault structure.
Figure 3.10 Example checkout from Coinbase Commerce.
Figure 3.11 Envisioned model of Nexus Mutual.
Figure 3.12 Etherisc flight delay insurance design.
Figure 3.13 Example of a Polymarket outcome market.
Chapter 4
Figure 4.1 Map of interconnected DeFi risks.
Figure 4.2 Total losses by exploit type.
Figure 4.3 Bitcoin's correlation with traditional assets.
Figure 4.4 Digital currency ownership as share of population.
Figure 4.5 Total cryptocurrency value received by illicit addresses.
Figure 4.6 Illicit share of all cryptocurrency transaction volume.
Chapter 5
Figure 5.1 Crypto‐asset classification under SCO60.
Figure 5.2 Regulatory standards of FSB members.
Figure 5.3 Applicable thematic regulation to different categories of crypto‐...
Figure 5.4 International crypto regulation.
Figure 5.5 Crypto‐asset categories in MiCA.
Chapter 6
Figure 6.1 Number of CBDC projects by type and status.
Figure 6.2 The two tier monetary system.
Figure 6.3 A possible future model of the monetary system and an envisioned ...
Figure 6.4 mCBDC models.
Figure 6.5 Participating commercial banks in the mBridge pilot project.
Figure 6.6 The legal claims of cash, R‐CBDCs, and consumer bank deposits....
Figure 6.7 CBDC pyramid of consumer needs and design choices.
Figure 6.8 R‐CBDC architectures.
Figure 6.9 R‐CBDC types.
Figure 6.10 eCNY Architecture.
Chapter 7
Figure 7.1 Tokenization of off‐chain assets.
Figure 7.2 Current securities issuance.
Figure 7.3 DLT‐enabled securities issuance.
Figure 7.4 Impact of DLT across the security's lifecycle.
Chapter 9
Figure 9.1 Liquidity provision in Singapore–France CBDC exchange trial.
Figure 9.2 Project Mariana architecture.
Figure 9.3 Project Guardian liquidity pool.
Figure 9.4 Unified ledger high level architecture.
Chapter 10
Figure 10.1 Digital asset evolutionary timeline.
Figure 10.2 BIS vision of the global monetary ecosystem.
Guide
Cover Page
Additional Praise for Decentralizing Finance
Title Page
Copyright
Dedication
Acknowledgments
Glossary
Foreword
Table of Contents
Begin Reading
Bibliography and Online Resources
Index
Wiley End User License Agreement
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Additional Praise for Decentralizing Finance
Kenneth Bok's book Decentralizing Finance helps to demystify DeFi and goes further by explaining how traditional financial services are being unbundled by new technologies. We need more literature to explain why self‐managed finance needs to be an integral component of the future digital economy.
—Linda Jeng, Head of Global Web3 Strategy at the Crypto Council for Innovation, Visiting Scholar on Financial Technology and Adjunct Professor at the Georgetown University Law Center's Institute for International Economic Law
Kenneth has displayed his vast experience, deep insights and thoughtful views on the fast‐moving, often‐misunderstood world of blockchain and distributed ledger technology, as well as digital/crypto assets with his notable knowledge and experience gained from traditional finance. His book, Decentralizing Finance is indeed valuable for not only the uninitiated who are seeking to learn more about this space, but also for the veteran who would gain much from Kenneth's opinions, reflections and forward‐looking views, in this realm. Kenneth has managed to pack all that into less than 250 pages of clear and concise, systematic reading, which makes it so much more pleasurable to read. I would highly recommend this to anyone interested in this industry.
—Hsu Li Chuan, Senior Partner, Dentons Rodyk & Davidson LLP
In this book Decentralizing Finance, Kenneth Bok comprehensively and systematically covers the many areas that are evolving in this new world. What is clear is that the institutions and instruments in the world of finance are changing. How will it look going forward? How will it be different from the world we already know? These are the pertinent questions addressed in this book. The author gives the reader a timely and authoritative overview of how, as finance decentralizes, digital assets and distributed ledgers are bringing about fundamental change. An essential read for anyone who wants to have a competent grasp of the tools needed to analyze the new status quo.
—Joo Seng Wong, Founder and CEO at Spark Systems
In his book on decentralized finance, Kenneth unveils profound insights into this dynamic landscape. Kenneth's perspective on the evolving DeFi realm is truly enlightening, providing valuable understanding of trends, challenges, and opportunities. With his expertise and clarity, he demystifies DeFi's complexities, making it accessible to readers of all levels. A must‐read for both novices and experts, Kenneth's book enriches our comprehension of this transformative space.
—Yi Ming Ng, CEO at Tribe
Decentralizing Finance
How DeFi, Digital Assets, and Distributed Ledger Technology are Transforming Finance
Kenneth Bok
This edition first published 2024
© 2024 by Kenneth Bok
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by law. Advice on how to obtain permission to reuse material from this title is available at http://www.wiley.com/go/permissions.
The right of Kenneth Bok to be identified as the author of this work has been asserted in accordance with law.
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Author Photo: Courtesy of Kenneth Bok
Everyone who works towards the greater good
“Finance, at its best, does not merely manage risk, but also acts as the steward of society’s assets and an advocate of its deepest goals. Beyond compensation, the next generation of finance professionals will be paid its truest rewards in the satisfaction that comes with the gains made in democratizing finance extending its benefits into corners of society where they are most needed. This is a new challenge for a new generation, and will require all of the imagination and skill that you can bring to bear. Good luck in reinventing finance. The world needs you to succeed.”
—Professor Robert J. Shiller, Speech to Finance Graduates, Finance and the Good Society
This book is dedicated to everyone working towards a more inclusive and efficient financial system.
Acknowledgments
The creation of this book was a collaborative effort, enriched by the knowledge, support, and insights of many individuals and organizations. I extend my deepest gratitude to those who played a crucial role.
Thank you to the numerous researchers and authors whose reports have been integral to this book. Their detailed insights have shaped many of the ideas and concepts presented here, and I have strived to reference their work appropriately.
Daniel Liebau: Thank you Dan for your support of this project. Your contribution to my journey in this DeFi path has been invaluable. I appreciate all the reports, introductions, and feedback you’ve sent my way.
A heartfelt thank you to my editors – Vithusha Rameshan, Syd Ganaden, Susan Cerra, and Purvi Patel – as well as the entire Wiley team responsible for bringing this book to life. Special appreciation goes to Carol Thomas for her meticulous copyediting. Your dedication and patience throughout the publishing process have been invaluable.
To my family, especially my mother, thank you for your love, encouragement, and understanding. Your belief in me has been a guiding force.
Timothy Draper, for being so generous with his time to speak at De/Centralize 2018 and writing the foreword for this book. The first time I had heard that Singapore was becoming a crypto hub was during an event at Draper University in San Mateo, California, back in 2014.
Special thanks to various professionals who have provided invaluable feedback and detailed commentary on the material, including Jeremy Kim, staff at the Monetary Authority of Singapore, and Lasse Clausen along with his team at 1kx.
Finally, thanks to all my colleagues, past and present, who supported me throughout this endeavor: Brandon Possin for editing and feedback on early chapters, Tim Han for previous support with De/Centralize, David Tan and Jennifer Lewis for constant encouragement and advice.
Glossary
There will be many terms that might be new to you if you are just starting out in DeFi. Crypto has a habit of reinventing itself semantically, and new terms like “web3” have emerged only recently. This can become even more confusing when we aim to cover both the crypto‐native side and the regulated side of DeFi. To provide clarity, let me offer some definitions for the main terminology used in DeFi concerning assets and technology.
Blockchain:
The underlying technology behind digital assets and crypto‐assets. Examples: Bitcoin and Ethereum.
CeFi:
Centralized Finance. These are crypto‐native centralized exchanges and centralized yield platforms. They are predominantly custodial in nature. Sometimes also pointing to centralized TradFi.
Crypto:
A general and informal term that commonly refers to cryptocurrency or crypto‐assets. It traces its origins back to cryptography, the underlying technology that secures and encrypts these digital assets. Can also refer to the industry as a whole.
Crypto‐asset:
The most inclusive and general term used to describe various types of cryptographic assets. This encompasses both cryptocurrencies and utility tokens, representing a wide range of digital assets operating within the crypto ecosystem.
Cryptocurrency:
A crypto‐asset with specific functions as a currency within a smart contract network to pay for fees, or a crypto‐asset such as Bitcoin whose dedicated function is to act as a money substitute. More commonly used than “crypto‐asset,” especially in the media.
DeFi:
Decentralized Finance. From the Bank of International Settlements (BIS): “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 a traditional centralized intermediary” (https://www.bis.org/publ/work1066.htm).
I define DeFi broadly as DLT‐based finance that replaces centralized databases and / or disintermediates centralized entities. More relation to crypto‐native DeFi but recently having relation with DLT‐enabled TradFi, who has interest in institutional DeFi. A narrower definition of crypto‐native DeFi would include elements of self‐custody, uncensorability, and community‐driven governance.
Digital Asset:
A general term for any kind of asset represented on a distributed ledger. May or may not be regulated. Now often being used by the regulated world to differentiate from the speculative crypto side. Nonetheless encapsulates crypto‐assets also.
Distributed Ledger Technology (DLT):
The more general class of blockchains, some of whom may not have blocks or chains, and have different consensus mechanisms. Also a preferred term on the regulated side. Examples include: Corda.
“Distributed ledger technology (DLT) refers to the protocols and supporting infrastructure that allow computers in different locations to propose and validate transactions and update records in a synchronised way across a network.” (BIS, https://www.bis.org/publ/qtrpdf/r_qt1709y.htm)
Token:
Crypto‐assets created on a specific blockchain (L1 / L2) such as Ethereum. For example, the ERC‐20 token.
TradFi:
Traditional Finance. The larger world of finance whose main nodes are central banks, commercial banks, and investment banks.
Web3:
Another generalized collective term for the overarching vision of a decentralized, blockchain, and token‐based internet. Where the Web2 is platform‐based and centralized, Web3 is decentralized and uncensorable.
Foreword
Bitcoin holds promise. It is the promise of a wealthier world. The kind of wealth that changes everything for the people of the world. The kind of wealth that transforms the global economy to one that is faster, better, cheaper, and more frictionless than the one we have today. The kind of wealth that brings the people of the world together and allows them the freedom to operate with minimal hindrance from government regulation.
At the same time, Bitcoin holds the promise for better government. A government that can account for every profit, every transaction, and every asset without the need for more IRS agents. A government that keeps perfect records on the blockchain, so that everyone is treated fairly, and no one can cheat the system. A government that people can all be proud of: one that allows the trust and freedom of action to build a business without unnecessary restrictions or regulations, since the entire Bitcoin blockchain is perfectly transparent.
Bitcoin also holds great promise for the retailer and the shopper. A shopper that pays in Bitcoin can get a discount on the purchase, and the retailer can save on bank and credit card fees. Bitcoin and the blockchain will keep perfect records so the shopper and retailer will never have a dispute on what was purchased, when, and by whom.
Bitcoin holds great promise for the unbanked in society. The unbanked are also often the homeless, the weakest, the poorest, and the least hopeful. A Bitcoin economy can help the unbanked become a part of the global economy. The unbanked are those who have so little money that a bank cannot afford to open an account for them. Without an account, they cannot easily buy and sell anything, so they are hamstrung to operate with more friction and less technology. Bitcoin can change all that for them. A Bitcoin wallet can be opened for free. They can jump into the world economy with zero friction, and begin to get their life on a good wealthier path.
And Bitcoin holds great promise for a venture capitalist like me. I look forward to a time when I can raise money from LPs in Bitcoin, invest money in a startup in Bitcoin, have the startup pay their employees and suppliers all in Bitcoin, and have all the taxes computed and paid in Bitcoin. This walled garden of business can allow perfect records without the need for an accountant, a bookkeeper, an auditor, a tax lawyer, a transfer agent, even a tax collector. Payments of return of capital and profits to LP investors and to the VC (GP) could all be done in a smart contract waterfall without the need of anyone in house checking the math. The entirety of that business could be frictionless, honest, and automated. The government would be paid, the investors would get exactly what is coming to them, and the cost of the operation could be decreased nearly entirely.
Bitcoin was and remains the origin of digital assets, DeFi, and distributed ledger technology. It combined cryptography, proof‐of‐work consensus mechanisms, and ingenious economic incentives to create the world's first decentralized digital asset independent of any government. It is no understatement to say that Bitcoin was the seed, and continues to be a vital part of the current ongoing revolution of the decentralization of finance.
A Bitcoin world is a world I want to live in. A wealthy world, a prosperous world, a trusting world, a free world, a fair world.
Enjoy Kenneth Bok's book. It will take you on a journey and teach you about the path to this great world we can envision together.
Timothy Draper
Founder, Draper Associates, DFJ, and Draper University
Introduction
The genesis block of Bitcoin bears the inscription, “Chancellor on Brink of Second Bailout for Banks.” This encoded message, imparted by Satoshi Nakamoto, signaled the advent of a paradigm shift in finance: distributed ledger technology. The distributed ledger transformation is not limited to crypto speculators; it is finally reaching the echelons of central banks and commercial banks.
Cryptocurrencies bear significant risk. The collapse of entities like FTX and Terra, coupled with extreme volatility and the largely unregulated nature of the crypto realm, suggest that it might not be an ideal investment avenue for the average consumer.
Despite these risks, the innovative technology behind cryptocurrency is undeniably powerful. It empowers anyone with internet access to transact and store their own crypto‐assets, opening up promising possibilities for financial inclusion. It represents the precursor of an open, global financial system without intermediaries, operating 24/7 and challenging traditional financial structures, thus paving the way for a more accessible and inclusive financial landscape.
As we will explore, blockchain technology – more broadly referred to as distributed ledger technology (DLT) – is spearheading dramatic changes and advancements in finance. DLT enables for an efficient, secure, and interoperable financial ecosystem, enabling faster and more inexpensive experiences for consumers and businesses. Its potential to transform payments and capital markets is enormous, extending even to implications for geopolitical dynamics.
Decentralized Finance (DeFi) is finance operating on DLT. More accurately, I would define DeFi as DLT‐based finance that replaces centralized databases and / or disintermediates centralized entities. In crypto‐native DeFi, this definition may include self‐custody, uncensorability, and community‐based governance. In the regulated world of central banks and commercial banks, DLT is also playing a role in Central Bank Digital Currencies (CBDCs), tokenized assets, tokenized bank deposits, and institutional DeFi.
This book aims to unravel the complex world of DeFi and explore its transformative impact on finance, preparing finance and investment professionals for the future ahead.
I.1 Who Am I?
Allow me to introduce myself and how I came about writing this book.
My career began at Goldman Sachs in London, where I worked as an exchange‐traded fund (ETF) trader on the Program Trading desk. My role involved using algorithms to hedge the firm's exposure to Eurozone ETFs in futures and equities markets, as well as executing orders for clients. Coincidentally, I bore witness to the unfolding of the global financial crisis in 2008 right from the trading floor. This first‐hand experience with the global financial system's flaws sparked in me a conviction that substantial improvements can be made in the realm of finance.
My journey into the world of digital assets commenced in 2014, when I began researching Bitcoin and bought it for the first time. This exploration fortunately led me to invest in the Ethereum crowdsale, and also into investing my Ether into other Layer 1 platforms such as Cosmos and Tezos. Additionally, I organized a conference called De/Centralize in Singapore in 2018, bringing many world‐class innovators in the industry to my home country.
Subsequently, I served as Head of Growth and Strategy at Zilliqa, a Singapore‐based Layer 1 blockchain platform. During my time there, I led ecosystem and business development, supporting developers and startups looking to build on Zilliqa. I also spearheaded FinTech and DeFi strategy, fostering collaborations with FinTechs such as Xfers, which launched Singapore's first stablecoin, and HG Exchange, a regulated security token exchange.
I currently run my own boutique DeFi / FinTech advisory company Blocks.sg. I'm also an active trader and angel investor in the crypto and DeFi space. Since 2014, I've executed various strategies such as arbitrage, yield farming, and relative value in the DeFi space. On the long‐only side, I've participated in numerous crowdsales, angel investments, and other kinds of advisory engagements. I'm also a pro bono mentor with R3, a leading financial DLT. Please reach out if you're building something interesting in the DeFi / FinTech space via my website: kennethbok.com
I.2 How This Book Is Organized
This book is organized into two main parts: Crypto‐native DeFi and DLT in Traditional Finance.
Part I, Crypto‐native DeFi, explores DeFi in its native setting: public blockchains on the internet. It operates in an unregulated environment, characterized by high risk, yet fosters remarkable innovation, global accessibility, and operates at a rapid pace.
Chapter 1, What Is DeFi?, provides an introduction to what DeFi is, offering a broad, top‐down perspective and its unique characteristics, together with an examination of its size, key participants, and an exercise for you to try it yourself.
Chapter 2, Infrastructure and Instruments, examines the infrastructure of DeFi, with a focus on Ethereum. Basics of blockchains, cryptography, the difference between Bitcoin and Ethereum, L1s and L2s, how transactions work in DeFi, smart contracts, and types of crypto‐assets.
Chapter 3, Activities and Applications, explores actual DeFi applications that run on L1s and L2s. Understanding how payments, trading, investing, lending, and borrowing work in DeFi. Delving into aggregation, governance/DAOs, real‐world assets, and examining relevant case studies.
Chapter 4, Risks and Mitigation, discusses cybersecurity, software, operational and financial risks associated with DeFi and how they can be mitigated. It includes case studies. It considers the risks endemic to DeFi and the risks that DeFi poses to the broader financial system, from a global regulatory perspective.
Chapter 5, Regulation, considers the vital role that regulation plays in shaping DeFi's evolution. Considering DeFi's global nature, our focus lies on key standard‐setting bodies like the BIS, FSB, IOSCO, and significant jurisdictions such as the US and EU. Additionally, we delve into DeFi‐specific regulations related to stablecoins and decentralized exchanges.
Part II, DLT in Traditional Finance, delves into how DLT is being implemented by commercial banks, central banks, and other financial institutions in the highly regulated and supervised financial world, which transacts in volumes significantly larger than that of crypto‐native DeFi. While innovation may move at a slower pace, this environment offers much greater integrity, stability, and consumer and business protection.
Chapter 6, Central Bank Digital Currencies (CBDCs), views how CBDCs represent a highly significant development that holds the potential to transform the base layer of digital money, consequently reshaping the landscape of finance as we currently know it. The chapter includes historical context, central bank motivations for CBDCs, comparisons between retail and wholesale CBDCs, analysis of their benefits and risks, central bank preferences for permissioned DLT, and highlights developments in Nigeria, the United States, and China regarding CBDC adoption.
Chapter 7, Asset Tokenization, notes how nearly any kind of financial asset can be tokenized on a DLT. We explore the what, why, and how of asset tokenization, understanding its significance and implications. We also look at the impact of DLT on capital markets, across five different segments: primary markets, secondary trading, clearing and settlement, custody, and asset servicing.
Chapter 8 considers Deposit Tokens, which refer to commercial bank deposits represented on a DLT. In this discussion, we distinguish between CBDCs, stablecoins, e‐money, and deposit tokens, understanding their unique characteristics and roles. Additionally, we explore the advantages of deposit tokens and explore case studies on deposit token projects, including the Regulated Liability Network (RLN) and initiatives from Onyx by JP Morgan.
Chapter 9, Institutional DeFi, investigates the ongoing efforts of central banks and commercial banks in piloting DeFi innovations within a regulated environment. We delve into how they are integrating automated market makers (AMMs), smart contracts, CBDCs, tokenized deposits, and tokenized assets. Our exploration includes considerations for institutions seeking to participate in DeFi, along with examples of pilots. Additionally, we explore FX as a key asset class for AMMs and examine the BIS's concept of a Unified Ledger.
Chapter 10, Conclusion, provides an overview of the current DeFi situation and looks ahead to what the future of DeFi might be.
I.3 Scope of This Book
A brief note on the scope of this book, taking into account the wide‐ranging topics of finance, technology, law, and regulation we are going to cover.
I.3.1 In Scope
All types of DLT
: This includes both public blockchains and permissioned DLT.
All types of finance
: This encompasses traditional finance and crypto finance, both regulated and unregulated.
Infrastructure, applications and technology
: While it is impossible to encompass every aspect within this domain, I have endeavored to address the most significant themes and core technologies of DeFi.
Law and Regulation
: The legal and regulatory landscape plays a central role in shaping the future prospects of DeFi. Recognizing the complexity of individual country specifics, I have taken a high‐level approach to address the overarching themes in this domain.
I.3.2 Out of Scope
Non‐financial applications of DLT
: While DLT holds potential across various domains, such as supply chain management, healthcare, and transport, this book focuses solely on DLT applications within the finance‐related context. Non‐financial applications of DLT are considered out of scope for this work.
Non‐financial Web3 applications
: The emerging Web3 certainly has many overlaps with crypto‐native DeFi, such as social media and gaming. In order to focus on our finance theme, this is also out of scope for this book.
I.4 Disclaimers
No endorsement of specific DeFi apps
: The mention of any specific DeFi apps or crypto‐assets are for educational purposes and do not constitute endorsements.
Rapidly changing information
: The information in this book is subject to change quickly. The volatile, highly innovative and dynamic nature of crypto may mean that things mentioned in the book could be different by the time you read them.
Author's positions
: At the time of writing, I may have positions in crypto‐assets and some of the startups mentioned in the book. I hold a position in Credix, and I may also have some holdings in Bitcoin and Ether.
Not financial advice
: This book is not financial advice. Please do your own research. The author takes no responsibility for any investment decisions or outcomes made based on the information provided.
Views of the author only
: The views expressed in this book are solely those of the author and do not represent the views of any other organization, including any organizations mentioned.
I.5 Corrections
Please contact me at [email protected] for any corrections to the material.
Part ICrypto‐native DeFi
1What Is DeFi?
I've developed a new open source P2P e‐cash system called Bitcoin. It's completely decentralized, with no central server or trusted parties, because everything is based on crypto proof instead of trust.
—Satoshi Nakamoto
Decentralized Finance (DeFi) is an alternative financial infrastructure that is open, permissionless, and interoperable, built on public blockchains such as Ethereum. DeFi consists of a wide variety of internet‐native applications and protocols that enable existing financial activities such as trading, investing, and payments, and also for entirely new financial capabilities. DeFi applications, being permissionless by design, are available for retail and institutional investors to utilize globally, with only an internet connection and sufficient know‐how being the prerequisites required to participate in DeFi. Like many emergent movements and technological trends, DeFi outpaces regulation and many aspects of DeFi are unregulated and suffer from a lack of standards necessary in financial applications. Nonetheless, DeFi represents an entirely new way to deliver financial services and could interface with traditional finance as well as financial technology (FinTech) in many ways.
Interfaces for DeFi take place through software tools and infrastructure already built for the existing cryptocurrency system, such as blockchains, managed infrastructure, web‐based browser wallets, centralized and decentralized exchanges, and the plethora of tools available for creating and maintaining decentralized applications (dApps). A more detailed explanation of the infrastructure, instruments, and applications will be covered in the following chapters.
Historically, core DeFi applications such as Uniswap and Aave occurred earlier in about 2018, but DeFi only came into prominence in Q2 2020, “DeFi Summer,” when the total value locked‐up by smart contracts skyrocketed above US$100 billion, coinciding with a bull market in cryptocurrencies which peaked in late 2021. See Figures 1.1 and 1.2.
Figure 1.1 Total value locked‐up in DeFi (2019–2023).
Source: https://defillama.com/
Figure 1.2 Market capitalization of all cryptocurrencies (2016–2022).
Source: Thompson Reuters Eikon, OECD. https://www.oecd.org/daf/fin/financial-markets/Why-Decentralised-Finance-DeFi-Matters-and-the-Policy-Implications.pdf
Within the cryptocurrency industry, DeFi is an established vertical, with well‐defined business models and product offerings. Other key verticals in crypto include general‐purpose blockchains (L1 / L2s), Games, Non‐Fungible Tokens (NFTs) and stablecoins. dApps are built on a specific blockchain, which results in distinct ecosystems for each blockchain. Each blockchain thus tends to have a DeFi ecosystem which consists of key dApps which serve a specific niche or function, such as decentralized exchanges, aggregators, and lending / borrowing platforms. dApps are also able to be multi‐chain or cross‐chain, allowing for bridging and aggregation of liquidity and functionality across multiple blockchains. The majority of DeFi apps are on Ethereum, although there now exist DeFi applications and ecosystems on other L1s such as Solana, Binance Smart Chain, Polkadot, and Avalanche.
On a broader level, DeFi is being analyzed and monitored by many TradFi industry participants, and also supranational organizations such as the Bank of International Settlements (BIS), the Organisation for Economic Co‐operation and Development (OECD), and the International Organization of Securities Commissions (IOSCO), with all three having produced reports and analysis on DeFi. The reports assess risks to global financial stability and implications to regulation and policy, but strike a cautiously optimistic tone to the technological innovations which DeFi and smart contracts might bring to finance as a whole.
DeFi applications have the potential to provide benefits to financial market participants in terms of speed of execution and transaction costs, driven by the efficiencies produced by DLT‐technological innovation and disintermediation of third parties replaced by software code of smart contracts. DeFi could possibly allow for a more equitable participation of users in markets depending on the design of governance arrangements. Given the open source nature of protocols, DeFi may promote innovation in financial services and could have some potential to promote financial inclusion depending on the design and transaction arrangements (e.g. fees charged).
—Why Decentralised Finance (DeFi) Matters and the Policy Implications, p. 10, OECD
DeFi has tremendous potential to lower transaction costs, improve financial inclusion and facilitate financial innovation through its global, open nature. It could prove as significant as FinTech in enabling a more democratic access to financial services by way of projects such as MPesa. It could reduce fees associated with financial services for lower‐income groups and small businesses. Given its nascent nature, DeFi faces significant structural and cultural challenges towards these aspirational goals.
DeFi is not without its risks, a topic we will explore in detail in Chapter 4. Some of the highest‐profile collapses in crypto, although primarily related to centralized crypto, have had ripple effects on DeFi as well. Two such examples are Terra and FTX.
The implosion of the Terra ecosystem and UST, an algorithmic “stablecoin,” was one of the biggest cryptocurrency collapses in history, affecting thousands of retail users and institutions involved in crypto asset trading and investing. At its peak, the market capitalization of LUNA, the token of the Terra ecosystem, was US$36 billion and UST was the third largest stablecoin (behind USDT and USDC) with a market capitalization of US$18 billion.1 Many people flocked to the promise of 19.5% per year rate that Anchor (a yield platform operated by Terra) paid out until it all collapsed very suddenly. The collapse of Terra was the beginning of a cryptocurrency financial contagion which led to the collapse of several other cryptocurrency firms including Celsius, Three Arrows Capital, BlockFi, FTX, and others.
1.1 The Role of Intermediaries in TradFi
A core tenet of DeFi is the disintermediation of financial intermediaries with the blockchain. Intermediaries are middlemen. If DeFi seeks to replace intermediaries through software, then it is only appropriate to ask what those existing functions are. How will blockchain‐based software enable them?
Most financial entities such as banks, exchanges, and insurance companies are intermediaries. Intermediaries perform the important functions of connecting those who have capital (investors and lenders) with those who seek capital (entrepreneurs and borrowers) in accountable, rigorous, auditable, and risk‐prudent processes. Intermediaries are core to the healthy functioning of the global financial system, and enable monetary and fiscal policy to be transmitted from central banks and governments down to businesses and consumers.
Global financial centers such as New York City, London, Shanghai, and Singapore are also frequently associated with good rule‐of‐law, infrastructure, and governance that enable financial market participants to operate stable businesses. This is critical in fast‐changing financial environments that demand a tremendous amount of interconnectivity.
Intermediaries perform a large number of roles, including investor protection, market integrity, and other systemically important functions. Regulators ensure intermediaries meet these goals through licensing requirements and legal enforcement.
Two examples of financial intermediaries are stock exchanges and banks. The New York Stock Exchange (NYSE) is the world's largest stock exchange, with an average daily trading volume in the hundreds of billions of dollars. By facilitating order books for different stocks and supporting the millions of orders that change price and size constantly on a millisecond basis, the NYSE allows for buyers and sellers of stocks to trade with one another securely and with low transaction costs. Stock exchanges enable traders to find the other side of the transaction, at the right price.
Banks that you and I have accounts with are also financial intermediaries. Banks accept deposits from savers and lend money to businesses and borrowers, who have to pass screening from the banks in light of their credit scores and other estimates on their ability to pay. This screening is a key role in making sure that loans are financially viable and that borrowers ultimately are being economically productive.
Banks are also fundamentally in the business of matching their assets and liabilities and ensuring that the interest they earn from their borrowers is higher than the interest paid to their lenders. Banks hedge and control their financial risk through the money markets (short term debt markets).
One of the key issues of DeFi is that most of the lending takes place pseudo‐anonymously (anonymous but having a distinct blockchain address) and is based on overcollateralization. This is in large contrast to the way loans are disbursed in TradFi as discussed briefly earlier. We will examine some initiatives such as decentralized identity and credit scoring that seek to bridge this gap.
1.2 Definitions
For the scope of this book, I will define DeFi in two ways: narrow and broad.
A narrow definition of DeFi:
DLT‐based finance that is self‐custodial, uncensorable, and community‐driven.
A broader definition of DeFi:
DLT‐based finance that disintermediates centralized entities.
There do not exist many formal definitions of DeFi, and distinctions vary between industry practitioners and academics. Nonetheless, here is a summary of the key features of DeFi, with both narrow and broad definitions.
The one feature that most industry practitioners and academics agree on is the non‐custodial or self‐custodial aspect of DeFi. That is, users are able to own their crypto assets directly through the use of private keys and not rely on a third‐party custodian to custody their assets. For clarity, I will henceforth refer to non‐custodial as self‐custodial, since that tends to be less confusing.
The other feature around DeFi custody which stems from public blockchains is that smart contracts (computer code executed on the blockchain, to be covered in Chapter 2) can custodize crypto. Smart contracts can hold funds and enable for a wide range of functionality owing to the programmable nature of the blockchain. Many of the DeFi protocols, such as automated market makers and borrow / lending platforms, utilize this feature of smart contract custody.
The second feature of DeFi is that it should be uncensorable, both on the transaction layer and the protocol layer. For example, if you are using Uniswap on Ethereum, both Uniswap (the application) and Ethereum (the protocol) must not have the ability to censor your transaction – that is – have no way of stopping your transaction. In direct contrast, a relationship where your assets are held or custodized by a central entity is referred to as centralized finance or CeFi.2Figure 1.3 shows a decision tree to differentiate between DeFi and CeFi.
The third feature of DeFi, especially within crypto, is about incentives for specific groups of actors for doing particular tasks and distributed governance. In other words, DeFi is community‐driven. Some might call these DAOs, or distributed autonomous organizations. The majority of DeFi projects have a circulating governance token that is designed for token holders to be able to propose and vote for issues that are material to the ongoing functioning of the project. For example, in Curve (a decentralized exchange), the CRV token is used for the control of the emission gauge of the rewards in the staking pools. The extent to which decentralized governance actually is decentralized is another topic of discussion that has been discussed by BIS3 and other research into governance.
Figure 1.3 Decision tree to differentiate between DeFi and CeFi.
Source: Qin, K., Zhou, L., Afonin, Y. et al. (2021). CeFi vs. DeFi – Comparing Centralized to Decentralized Finance. arXiv:2106.08157
More broadly speaking, the core mission and tenet of DeFi is disintermediation. This is also in line with a similar sounding “decentralization.” A broader definition of DeFi is financial disintermediation with smart contracts and blockchains. To be more precise, smart contracts that run on public blockchains, since private blockchains are limited by design. In regards to this broader definition of DeFi, DeFi and crypto are almost interchangeable by meaning.
The adoption of DeFi from TradFi institutions is also promising. One example is the tokenization of regulated securities and putting them on‐chain to be used in DeFi‐style trading pools as collateral. Thus, I would argue that the definition of DeFi is broadening from the crypto‐native perspective. Just as with Central Bank Digital Currencies (CBDCs) and permissioned blockchains, innovations in crypto have readily transposed to the centralized world, albeit in piecemeal ways that fit within existing mandates, requirements, and processes.
1.3 Other Characteristics of DeFi
Here are a few more key characteristics of DeFi that set it apart from TradFi. Some of them are advantages, some of them are disadvantages and there are some that are both. Here are the key ones that will help you to understand DeFi from a high‐level perspective.
1.3.1 Interoperability / Composability
DeFi applications and protocols are designed to be “money legos” – being able to interoperate with one another with application programming interfaces (APIs). Complex transactions may involve multiple calls to multiple applications in one transaction. Interoperability of applications and protocols allow for easy aggregation and other kinds of abstraction, such as dashboards.
1.3.2 Transparency
DeFi takes place on smart contracts, which are by nature transparent and auditable. Like open‐source software, this makes it easy to audit the code. Verification of transactions is also easier in a transparent system: for example, for a simple token transfer from Alice to Bob, Alice would not even need to ask Bob if he has received the token to verify the transaction has completed – all she needs to do is to look at his address on the block explorer.
1.3.3 Openness
DeFi is designed to be permissionless and open. One does not need to provide any kind of identification to the blockchain in order to open a wallet or account. In theory, this has great potential for DeFi to serve the billions of the unbanked and underbanked who do not have formal identification or have challenges opening a bank account.
