Federal Reserve Research: DeFi is Leading Toward a “Paradigm Shift in the Financial Industry”

“DeFi has unleashed a wave of innovation,” says the paper, noting that it is a niche market that has recently gained a lot of traction and seeing rapidly growing volumes but with certain risks.

The Federal Reserve Bank of St. Louis published a research paper on decentralized finance (DeFi) last week, explaining a potential paradigm shift while highlighting the opportunities and potential risks of the ecosystem.

While still a niche market with certain risks, DeFi may “potentially contribute to a more robust and transparent financial infrastructure,” wrote the author Fabian Schär, a professor for distributed ledger technologies and fintech at the University of Basel.

A blockchain-based financial infrastructure that has recently gained a lot of traction replicates existing financial services in a more open and transparent way, reads the report. It further points out that smart contracts are the backbone of all DeFi protocols and apps.

While the volumes are relatively low in this niche market, Schär notes that they are rapidly growing. This “spectacular growth” of these assets locked in the smart contacts along with the innovative protocols suggests that,

“DeFi may become relevant in a much broader context and has sparked interest among policymakers, researchers, and financial institutions.”

In terms of offering “exciting” opportunities, DeFi can increase the efficiency, transparency, and accessibility of the financial infrastructure. The author said, “DeFi has unleashed a wave of innovation.”

He goes on to point out how developers are using smart contracts and the decentralized settlement layer to create trustless versions of traditional financial instruments, and at the same time, they are creating entirely new financial instruments, such as atomic swaps, autonomous liquidity pools, decentralized stablecoins, and flash loans, that could not be realized without the underlying public blockchain.

While this technology has great potential, Schär said, there are certain risks involved as well in terms of smart contract execution risk, operational security, scalability issues, and dependencies on other protocols and external data. In some cases, the term “decentralized” is even deceptive. However, the author said,

“If these issues can be solved, DeFi may lead to a paradigm shift in the financial industry and potentially contribute toward a more robust, open, and transparent financial infrastructure.”

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