Decentralized finance: On blockchain-and smart contract-based financial markets, Schär, F., 2021

What core problem does DeFi aim to solve in traditional finance?

DeFi seeks to eliminate intermediaries and their associated fees by automating financial processes via blockchain and smart contracts, thus increasing transparency and user control over funds.

Explain the primary risk associated with centralized crypto exchanges (CEXs).

Custody risk—the exchange holds users’ funds in its own wallets, so if the exchange is hacked, mismanaged, or insolvent, users can lose their deposits. Additionally, lack of transparency around reserves exacerbates this risk.

What does “custody risk” mean in the context of cryptocurrency trading?

It refers to the danger that a custodian (like a CEX) holding assets on a user’s behalf could become compromised (by hacking, bankruptcy, or fraud), causing users to potentially lose their funds.

What are the two main types of decentralized exchanges (DEXs) mentioned by Schär?

• Order‐book DEXs – Trades are matched on‐chain or partially on‐chain without a central intermediary holding funds.

• Automated Market Makers (AMMs) – Rely on liquidity pools and a pricing formula (e.g., x·y = k) rather than an order book.

How do AMMs (Automated Market Makers) work in practice?

They use liquidity pools funded by users, with prices set by a mathematical formula. Traders swap tokens against the pool rather than a counterparty, and liquidity providers earn fees for supplying capital.

Why do AMMs not pose the same custodial risk as centralized exchanges?

With AMMs, users retain control of their tokens until the smart contract executes a trade. Funds are not pooled under a single company’s control, which removes the risk of an exchange’s insolvency or mismanagement.

If DEXs offer self-custody and transparent on‐chain processes, why do most users still trade on CEXs?

CEXs often provide easier interfaces, deeper liquidity, faster transaction speeds, and direct fiat on/off ramps. For many retail users, this convenience and familiarity outweigh the benefits of self-custody.

What is slippage, and why can it be higher on an AMM versus a CEX?

Slippage is the price difference between the expected trade price and the executed price. AMMs rely on liquidity pools and automated formulas; if liquidity is low or trade size is large, prices can move unfavorably more than on an order book with deeper liquidity.

Beyond custody risk, name two other prominent risks of fully decentralized finance.

1. Smart contract exploits – Coding errors or malicious loopholes can lead to large‐scale losses.

2. Governance centralization – A small group of large token holders might control protocol changes, undermining true decentralization.

How does DeFi handle dispute resolution and regulatory compliance compared to traditional finance?

DeFi often lacks formal recourse or consumer protections, relying on immutable smart contracts. This can lead to regulatory uncertainty, as standard legal frameworks for oversight, AML/KYC, or user protection are not consistently applied.

Summarize how Schär sees the potential of DeFi, despite its current flaws.

DeFi could revolutionize finance by reducing costs, automating processes, and enhancing transparency, but it must address vulnerabilities (smart contract risks, governance centralization, legal ambiguities) for widespread adoption.

What does the collapse of FTX illustrate about the difference between DeFi and CEX?

FTX was a centralized exchange, so users lost access to funds when the entity failed. In contrast, a fully decentralized platform does not take custody of user assets, removing a single point of failure for user funds.