Is Decentralized Finance (DeFi) Efficient?
53 Pages Posted: 3 May 2022
Date Written: April 27, 2022
How efficient is Decentralized Finance (DeFi)? To answer this question, we study the efficiency and the role of intermediation in a large DeFi segment, namely, the market for Initial Coin Offerings (ICOs). In particular, we advance a search-related theory of DeFi, in which search frictions partly offset the efficiency gains from reduced transaction costs thanks to blockchain technology and smart contracts. The intensity of search, i.e. the process of identifying valuable projects, is increasing in market granularity. Blockchain technology increases market granularity through lower entry barriers. Lower-end entrants, however, increase aggregate search intensity but lack search skills. The resulting search-related inefficiency creates a niche for DeFi intermediaries. Consistent with this theory, our findings suggest that DeFi intermediaries reduce search frictions and extract economic rents for their services. Relative to the Walrasian equilibrium, DeFi is relatively inefficient, and search frictions reduce the welfare for society almost by half. The evidence indicates that perfectly decentralized finance markets would not be optimal for society.
Keywords: Decentralized Finance (DeFi), Initial Coin Offering (ICO), blockchain-based crowdfunding, tokens, entrepreneurial finance, crypto funds, intermediation, search
JEL Classification: G23, G24, L26
Suggested Citation: Suggested Citation