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Composable Finance

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Abstract

Composability—open interactions between assets and protocols—facilitates a modular financial architecture. I document the emergence of composed asset transformation, where tokenized assets are re-bundled to alter access, liquidity, and risk characteristics to broaden and enhance the set of tokenized U.S. dollar instruments. Yet, I argue that “naive” composability fundamentally conflicts with the provision of pooled arrangements needed for liquidity provision, risk-sharing, and capital backstops. I demonstrate this in an economy consisting of a vertical chain of protocols. Upper-layer protocols expand access to users, but bootstrap contingent liquidity from lower-layer protocols, resulting in a waterfall of externalities. In equilibrium, the base protocol rations liquid reserves, resulting in systemic illiquidity across the economy. Under severe circumstances, total utilization shrinks with composability. I offer principles and direction for building a sustainable, composable system.

Suggested Citation

  • Michael Junho Lee, 2026. "Composable Finance," Staff Reports 1177, Federal Reserve Bank of New York.
    • Handle: RePEc:fip:fednsr:102386
    DOI: 10.59576/sr.1177
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    References listed on IDEAS

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    JEL classification:

    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • D47 - Microeconomics - - Market Structure, Pricing, and Design - - - Market Design

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