A Practitioner's Guide to Decentralized Finance (DeFi), Digital Assets, and Distributed Ledger Technology
In Decentralizing Finance: How DeFi, Digital Assets and Distributed Ledger Technology Are Transforming Finance, blockchain and digital assets expert Kenneth Bok offers an insightful exploration of the current state of decentralized finance (DeFi). As distributed ledger technology (DLT) increasingly optimizes and democratizes financial ecosystems worldwide, this book serves as a comprehensive guide to the most salient aspects of the ongoing transformation.
The text delves into both crypto-native DeFi and DLT applications in regulated financial markets, providing:
- Comprehensive analysis of crypto-native DeFi across key areas such as its competitive landscape, infrastructure, financial instruments, activities, and applications
- Coverage of key risks, mitigation strategies, and regulatory frameworks, analyzed through the perspective of international financial standard-setting bodies
- Insight into how DLT is reshaping traditional financial systems through innovations like central bank digital currencies (CBDCs), tokenized assets, tokenized deposits, and institutional-grade DeFi platforms
In a world where financial technology is rewriting the fundamental code of digital currency, the future of money is undeniably DLT-centric. How will this seismic shift interact with existing financial infrastructures? Can decentralization and traditional banking coexist and potentially synergize? This book endeavors to answer these pressing questions for financial professionals navigating these transformative times.
Authored by a former Goldman Sachs trader, past Head of Growth at Zilliqa, and an early Ethereum investor with extensive experience in both traditional finance and the crypto ecosystem, Decentralizing Finance provides you with an insider's perspective on the revolution that is DeFi.
Now taking pre-orders for delivery Jan 2024 Amazon US / UK Amazon Singapore
In a space that is often fast-moving and difficult to fully understand, Bok successfully demystifies many of the key questions that continue to surround DeFi. At R3 we have witnessed first-hand the evolution of emerging innovations such as CBDCs and tokenization, and what this book accomplishes is a detailed overview of the convergence between these new economic models and traditional financial frameworks. As more regulated institutions begin to realize the cost-saving and efficiency benefits of DLT, it is vital that we further education and awareness. The book’s thoughtful breakdown of important industry initiatives, such as the Regulated Liability Network, can further enable readers to gain detailed insight into DeFi, without being overwhelmed by its complexities. Overall, “Decentralizing Finance” is a must-read for those interested in the impact of DLT and digital assets on today’s financial services industry.
Todd McDonald, Co-Founder and Chief Strategy Officer at R3
In the rapidly changing world of DeFi, Kenneth’s book is both relevant and timely, offering authoritative insights on the industry’s current evolution. In sharing his vision for the future, he brings valuable perspectives from deep experience in digital assets and blockchain as an investor, trader and more. Whether you are a crypto-native or just starting out in DeFi, I recommend this as an essential and informative read.
Darius Sit, Founder & CIO at QCP Capital
Kenneth Bok's book provides a solid overview of the fast-moving Decentralized Finance ecosystem. In particular, he introduces critical developments within and outside the regulatory perimeter. But Ken does not stop there; he also shares his future vision for DeFi - pick up a copy to find what it is. I recommend his book to anyone who wants to understand DLT & blockchain-based finance and is overwhelmed by the pace of industry developments and the quantity of academic papers released daily. Ken uniquely contributes to our understanding of DeFi by delivering the future standard introductory work for industry practitioners.
Daniel Liebau, Affiliated Faculty, SMU Academy at Singapore Management University
Kenneth Bok offers a comprehensive overview of the decentralized finance (DeFi) landscape by clearly defining the various layers of the application and infrastructure stack, presenting the key use cases and the differing mechanisms, and relating them to the current traditional finance and regulatory systems. Kenneth also offers glimpses into how factors such as government and market competition will change the landscape moving forward. This book should be read by anyone looking to understand DeFi from a theoretical and practical lens, as well as the associated benefits and risks of participating directly in the ecosystem.
Lasse Clausen, Founding Partner at 1kx
Kenneth Bok's book "Decentralizing Finance" helps to demystify DeFi and goes further by explaining how traditional financial services are being unbundled by new technologies. We need more literature to explain why self-managed finance needs to be an integral component of the future digital economy.
Linda Jeng, Head of Global Web3 Strategy at the Crypto Council for Innovation, Visiting Scholar on Financial Technology and Adjunct Professor at the Georgetown University Law Center's Institute for International Economic Law
Kenneth has displayed his vast experience, deep insights and thoughtful views on the fast-moving, often-misunderstood world of blockchain and distributed ledger technology, as well as digital/crypto assets with his notable knowledge and experience gained from traditional finance. His book, “Decentralising Finance” is indeed valuable for not only the uninitiated who are seeking to learn more about this space, but also for the veteran who would gain much from Kenneth’s opinions, reflections and forward-looking views, in this realm. Kenneth has managed to pack all that into less than 250 pages of clear and concise, systematic reading, which makes it so much more pleasurable to read. I would highly recommend this to anyone interested in this industry.
Hsu Li Chuan, Senior Partner, Dentons Rodyk & Davidson LLP
In this book Decentralizing Finance, Kenneth Bok comprehensively and systematically covers the many areas that are evolving in this new world. What is clear is that the institutions and instruments in the world of finance are changing. How will it look going forward? How will it be different from the world we already know? These are the pertinent questions addressed in this book. The author gives the reader a timely and authoritative overview of how, as finance decentralizes, digital assets and distributed ledgers are bringing about fundamental change. An essential read for anyone who wants to have a competent grasp of the tools needed to analyze the new status quo.
Joo Seng Wong, Founder and CEO at Spark Systems
In his book on decentralized finance, Kenneth unveils profound insights into this dynamic landscape. Kenneth's perspective on the evolving DeFi realm is truly enlightening, providing valuable understanding of trends, challenges, and opportunities. With his expertise and clarity, he demystifies DeFi's complexities, making it accessible to readers of all levels. A must-read for both novices and experts, Kenneth's book enriches our comprehension of this transformative space.
Yi Ming Ng, CEO at Tribe
Table of Contents
Acknowledgements Introduction Chapter 1: What is DeFi? 1.1 The Role of Intermediaries in TradFi 1.2 Definitions 1.3 Other Characteristics of DeFi 1.4 The DeFi Stack 1.5 Size of DeFi 1.6 Key Participants in DeFi 1.7 DeFi and FinTech 1.8 How can I try DeFi? 1.9 Where does DeFi meet TradFi? 1.10 What are the risks of DeFi? 1.11 Chapter Summary Chapter 2: Infrastructure and Instruments 2.1 The Infrastructure of DeFi 2.2 Basics of Blockchains 2.3 Bitcoin and Ethereum 2.4 Permissioned vs Public Blockchains 2.5 L1s and L2s 2.6 Accounts, Keys, Wallets and Addresses 2.7 Transactions 2.8 Smart Contracts 2.9 Clients and Nodes 2.10 Block Explorers 2.11 Custody 2.12 Oracles 2.13 RegTech 2.14 Identity 2.15 Bridges 2.16 DeFi Instruments 2.17 Stablecoins 2.18 Derivatives 2.19 Chapter Summary Chapter 3: Activities and Applications 3.1 Trading / DEXs 3.2 Overcollateralized Lending / Borrowing 3.3 Governance / DAOs 3.4 Undercollateralized Lending 3.5 Investing 3.6 Payments 3.7 Insurance 3.8 Prediction Markets 3.9 Chapter Summary Chapter 4: Risks and Mitigation 4.1 Types of losses 4.2 Basic terminology 4.3 Endogenous DeFi risks 4.3.1 Smart contract risks: Code Exploits 4.3.2 Economic Exploit Example: Mango Markets 4.3.3 Operational Exploit Example: Ronin Bridge Hack 4.3.4 CeFi Contagion / Systemic Risk 4.4 Exogenous DeFi risk 4.4.1 Financial Stability 4.4.2 Pronounced risks in developing countries 4.4.3 Banking-to-crypto concentration risks 4.4.4 Stablecoins 4.4.5 Market Integrity 4.4.5 Frontrunning 4.4.6 Market Manipulation 4.4.7 Money Laundering, Funding of Illicit Activity and Terrorism 4.4.8 Consumer protection 4.4.9 Disclosure 4.4.10 Data protection 4.5 Chapter Summary Chapter 5: Regulation 5.1 Global nature of crypto and DeFi 5.2 What regulators want 5.3 Are tokens securities? 5.4 The Travel Rule 5.5 Prudential treatment of crypto-asset exposures 5.6 SSBs, US and EU 5.7 EU - MiCA 5.8 US 5.9 DeFi Specific Regulation 5.10 Chapter Summary Chapter 6: Central Bank Digital Currencies 6.1 Prologue: Libra 6.2 Role of the Central Bank 6.3 Structure of the monetary system and a view towards the future 6.4 Central bank motivations and considerations around CBDCs 6.5 Retail vs Wholesale CBDCs 6.6 Wholesale CBDCs 6.7 Case study: Project mBridge 6.8 Retail CBDCs 6.9 Benefits and Risks of R-CBDCs 6.10 Central banks preference for permissioned DLTs 6.11 R-CBDC Design choices 6.12 Types of R-CBDCs 6.13 Examples of R-CBDCs 6.14 Case Study: Nigerian eNaira 6.15 Case study: US 6.16 Case Study: eCNY 数字人民币 6.17 Chapter Summary Chapter 7: Asset Tokenization 7.1 What is asset tokenization? 7.2 Benefits of asset tokenization 7.3 How is tokenization performed? 7.4 Considerations for tokenization 7.5 DLT in Capital Markets 7.5.1 Primary Markets 7.5.2 Secondary Markets 7.5.3 Clearing and Settlement 7.5.4 Custody 7.5.5 Asset Servicing 7.6 Chapter Summary Chapter 8: Deposit Tokens 8.1 What are Deposit Tokens? 8.2 Benefits of Deposit Tokens 8.3 Deposit token projects 8.4 Chapter Summary Chapter 9: Institutional DeFi 9.1 Considerations for Institutions to participate in DeFi 9.2 Institutional DeFi Examples 9.3 AMMs and FX 9.4 Considerations for AMMs and tokenized assets 9.5 Unified Ledger 9.6 Chapter Summary Conclusion 10.1 The Crypto-Fiat Innovation Dialectic 10.2 Future Scenarios for DeFi: the Wild West, the Citadel and the Bazaar 10.3 The Future of Money Bibliography and Online Resources
The genesis block of Bitcoin bears the inscription, "Chancellor on Brink of Second Bailout for Banks." This encoded message, imparted by Satoshi Nakamoto, signaled the advent of a paradigm shift in finance: distributed ledger technology. The distributed ledger transformation is not limited to crypto speculators; it is finally reaching the echelons of central banks and commercial banks.
Cryptocurrencies bear significant risk. The collapse of entities like FTX and Terra, coupled with extreme volatility and the largely unregulated nature of the crypto realm, suggest that it might not be an ideal investment avenue for the average consumer.
Despite these risks, the innovative technology behind cryptocurrency is undeniably powerful. It empowers anyone with internet access to transact and store their own crypto-assets, opening up promising possibilities for financial inclusion. It represents the precursor of an open, global financial system without intermediaries, operating 24/7 and challenging traditional financial structures, thus paving the way for a more accessible and inclusive financial landscape.
As we will explore, blockchain technology - more broadly referred to as distributed ledger technology (DLT) - is spearheading dramatic changes and advancements in finance. DLT enables for an efficient, secure and interoperable financial ecosystem, enabling faster and more inexpensive experiences for consumers and businesses. Its potential to transform payments and capital markets is enormous, extending even to implications for geopolitical dynamics.
Decentralized Finance (DeFi) is finance operating on DLT. More accurately, I would define DeFi as DLT-based finance that replaces centralized databases and / or disintermediates centralized entities. In crypto-native DeFi, this definition may include self-custody, uncensorability and community-based governance. In the regulated world of central banks and commercial banks, DLT is also playing a role in Central Bank Digital Currencies (CBDCs), tokenized assets, tokenized bank deposits and institutional DeFi.
This book aims to unravel the complex world of DeFi and explore its transformative impact on finance, preparing finance and investment professionals for the future ahead.
Who am I?
Allow me to introduce myself and how I came about writing this book.
My career began at Goldman Sachs in London, where I worked as an ETF trader on the Program Trading desk. My role involved using algorithms to hedge the firm's exposure to Eurozone ETFs in futures and equities markets, as well as executing orders for clients. Coincidentally, I bore witness to the unfolding of the global financial crisis in 2008 right from the trading floor. This firsthand experience with the global financial system's flaws sparked in me a conviction that substantial improvements can be made in the realm of finance.
My journey into the world of digital assets commenced in 2014, when I began researching Bitcoin and bought it for the first time. This exploration fortunately led me to invest in the Ethereum crowdsale, and also into investing my Ether into other Layer 1 platforms such as Cosmos and Tezos. Additionally, I organized a conference called De/Centralize in Singapore in 2018, bringing many world-class innovators in the industry to my home country.
Subsequently, I served as Head of Growth and Strategy at Zilliqa, a Singapore-based Layer 1 blockchain platform. During my time there, I led ecosystem and business development, supporting developers and startups looking to build on Zilliqa. I also spearheaded FinTech and DeFi strategy, fostering collaborations with FinTechs such as Xfers, which launched Singapore's first stablecoin, and HG Exchange, a regulated security token exchange.
I currently run my own boutique DeFi / FinTech advisory company Blocks.sg. I’m also an active trader and angel investor in the crypto and DeFi space. Since 2014, I’ve executed various strategies such as arbitrage, yield farming and relative value in the DeFi space. On the long-only side, I’ve participated in numerous crowdsales, angel investments and other kinds of advisory engagements. I'm also a pro bono mentor with R3, a leading financial DLT. Please reach out if you’re building something interesting in the DeFi / FinTech space via my website: kennethbok.com
How this book is organized
This book is organized into two main sections: Crypto-native DeFi and DLT in Traditional Finance.
Part I: Crypto-native DeFi
This first part explores DeFi in its native setting: public blockchains on the internet. It operates in an unregulated environment, characterized by high risk, yet fosters remarkable innovation, global accessibility, and operates at a rapid pace.
Chapter 1: What is DeFi?
An introduction to what DeFi is, offering a broad, top-down perspective and its unique characteristics. Examination of its size, key participants, and an exercise for you to try it yourself.
Chapter 2: Infrastructure and Instruments
Examining the infrastructure of DeFi, with a focus on Ethereum. Basics of blockchains, cryptography, the difference between Bitcoin and Ethereum, L1s and L2s, how transactions work in DeFi, smart contracts, and types of cryptoassets.
Chapter 3: Activities and Applications
Exploring actual DeFi applications that run on L1s and L2s. Understanding how payments, trading, investing, lending, and borrowing work in DeFi. Delving into aggregation, governance/DAOs, real-world assets, and examining relevant case studies.
Chapter 4: Risks and Mitigation
Cybersecurity, software, operational and financial risks associated with DeFi and how they can be mitigated. Case studies. Risks endemic to DeFi and risks that DeFi poses to the broader financial system, from a global regulatory perspective.
Chapter 5: Regulation
Regulation plays a vital role in shaping DeFi's evolution. Considering DeFi's global nature, our focus lies on key standard-setting bodies like the BIS, FSB, IOSCO, and significant jurisdictions such as the US and EU. Additionally, we delve into DeFi-specific regulations related to stablecoins and decentralized exchanges.
Part II: DLT in Traditional Finance
The second part delves into how DLT is being implemented by commercial banks, central banks, and other financial institutions in the highly regulated and supervised financial world, which transacts in volumes significantly larger than that of crypto-native DeFi. While innovation may move at a slower pace, this environment offers much greater integrity, stability, and consumer and business protection.
Chapter 6: Central Bank Digital Currencies (CBDCs)
CBDCs represent a highly significant development that holds the potential to transform the base layer of digital money, consequently reshaping the landscape of finance as we currently know it. This chapter includes historical context, central bank motivations for CBDCs, comparisons between retail and wholesale CBDCs, analysis of their benefits and risks, central bank preferences for permissioned DLT, and highlights developments in Nigeria, US, and China regarding CBDC adoption.
Chapter 7: Asset Tokenization
Nearly any kind of financial asset can be tokenized on a DLT. We explore the what, why, and how of asset tokenization, understanding its significance and implications. We also look at the impact of DLT on capital markets, across 5 different segments: primary markets, secondary trading, clearing and settlement, custody and asset servicing.
Chapter 8: Deposit Tokens
Deposit tokens refer to commercial bank deposits represented on a DLT. In this discussion, we distinguish between CBDCs, stablecoins, e-money, and deposit tokens, understanding their unique characteristics and roles. Additionally, we explore the advantages of deposit tokens and explore case studies on deposit token projects, including the Regulated Liability Network (RLN) and initiatives from Onyx by JP Morgan.
Chapter 9: Institutional DeFi
This chapter investigates the ongoing efforts of central banks and commercial banks in piloting DeFi innovations within a regulated environment. We delve into how they are integrating automated market makers (AMMs), smart contracts, CBDCs, tokenized deposits, and tokenized assets. Our exploration includes considerations for institutions seeking to participate in DeFi, along with examples of pilots. Additionally, we explore FX as a key asset class for AMMs and examine the BIS's concept of a Unified Ledger.
Scope of this book
A brief note on the scope of this book, taking into account the wide-ranging topics of finance, technology, legal and regulation we are going to cover.
1. All types of DLT: This includes both public blockchains and permissioned DLT.
2. All types of finance: This encompasses traditional finance and crypto finance, both regulated and unregulated.
3. Infrastructure, applications and technology: While it is impossible to encompass every aspect within this domain, I have endeavored to address the most significant themes and core technologies of DeFi.
4. Law and Regulation: The legal and regulatory landscape plays a central role in shaping the future prospects of DeFi. Recognizing the complexity of individual country specifics, I have taken a high-level approach to address the overarching themes in this domain.
Out of Scope
1. Non-financial applications of DLT: While DLT holds potential across various domains, such as supply chain management, healthcare, and transport, this book focuses solely on DLT applications within the finance-related context. Non-financial applications of DLT are considered out of scope for this work.
2. Non-financial Web3 applications: The emerging Web3 certainly has many overlaps with crypto-native DeFi, such as social media and gaming. In order to focus on our finance theme, this is also out of scope for this book.
1. No Endorsement of Specific DeFi Apps: The mention of any specific DeFi apps or cryptoassets are for educational purposes and do not constitute endorsements.
2. Rapidly Changing Information: The information in this book is subject to change quickly. The volatile, highly innovative and dynamic nature of crypto may mean that things mentioned in the book could be different by the time you read them.
3. Author's Positions: At the time of writing, I may have positions in cryptoassets and some of the startups mentioned in the book. I hold a position in Credix, and I may also have some holdings in Bitcoin and Ether.
4. Not Financial Advice: This book is not financial advice. Please do your own research. The author takes no responsibility for any investment decisions or outcomes made based on the information provided.
5. Views of the Author Only: The views expressed in this book are solely those of the author and do not represent the views of any other organization, including any organizations mentioned.
Please contact me at firstname.lastname@example.org for any corrections to the material.
There will be many terms that might be new to you if you are just starting out in DeFi. Crypto has a habit of reinventing itself semantically, and new terms like "web3" have emerged only recently. This can become even more confusing when we aim to cover both the crypto-native side and the regulated side of DeFi. To provide clarity, let me offer some definitions for the main terminology used in DeFi concerning assets and technology.
DeFi: Decentralized Finance. From the Bank of International Settlements (BIS): “Decentralized Finance (DeFi) is a new financial paradigm that leverages distributed ledger technologies to offer services such as lending, investing, or exchanging cryptoassets without relying on a traditional centralized intermediary.”
I define DeFi broadly as DLT-based finance that replaces centralized databases and / or disintermediates centralized entities. More relation to crypto-native DeFi but recently having relation with DLT-enabled TradFi, who has interest in institutional DeFi. A narrower definition of crypto-native DeFi would include elements of self-custody, uncensorability and community-driven governance.
TradFi: Traditional Finance. The larger world of finance whose main nodes are central banks, commercial banks and investment banks.
Crypto: A general and informal term that commonly refers to cryptocurrency or crypto-assets. It traces its origins back to cryptography, the underlying technology that secures and encrypts these digital assets. Can also refer to the industry as a whole.
Crypto-asset: The most inclusive and general term used to describe various types of cryptographic assets. This encompasses both cryptocurrencies and utility tokens, representing a wide range of digital assets operating within the crypto ecosystem.
Cryptocurrency: A crypto-asset with specific functions as a currency within a smart contract network to pay for fees, or a crypto-asset such as Bitcoin whose dedicated function is to act as a money substitute. More commonly used than ‘crypto-asset’, especially in the media.
Token: Crypto-assets created on a specific blockchain (L1 / L2) such as Ethereum. Eg. ERC-20 token.
Digital Asset: A general term for any kind of asset represented on a distributed ledger. May or may not be regulated. Now often being used by the regulated world to differentiate from the speculative crypto side. Nonetheless encapsulates crypto-assets also.
Blockchain: The underlying technology behind digital assets and crypto-assets. Examples: Bitcoin and Ethereum.
Distributed Ledger Technology (DLT): The more general class of blockchains, some of whom may not have blocks or chains, and have different consensus mechanisms. Also a preferred term on the regulated side. Examples include: Corda.
BIS: “Distributed ledger technology (DLT) refers to the protocols and supporting infrastructure that allow computers in different locations to propose and validate transactions and update records in a synchronised way across a network.”
Web3: Another generalized, collective term for the overarching vision of a decentralized, blockchain and token-based internet. Where Web2 is platform-based and centralized, Web3 is decentralized and uncensorable.
CeFi: Centralized Finance. These are crypto-native centralized exchanges and centralized yield platforms. They are predominantly custodial in nature. Sometimes also pointing to centralized TradFi.