DeFi Protocol Risks: The Paradox of DeFi

Decentralized Finance (or “DeFi”) is growing in volume and in importance. DeFi promises cheaper and more open access to financial services by reducing the costs and risks of using centralized intermediaries. DeFi also holds the promise of interoperability across blockchains that could help tear down financial sector silos, greatly promoting innovation and building vibrant financial ecosystems. However, DeFi is not without its challenges, which are understudied. This article does not seek to provide a comprehensive list of DeFi risks but to help readers conceptually understand the drivers behind the risks inherent in DeFi. Many of the risks described above stem from the decentralized nature of blockchains. The goal of automating the delivery of financial services and reducing human dependencies also has the congruent effect of reducing oversight and control. Disintermediating traditional intermediaries reduces high fees and entry friction, but also creates new opportunities for new types of intermediaries. This article discusses some of the new types of risks introduced by DeFi that are inherent to blockchain systems along with traditional types of financial risks in DeFi that manifest in new ways: (i) interconnections with the traditional financial system, (ii) operational risks stemming from underlying blockchains, (iii) smart contract-based vulnerabilities, (iv) other governance and regulatory risks, and (v) scalability challenges. In an effort to remove humans and automate as much as possible through smart contracts, DeFi has introduced or amplified these risks. The growth of DeFi will depend on its ability to navigate and build compatibility with traditional finance and on how laws and regulations respond. Perhaps the biggest challenge of all is that the DeFi ecosystem continues to grow while its underlying base layer (public infrastructure such as Bitcoin or Ethereum) faces growing pains. As DeFi grows in importance and becomes more mainstream, policymakers and industry representatives need to better understand the economic and policy consequences of these new types of risks in order to build regulatory approaches and risk management practices that can support and facilitate a healthy and robust DeFi ecosystem and, ultimately, the financial stability of the greater financial system and real economy.