Composable Finance

Michael Junho Lee
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Michael Junho Lee: https://www.newyorkfed.org/research/economists/mlee

No 1177, Staff Reports from Federal Reserve Bank of New York

Abstract: Composability—open interactions between assets and protocols—facilitates a modular financial architecture. I document the emergence of composed asset transformation, where tokenized assets are re-bundled to alter access, liquidity, and risk characteristics to broaden and enhance the set of tokenized U.S. dollar instruments. Yet, I argue that “naive” composability fundamentally conflicts with the provision of pooled arrangements needed for liquidity provision, risk-sharing, and capital backstops. I demonstrate this in an economy consisting of a vertical chain of protocols. Upper-layer protocols expand access to users, but bootstrap contingent liquidity from lower-layer protocols, resulting in a waterfall of externalities. In equilibrium, the base protocol rations liquid reserves, resulting in systemic illiquidity across the economy. Under severe circumstances, total utilization shrinks with composability. I offer principles and direction for building a sustainable, composable system.

Keywords: composability; tokenization; composed asset transformation; decentralized finance; protocol economy (search for similar items in EconPapers)
JEL-codes: D47 E42 G10 G20 (search for similar items in EconPapers)
Pages: 25
Date: 2026-01-01
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DOI: 10.59576/sr.1177

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