Decentralized Finance: Protocols, Risks, and Governance

ArXiv ID: 2312.01018 “View on arXiv”

Authors: Unknown

Abstract

Financial markets are undergoing an unprecedented transformation. Technological advances have brought major improvements to the operations of financial services. While these advances promote improved accessibility and convenience, traditional finance shortcomings like lack of transparency and moral hazard frictions continue to plague centralized platforms, imposing societal costs. In this paper, we argue how these shortcomings and frictions are being mitigated by the decentralized finance (DeFi) ecosystem. We delve into the workings of smart contracts, the backbone of DeFi transactions, with an emphasis on those underpinning token exchange and lending services. We highlight the pros and cons of the novel form of decentralized governance introduced via the ownership of governance tokens. Despite its potential, the current DeFi infrastructure introduces operational risks to users, which we segment into five primary categories: consensus mechanisms, protocol, oracle, frontrunning, and systemic risks. We conclude by emphasizing the need for future research to focus on the scalability of existing blockchains, the improved design and interoperability of DeFi protocols, and the rigorous auditing of smart contracts.

Keywords: Decentralized Finance (DeFi), Smart Contracts, Blockchain, Governance Tokens, Systemic Risk, Crypto / Digital Assets

Complexity vs Empirical Score

  • Math Complexity: 2.5/10
  • Empirical Rigor: 3.0/10
  • Quadrant: Philosophers
  • Why: The paper is a qualitative survey explaining DeFi concepts, risks, and governance with minimal advanced mathematics or empirical data backtesting. It categorizes risks and proposes research directions but lacks code, datasets, or statistical metrics for immediate implementation.
  flowchart TD
    A["Research Goal<br>DeFi: Protocols, Risks, & Governance"] --> B{"Key Methodology"}
    B --> C["Analyze Smart Contract Operations"]
    B --> D["Evaluate Governance Token Models"]
    
    C & D --> E{"Computational Processes<br>via DeFi Ecosystem"}
    E --> F["Lending & Exchange Protocols"]
    E --> G["Consensus & Oracle Mechanisms"]
    
    F & G --> H{"Key Findings & Outcomes"}
    
    H --> I["Identified 5 Risk Categories<br>Consensus, Protocol, Oracle, Frontrunning, Systemic"]
    H --> J["Future Research Priorities<br>Scalability, Interoperability, Auditing"]
    
    style A fill:#e1f5fe
    style H fill:#fff3e0