“Decentralized finance” products and services – or DeFi – are rapidly growing in the world of cryptocurrency. By using public, digital ledgers called blockchains, DeFi aims to create a financial system that operates without any traditional central institutions, like banks.

In theory, DeFi services such as lending, payments, investing, and crowdfunding could be executed all day, every day – with no need for a third party to verify their accuracy and reliability, said Edward Dumas, a lead markets specialist at the Federal Reserve Bank of Boston. Transactions would be secure and anonymous, with financial services available to all people.

“That’s the vision,” Dumas said. “Now, the reality of DeFi … is still in its infancy.”

Dumas said that amid the focus on its benefits, the continually evolving technology may also pose risks to the broader economy. These risks – and what they could mean to the financial system – are explored in a Supervisory Research and Analysis working paper that Dumas co-authored, “Decentralized Finance (DeFi): Transformative Potential & Associated Risks.”

In the paper, the authors note that blockchains aren’t as secure as many people believe. They warn that DeFi can become a tool for criminals and that the very interconnectedness of DeFi can also lead to vulnerabilities.

“The rapid growth (of DeFi) … suggests that policymakers should start giving serious consideration to a full range of financial stability issues that could arise should such activities become systemically important,” they wrote.

Paper: Decentralized finance offers transparency but raises questions about accountability

Dumas – who works in the Boston Fed’s Supervision, Regulation & Credit department – wrote the paper with Francesca Carapella, Jacob Gerszten, and Nathan Swem (all at the Federal Reserve Board), and Larry Wall (Federal Reserve Bank of Atlanta).

They note that by using blockchains, DeFi offers transparency on near-real time transactions. Users can access a public, continuously updated record of activities generally considered to be “immutable” or unchangeable.

But the researchers say that blockchains have been successfully hacked by malicious actors seeking cryptocurrency profits. And they say that even if blockchains were to become completely immutable, that may not be a good thing.

“Blockchain transactions that involve fraud or theft might not be reversed as quickly or easily as they would in traditional finance,” the researchers said.

The authors say that because DeFi has no central authority, there could be technical challenges fixing “bugs,” or mistakes, in the programs stored on the blockchains that run DeFi products and services.

The researchers add that the interconnections DeFi creates between markets also present a financial risk: “A shock to one market may spread through DeFi connections to other markets.”

They also note that the censorship-resistant nature of DeFi, which aims to make it accessible to everyone, can invite criminal activity and risk-taking.

“Blockchains are already being used to facilitate scams, theft, money laundering, and a variety of other criminal activity. (And they) could facilitate activities that, despite being legal, may increase the risk of financial instability,” the authors wrote.

DeFi could work together with traditional finance, or cause disruptions

Dumas said it’s still unclear how DeFi will co-exist with the traditional financial system. He said they could work in tandem, or DeFi could disrupt the traditional system and cause competition.

“If you think about the existing banking system as a mechanism to preserve the financial well-being of the economy, and through which the Federal Reserve enacts monetary policy, … we'd have concerns about what impacts (disruptions) could have on the economy,” he said.

The researchers say that as traditional banks offer more cryptocurrency services and loans, it’s possible they may not fully realize the market’s risks, which could lead to legal issues. And it may be easier for customers to sue banks and other traditional financial firms – even in cases where they had relatively minor involvement – rather than try to determine responsible parties “on the DeFi side.”

“If a meltdown occurs in the crypto market, banks could suffer direct losses on their services and loans, create legal exposure from customers who suffered losses in the crypto market, and risk reputational damage,” they wrote.

Dumas said DeFi experimentation is ongoing, and it’s important to acknowledge and plan for potential risks related to DeFi and cryptocurrency.

“It's an exciting area, but it's one that needs to be closely paid attention to, to ensure that we don't find ourselves creating more harm than good,” he said.

Read the working paper here.