The Economist cover story: The Promises and Risks of DeFi

Source: The Economist

Editor: Nan Feng

Skeptics have many excuses. The earliest users of Bitcoin (the original cryptocurrency) used it to buy drugs, and now hackers use it to demand ransoms. This year, hackers discovered a vulnerability in some code, resulting in the theft of hundreds of millions of dollars in ETH (another digital currency). In fact, many "believers" are trying to get rich quickly from the global frenzy of crypto assets worth $2.2 trillion. Others are exceptionally loyal. In June of this year, Salvadoran President Nayib Bukele wept at the podium while announcing that the country would adopt Bitcoin as its official currency, claiming that Bitcoin would save the nation.

Those scammers, fools, and turncoats are indeed annoying. However, the financial services ecosystem that is emerging from this, known as decentralized finance (DeFi), is worth pondering. With all its promises and risks, DeFi has the potential to change the way the financial system operates. The surge of innovation in DeFi is reminiscent of the wave of inventions in the early days of the internet. In this era, as people increasingly live online, this cryptocurrency revolution may even reshape the architecture of the digital economy.

DeFi is one of the three major technological trends disrupting finance. Tech "platform" companies are rushing into the payment and banking sectors; governments are launching digital currencies. And DeFi offers another avenue, aiming to decentralize rather than centralize power. To understand how DeFi does this, we can start with blockchain. Blockchain is a vast network of computers that maintains an open, immutable public record and updates it without the need for a central authority.

As the first large blockchain network born in 2009, Bitcoin now distracts attention. In contrast, Ethereum, a blockchain network created in 2015, is where most DeFi applications are built upon, and it is reaching critical mass. Developers of Ethereum view finance as a lucrative target. Traditional banking requires massive infrastructure to maintain trust among strangers, from clearinghouses and compliance to capital rules and courts. This infrastructure is expensive and often captured by insiders: think of credit card fees and bankers' yachts. In contrast, transactions on the blockchain are reliable, cheap, transparent, and fast—at least in theory.

Although the related terminology can be a bit daunting (fees are called "Gas", the main currency is ETH, and ownership contracts for digital assets are called NFTs), the fundamental activities occurring in DeFi are familiar to everyone, including trading on exchanges and issuing loans and absorbing deposits through automated protocols known as smart contracts. One measure of these activities is the value of digital assets used as collateral: from nearly zero at the beginning of 2018 to now reaching $90 billion; another measure is the value of transactions verified by Ethereum: in the second quarter of this year, this figure reached $2.5 trillion, roughly equivalent to Visa's transaction volume, or one-sixth of Nasdaq's trading volume.

The dream of establishing a low-friction financial system is just the beginning. DeFi is expanding into more ambitious areas. MetaMask is a DeFi wallet with over 10 million users, serving as users' digital identity. To enter a decentralized (metaverse), a virtual world composed of stores operated by its users, you need to connect your wallet to a cartoon avatar that can roam around. As more consumption shifts online, the digital world will become the focal point of intensified competition. Large tech companies may impose hefty fees on these small economies: imagine Apple's app store charges or Facebook selling your virtual avatar's privacy. In contrast, a better option might be a decentralized network that hosts applications and is co-operated by users, where DeFi can provide payment and property rights.

Cryptocurrency enthusiasts envision a utopian world. But for DeFi to be as reliable as JPMorgan Chase or PayPal, there is still a long way to go. Some issues are perennial. A common criticism is that blockchain platforms cannot easily scale, and the computers in blockchain networks consume vast amounts of electricity. But Ethereum is a self-improving machine. When demand for the Ethereum network is high, the verification fees it charges rise, encouraging developers to work on reducing its usage intensity. Ethereum will have new versions; one day, other better blockchains may replace it.

However, DeFi also raises the question of how a virtual economy with its own norms interacts with the real world. One concern is the lack of external value support. Cryptocurrencies are no different from the dollar because they rely on a shared expectation of their utility; however, traditional currencies are backed by the monopoly power of states and central banks as lenders of last resort. Without this support, DeFi would be easily affected by panic. Additionally, contract enforcement outside the virtual world is also an issue. A blockchain contract may indicate that you own a house, but only the police can enforce an eviction.

In the realm of DeFi, governance and accountability are not well established. A sequence of transactions that cannot be overturned by humans can be dangerous, especially considering that coding errors are hard to avoid; money laundering activities flourish in the uncontrolled gray areas between Ethereum and the banking system; despite claiming to be decentralized, some programmers and application owners have disproportionate control over DeFi systems; a malicious attacker could even control the majority of computers running a particular blockchain network.

Alice's DeFi Adventure

Digital libertarians prefer DeFi to remain autonomous—imperfect but pure. However, as U.S. financial regulators and cryptocurrency expert Gary Gensler pointed out, for DeFi to succeed, it must integrate with traditional financial and legal systems. Many DeFi applications are run by decentralized organizations that vote on certain issues; these entities should be subject to laws and regulations. A club of central banks—the Bank for International Settlements suggests that government digital currencies may be used in DeFi applications to provide stability.

Finance is entering a new era, where the three novel yet flawed visions of tech platforms, big government, and DeFi will compete and converge, each embodying a technological architecture and ideology about how the economy should operate. Just like the internet in the 1990s, no one knows where this revolution will end, but it will change the way money works, as well as the entire digital world.

This article reflects the views of the original author and does not constitute any investment advice or recommendations.

This article was first published on Unitimes App