Mapping Microscopic and Systemic Risks in TradFi and DeFi: a literature review

TL;DR

This paper reviews and compares systemic risks in traditional finance and decentralized finance, proposing a conceptual framework to understand risk formation, propagation, and interdependence between these interconnected financial ecosystems.

Contribution

It introduces a novel conceptual mapping of systemic risks in TradFi and DeFi, highlighting their differences, similarities, and the concept of bidirectional risk spillover called crosstagion.

Findings

Identifies key risk mechanisms in TradFi and DeFi

Highlights how risks propagate differently in each system

Introduces the concept of bidirectional risk spillover (crosstagion)

Abstract

This work explores the formation and propagation of systemic risks across traditional finance (TradFi) and decentralized finance (DeFi), offering a comparative framework that bridges these two increasingly interconnected ecosystems. We propose a conceptual model for systemic risk formation in TradFi, grounded in well-established mechanisms such as leverage cycles, liquidity crises, and interconnected institutional exposures. Extending this analysis to DeFi, we identify unique structural and technological characteristics - such as composability, smart contract vulnerabilities, and algorithm-driven mechanisms - that shape the emergence and transmission of risks within decentralized systems. Through a conceptual mapping, we highlight risks with similar foundations (e.g., trading vulnerabilities, liquidity shocks), while emphasizing how these risks manifest and propagate differently due to the contrasting architectures of TradFi and DeFi. Furthermore, we introduce the concept of crosstagion, a bidirectional process where instability in DeFi can spill over into TradFi, and vice versa. We illustrate how disruptions such as liquidity crises, regulatory actions, or political developments can cascade across these systems, leveraging their growing interdependence. By analyzing this mutual dynamics, we highlight the importance of understanding systemic risks not only within TradFi and DeFi individually, but also at their intersection. Our findings contribute to the evolving discourse on risk management in a hybrid financial ecosystem, offering insights for policymakers, regulators, and financial stakeholders navigating this complex landscape.