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Grasping De(centralized) Fi(nance) Through the Lens of Economic Theory

Author

Listed:
  • Jonathan Chiu
  • Charles M. Kahn
  • Thorsten Koeppl

Abstract

In this article, we use a simple stylized model of collateralized lending to analyze the value proposition and limitations of decentralized finance (DeFi). DeFi uses a decentralized ledger to run smart contracts that automatically enforce the terms of a lending contract and safeguard the collateral. DeFi can lower the costs associated with intermediated lending and improve financial inclusion. Limitations are the volatility of the crypto collateral and stablecoins used for settlement, the possible incompleteness of smart contracts and the lack of a reliable oracle. A proper infrastructure reducing such limitations could improve the value of DeFi.

Suggested Citation

  • Jonathan Chiu & Charles M. Kahn & Thorsten Koeppl, 2022. "Grasping De(centralized) Fi(nance) Through the Lens of Economic Theory," Staff Working Papers 22-43, Bank of Canada.
    • Handle: RePEc:bca:bocawp:22-43
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    References listed on IDEAS

    as
    1. Jonathan Chiu & Thorsten V Koeppl, 2019. "Blockchain-Based Settlement for Asset Trading," Review of Financial Studies, Society for Financial Studies, vol. 32(5), pages 1716-1753.
    2. Ye Li & Simon Mayer & Simon Mayer, 2021. "Money Creation in Decentralized Finance: A Dynamic Model of Stablecoin and Crypto Shadow Banking," CESifo Working Paper Series 9260, CESifo.
    3. Lin William Cong & Zhiguo He, 2019. "Blockchain Disruption and Smart Contracts," Review of Financial Studies, Society for Financial Studies, vol. 32(5), pages 1754-1797.
    4. Sirio Aramonteand & Wenqian Huang & Andreas Schrimpf, 2021. "DeFi risks and the decentralisation illusion," BIS Quarterly Review, Bank for International Settlements, December.
    5. Agostino Capponi & Ruizhe Jia, 2021. "The Adoption of Blockchain-based Decentralized Exchanges," Papers 2103.08842, arXiv.org, revised Jul 2021.
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    Cited by:

    1. Naudts, Ellen, 2023. "The future of DAOs in finance - in need of legal status," Occasional Paper Series 331, European Central Bank.

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    More about this item

    Keywords

    Digital currencies and fintech; Payment clearing and settlement systems;

    JEL classification:

    • G2 - Financial Economics - - Financial Institutions and Services

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