The rise of intermediary-less decentralized finance (“DeFi”) lending has led many to wonder how it should be regulated. Although DeFi lending could potentially offer reduced risks of centralization and market frictions, investors in DeFi lending are currently exposed to centralized risks and losses in the volatile market in the absence of regulation. The SEC suggested that the agency might regulate the sector under the federal securities laws. A truly decentralized lending project, however, does not involve any centralized entity that could carry the burden of compliance with the securities laws. This Note shows that many DeFi lending projects are not truly decentralized and are in various stages of decentralization. Unlike P2P lenders and financial intermediaries that bear the costs of compliance, many DeFi developers seek to build automated lending systems and gradually relinquish their control over their creation. However, with the lack of regulation, the investors have no means to tell actors who seek to build secure decentralized systems from those who do not in the early stage of DeFi protocol development. To address the issue, this Note proposes a three-part framework that would oversee the process of decentralization for DeFi lending projects, drawing its structure from the U.S. banking regulation focused on supervision. First, the framework recognizes the value of decentralization in reducing market frictions and risks of centralization. Second, the framework establishes a federal agency that oversees the process of decentralization on the flexible safety and soundness standard of Glass-Steagall Act. Third, the framework grants enforcement powers to the federal agency to sanction DeFi platforms that do not comply with government regulations.
Rubén Leal Buenfil, Alexander Hernandez Romanowski
In order to make public policy recommendations to efficiently regulate Decentralized Finance (DeFi), we conducted an exploratory study examining the state of the art, organizing the public debate and analyzing real-world applications of this cutting-edge technology.We found that DeFi has the potential to increase efficiency in financial markets, promote competition, improve access to capital and contribute to economic growth.For all its potential benefits, however, the technology also presents substantial challenges in the form of user accessibility, market stability, fair competition and law enforcement.Growth of the emerging DeFi market depends on successfully addressing the concerns of investors, consumers and authorities without simultaneously regulating the technology into inefficiency and disuse.Taking into account the implications of DeFi for antitrust policies and economic growth, we explore the applicability of a balanced embedded-regulation, which holds promise as a bridge between innovation and regulation.The main limitation of this study is related to the constantly-evolving nature of DeFi technology.Recommendations for its regulation may vary as new evidence becomes available, but this document may pave the way for further research.
Sarah Azouvi, Guy Goren, Lioba Heimbach, Alexander Hicks
In 2021 Ethereum adjusted the transaction pricing mechanism by implementing EIP-1559, which introduces the base fee - a network fee that is burned and dynamically adjusts to the network demand. The authors of the Ethereum Improvement Proposal (EIP) noted that a miner with more than 50% of the mining power could be incentivized to deviate from the honest mining strategy. Instead, such a miner could propose a series of empty blocks to artificially lower demand and increase her future rewards. In this paper, we generalize this attack and show that under rational player behavior, deviating from the honest strategy can be profitable for a miner with less than 50% of the mining power. We show that even when miners do not collaborate, it is at times rational for smaller miners to join the attack. Finally, we propose a mitigation to address the identified vulnerability.
The world financial crisis of the late 2000s was for some the dawn of a new era in which state currency monopolies would be replaced by privately-issued digital currencies following strict rules of supply growth. Rather than trust big government and big banks with our money, cryptocurrencies would allow us to “trust the code” and the “mathematical structure” of blockchain technologies.In Brazil, as elsewhere, this neoliberal techno-utopia has not arisen. Though their use as speculative assets has increased, cryptocurrencies have not become a popular means of payment. The use of electronic money, on the other hand, issued by novel corporate entities called payment institutions, is now commonplace. Unlike cryptocurrencies, digital banking and electronic money in Brazil rest on a solid legal and institutional framework designed to incorporate them into the payments system. Digital banks enjoy most of the privileges bestowed upon traditional banks, making it possible for customers to use digital accounts in the same manner as a traditional checking account. In short, digital banks have become privileged members of Brazil’s state-led “pay community” and this is why they have flourished. Even in the digital era, money is a creature of the state.
Mohammad A. AlAhmad, Adel Alfouderi, Ahmad Alonaizi, Meshal Aldhamen
Bitcoin has had a tremendous impact on the monetary system around the globe today since its launch in 2009 by its founder, Satoshi Nakamoto. Since then, over three thousand cryptocurrencies have risen to compete with traditional fiat currencies. While many experts believe that cryptocurrencies are more comparable to assets like gold, few others believe that cryptocurrencies could replace traditional fiat currencies as a medium of payment, just as Satoshi envisioned when he published the Bitcoin protocol. As such, there exist few papers in the literature discussing the potential for Bitcoin to become a major payment currency. Nevertheless, there is a lack of research in evaluating whether Bitcoin is set to dominate the market as a payment currency, or whether another cryptocurrency would take the lead. In addition, the issue of strict regulation capping the potential of cryptocurrencies has been well-studied in the literature and, hence, this paper tries to evaluate the top five leading cryptocurrencies (based on their market cap value as of July 2020) from a different perspective. Particularly, the evaluation is based on five benchmark evaluation factors: Speed, Activity, Decentralization, Users, and Community. For this preliminary study, we assign all these benchmarks an equal weight. Our conclusion shows that Ethereum could be more suitable as a future payment currency rather than Bitcoin.
L'association de la connectivité internet et de la confiance numérique intégrée est en train de rebattre les cartes du monde des paiements. Un nouveau monde s'ouvre via l'utilisation croissante des distributed ledger technologies dans de nombreuses applications financières. Cet article présente les cryptomonnaies, les monnaies stables et les monnaies numériques des banques centrales sous un angle technique et de cas d'usages. Il discute de la programmabilité, c'est-à-dire de la manière d'automatiser l'utilisation des transactions, de la stabilité, c'est-à-dire de la garantie de la valeur de stockage de ces nouveaux actifs, de l'interopérabilité, c'est-à-dire de la manière dont nous pouvons facilement les relier et les combiner, et de l'utilisation générale de ces nouvelles infrastructures. Classification JEL : D02, O33.
Emerging technologies are revolutionizing the banking and financial services industry, with innovations such as blockchain, artificial intelligence, machine learning, cloud computing, and FinTech solutions reshaping financial transactions, security, and risk management. These advancements improve operational efficiency, reduce costs, and enhance customer experience. However, they also introduce challenges, including regulatory compliance, cybersecurity risks, and increased financial instability due to rapid technological shifts. Blockchain has the potential to increase transparency and security in financial transactions, while AI and machine learning optimize credit scoring, fraud detection, and personalized financial services. The integration of quantum computing, augmented reality, and decentralized finance (DeFi) presents further opportunities for financial transformation. Despite these benefits, financial institutions must balance innovation with regulatory and ethical concerns. This study explores the role of emerging technologies in reshaping banking, emphasizing their potential benefits and limitations. Strategic collaboration between traditional banks and FinTech companies is crucial for sustainable financial growth.
Mikel Cortes-Goicoechea, Tarun Mohandas-Daryanani, José L. Muñoz, Leonardo Bautista-Gomez
Like most modern blockchain networks, Ethereum has relied on economic incentives to promote honest participation in the chain's consensus. The distributed character of the platform, together with the “randomness” or “luck” factor that both proof of work (PoW) and proof of stake (PoS) provide when electing the next block proposer, pushed the industry to model and improve the reward system of the system. With several improvements to predict PoW block proposal rewards and to maximize the extractable rewards of the same ones, the ultimate Ethereum's transition to PoS applied in the Paris Hard-Fork, more generally known as “The Merge”, has meant a significant modification on the reward system in the platform. In this paper, we aim to break down both theoretically and empirically the new reward system in this post-merge era. We present a highly detailed description of the different rewards and their share among validators' rewards. Ultimately, we offer a study that uses the presented reward model to analyze the performance of the network during this transition.
Double-entry accounting has been used globally for the past six hundred years and has become the base for all corporate financial reporting. Blockchain technology with distributed ledger now provides a new method of accounting termed “triple-entry accounting”. This method consists of recording and storage of business transactions, as a third entry on the blockchain. This third entry is expected to deliver a system that is trustworthy, immutable, and transparent. This study conducts a detailed review of the present literature on triple-entry accounting with blockchain technology and its impact on fraudulent practices. The review shows current literature has limited information on how this methodology will deter financial and accounting fraud. Drawing on the case studies of twenty-four companies involved in fraudulent practices globally, this paper describes common practices in manipulating financial statements, falsifying accounting records, and fraudulent banking transactions. The study explains the mechanics of how these practices can be prevented using triple-entry accounting in the blockchain environment and how the technique will bring about changes in the audit process and in the roles of internal and external auditors in the organization. The study recommends research propositions focused on governance and financial performance of a company when this method is adopted.
The world has for a long time adopted a financial system where risk control is placed in the care of central authorities or intermediaries. People who invest in the current financial system relinquish their assets to intermediaries such as a bank, stock exchanges, mutual fund companies, insurance companies, and brokers. Many problems have arisen, casting doubt on the effectiveness of the current financial system. An innovative system that introduces the prospects of removing banks’ and other institutions’ control over money, financial products, and financial services is emerging – decentralized finance (DeFi). An extensive study on the subject was done, focusing on the viability of decentralized finance to replace the role of traditional financial systems, using recently published reports. Decentralized finance, a financial ecosystem built on blockchain technologies, is geared toward disrupting the traditional finance world. The features of DeFi promise to revolutionize various financial transactions including DeFi lending and borrowing, decentralized insurance, and decentralized exchanges. DeFi strives to allow direct financial transactions between users, minus the controls of any single entity. Being relatively new, even with all the opportunities it offers, DeFi may have a higher level of risk due to difficulties with regulation, infrastructural mishaps, and potential hacks and scams. Despite the hype around DeFi, it is prudent to understand not only the rewards but also the risks. Decentralized finance is in its early stages of evolution. As we move forward, many issues must be addressed and advancements made before DeFi becomes safe to use.
This paper examines the historical development and cross-sectional heterogeneities of Financial Market Infrastructure (FMI). From an evolutionary perspective, we review and compare FMIs in the US, Europe, and China. We identify an emerging trend in which the development of FMI is transitioning from digitalization to tokenization with the rise of Distributed Ledger Technology (DLT). Digitalization reinforces centralization, while tokenization promotes decentralization, posing complex challenges to regulatory framework which is also part of FMI. We then specifically analyze DLT-based FMI in the bond market, evaluate different models of tokenization, and propose a heterogeneous consortium blockchain solution.
This paper investigates a possible future symbiotic relationship of decentralised finance (DeFi) with the traditional banking sector, with the banking system integrating compliant versions of DeFi in parts of its operations. In particular, the paper indicates empirical trends showing the increasing investment of major global banks in the wider DeFi space through the investment in distributed ledger technologies and the acquisition of cryptorelated entities. The development of compliant tokenisation will be a catalyst for the potential integration of compliant versions of DeFi with banks, and DeFi pools could constitute the currently lacking secondary market for regulated tokenised assets. Repos of tokenised assets in compliant versions of DeFi could also reduce the risk of DeFi as compared with the current use of non-compliant or unregulated crypto-assets as collateral. The integration of compliant DeFi applications by banks as part of their operations would — paradoxically — require a certain level of re-centralisation of DeFi in order to make it compliant and address the long list of important risks observed in current forms of DeFi activity.
Gianna Figà‐Talamanca, Sergio M. Focardi, Davide Mazza, Marco Patacca
In this chapter, we outline a theory of cryptocurrencies that parallels the standard theory of money. We evidence that cryptocurrencies satisfy some but not all conditions that qualify a medium of exchange as money. Specifically, the process of creation and distribution of cryptocurrencies significantly differs from that of money impacting trust and value creation. New form of cryptocurrencies, such as central bank digital currencies, are considered. We outline scenarios of future evolution of cryptocurrencies and how they might be adopted by central banks to replace cash and/or to have direct interaction with the public.
Central banks need to modernise their wholesale payment services. This is not to say they must choose between modernising their real-time gross settlement systems or building a new wholesale central bank digital currency system. Rather, as this paper will argue, they must develop a common, standardised hybrid platform for the global financial (wholesale) markets. Indeed, central banks need to provide interoperable cross-border payment services by accepting foreign participants and coordinating their short-term liquidity instruments. This paper argues that if central banks want to serve future wholesale markets, they will need to provide 24/7/365 services with cross-border finality for simple fund transfers, but also for deliveryversus-payment and payment-versus-payment settlements at the transaction level. The paper will discuss how interoperability is a key issue, and requires completely common message and communication standards, but especially common identification and security standards in which distributed ledger technology and transaction-chaining are important elements. Wholesale systems must be highly resilient. As this paper shows, cooperation between central banks is essential if they are to deliver cross-border wholesale payment services for the global financial markets of the future.
Carlos Alberto Durigan, Fernando José Barbin Laurindo
Cryptocurrency can be understood as a digital asset transacted among participants in the crypto economy. Every cryptocurrency must have an associated Blockchain. Blockchain is a Distributed Ledger Technology (DLT) which supports cryptocurrencies, this may be considered as the most promising disruptive technology in the industry 4.0 context. Decentralized finance (DeFi) is a Blockchain-based financial infrastructure, the term generally refers to an open, permissionless, and highly interoperable protocol stack built on public smart contract platforms, such as the Ethereum Blockchain. It replicates existing financial services in a more open and transparent way. DeFi does not rely on intermediaries and centralized institutions. Instead, it is based on open protocols and decentralized applications (Dapps). Considering that there are many digital coins, stablecoins and central bank digital currencies (CBDCs), these currencies should interact among each other sometime. For this interaction the Information Technology elements play an important whole as enablers and IT strategic alignment. This paper considers the strategic alignment model proposed by Henderson and Venkatraman (1993) and Luftman (1996). This paper seeks to answer two main questions 1) What are the common IT elements in the DeFi? And 2) How the elements connect to the IT strategic alignment in DeFi? Through a Systematic Literature Review (SLR). Results point out that there are many IT elements already mentioned by literature, however there is a lack in the literature about the connection between IT elements and IT strategic alignment in a Decentralized Finance (DeFi) architectural network. After final considerations, limitations and future research agenda are presented. Keywords: IT Strategic alignment, Decentralized Finance (DeFi), Cryptocurrency, Digital Economy.
In traditional finance, the Black & Scholes model has guided almost 50 years of derivatives pricing, defining a standard to model any volatility-based product. With the rise of Decentralized Finance (DeFi) and constant product Automated Market Makers (AMMs), Liquidity Providers (LPs) are playing an increasingly important role in markets functioning, but, as the recent bear market highlighted, they are exposed to important risks such as Impermanent Loss (IL). In this paper, we tailor the formulas introduced by Black & Scholes to DeFi, proposing a method to calculate the greeks of an LP. We also introduce Impermanent Gain, a product that LPs can use to hedge their position and traders can use to bet on a rise in volatility and benefit from large market moves.
This paper investigates the causes and the consequences of the FTX digital currency exchange’s failure in November 2022. Analysing on-chain data, we report that FTX heavily relied on leveraging and misusing its native token, FTT, and we show how this behaviour exacerbated the company’s fragile financial situation. To gain further insights into the downfall, we employ state-of-the-art network science instruments to model the evolutionary dependency structures of 199 cryptocurrencies on an hourly basis, and we investigate tick-by-tick public trades at the time of the events. We identify the collapse of the Terra-Luna ecosystem as the pivotal event that triggered a significant decrease in the exchange’s liquidity. Results suggest that the crash was actively accelerated by Binance tweets causing a systemic reaction in the cryptocurrency market. Finally, identifying the actors who mostly benefited from the FTX’s collapse and highlighting a generalised trend toward centralisation in the crypto space, we emphasise the importance of genuinely decentralised finance for a transparent, future digital economy.
Jiahua Xu, Yebo Feng, D. H. Cámpora Pérez, Benjamin Livshits
Decentralized finance (DeFi) is an integral component of the blockchain ecosystem, enabling a range of financial activities through smart-contract-based protocols. Traditional DeFi governance typically involves manual parameter adjustments by protocol teams or token holder votes, and is thus prone to human bias and financial risks, undermining the system's integrity and security. While existing efforts aim to establish more adaptive parameter adjustment schemes, there remains a need for a governance model that is both more efficient and resilient to significant market manipulations. In this paper, we introduce "Auto$.$gov", a learning-based governance framework that employs a deep Qnetwork (DQN) reinforcement learning (RL) strategy to perform semi-automated, data-driven parameter adjustments. We create a DeFi environment with an encoded action-state space akin to the Aave lending protocol for simulation and testing purposes, where Auto$.$gov has demonstrated the capability to retain funds that would have otherwise been lost to price oracle attacks. In tests with real-world data, Auto$.$gov outperforms the benchmark approaches by at least 14% and the static baseline model by tenfold, in terms of the preset performance metric--protocol profitability. Overall, the comprehensive evaluations confirm that Auto$.$gov is more efficient and effective than traditional governance methods, thereby enhancing the security, profitability, and ultimately, the sustainability of DeFi protocols.
The adoption of new financial instruments is naturally met with skepticism and apprehension. Capital markets as we know them today possess the amazing capability to package any exposure into a digestible instrument for market participants to utilize. However, prudence requires us to verify that these instruments do not suffer from inefficiencies that may prove hazardous to investors. In this article, the authors verify the efficiency of CME Bitcoin Futures Options by testing boundary arbitrage, put-call parity arbitrage, and box spread arbitrage conditions. The results strongly suggest that no reasonable arbitrage opportunities exist and that CME Bitcoin Futures Options are well-suited for institutional scale investing. Hence, we believe their use by institutions to hedge, speculate, and/or facilitate transactions between decentralized markets (“DeFi”) and traditional markets (“TradFi”) will grow significantly in the next few years.
Abstract In recent years, the use of cryptocurrencies has increased. As these currencies continue to play a larger role, they eventually will be an important component of banking system activity. Moreover, in addition to the standard role of financial intermediaries to facilitate lending, intermediaries can be valuable firms that help provide safekeeping of tokens. The objective of this paper is to demonstrate these important functions in a microfounded model of monetary exchange. Furthermore, we also consider the possibility that central banks issue their own digital currencies that may affect the level of intermediation in the private banking system.
Liquidations in Decentralized Finance (DeFi) are both a blessing and a curse -- whereas liquidations prevent lenders from capital loss, they simultaneously lead to liquidation spirals and system-wide failures. Since most lending and borrowing protocols assume liquidations are indispensable, there is an increased interest in alternative constructions that prevent immediate systemic-failure under uncertain circumstances. In this work, we introduce reversible call options, a novel financial primitive that enables the seller of a call option to terminate it before maturity. We apply reversible call options to lending in DeFi and devise Miqado, a protocol for lending platforms to replace the liquidation mechanisms. To the best of our knowledge, Miqado is the first protocol that actively mitigates liquidations to reduce the risk of liquidation spirals. Instead of selling collateral, Miqado incentivizes external entities, so-called supporters, to top-up a borrowing position and grant the borrower additional time to rescue the debt. Our simulation shows that Miqado reduces the amount of liquidated collateral by 89.82% in a worst-case scenario.