How might crypto-assets transform finance? In their December 2020 paper entitled “DeFi and the Future of Finance”, Campbell Harvey, Ashwin Ramachandran and Joey Santoro examine the potential for decentralized finance (DeFi) to disrupt traditional financial infrastructure. They summarize origins and essential features of DeFi, its potential to improve traditional finance and its risks. They also speculate on future development of DeFi. Based on a review of relevant research and events, they conclude that:
- Demand for the U.S. dollar (USD) derives from its central role in the network that is the U.S. economy (pay taxes, purchase goods and repay debt denominated in USD). The Federal Reserve Bank adjusts USD supply via monetary policy to achieve financial or political goals. Inflation confounds USD ability to store value.
- Gold is a successful inflation hedge due to its practically limited supply, utility and general global trust, but its volatility means that hedging is reliable only at extremely long horizons.
- The DeFi alternative aims to combine open-source financial building blocks into sophisticated products with minimal frictions.
- Blockchains (software protocols that allow multiple parties to share assumptions/data without any other source of trust) are key to DeFi. The most popular blockchain application is cryptocurrency, with Bitcoin the first mover. Bitcoin is a payment network that stores and exchanges bitcoins globally without intermediaries or regulation. Its scarcity and privacy offer a way to store value and hedge political/economic/monetary risks. Its value increases as its network expands, but its design inhibits use for small transactions.
- Smart contracts are encode rules for some kind of transaction between parties without any other source of trust overlaid on a blockchain platform (with Ethereum the prime example).
- dApps are standard smart contracts that support frequently used kinds of transactions/agreements between parties.
- Stablecoins are crypto-assets designed to maintain price parity with some target asset (such as USD or gold) to address the frictions inherent in high cryptocurrency volatilities. An off-blockchain reserve of the target asset held by a routinely audited external entity backs these crypto-assets.
- Incentives within DeFi involve direct crypto-asset payments or fees that encourage or discourage users regarding specific actions to support smooth network functioning.
- DeFi offers improvements to traditional finance infrastructure inefficiency, lack of access, opacity, centralized control and lack of interoperability. Specifically, DeFi potentially offers:
- dApps available for any size transaction accommodating high volumes with low frictions.
- User access to a robust financial infrastructure regardless of wealth or location.
- Open code for contractual agreements that eliminates opacity for users.
- Freedom from governmental controls over infrastructure features such as money supply and rate of inflation, and from institutional restrictions on access to the best investment opportunities.
- Ease of interoperability based on open source code, eliminating such awkward interactions as certified checks and wire transfers.
- Principal current risks for DeFi are smart contract defects, oversight, scaling, oracle, exchange and regulatory risks.
- Formal development practices to suppress risk of smart contract bugs and programming errors are still under development.
- Many DeFi implementations rely on human oversight to manage protocol risk.
- Ethereum is currently capable of handling less than 0.1% of the throughput managed by Visa. To date, all efforts to scale Ethereum to high volume have failed.
- DeFi reliance on external data feeds, or oracles (such as stock prices), introduces a means to attack the DeFi infrastructure externally and is the most serious current systemic threat to DeFi.
- DeFi exchanges now vary considerably in design and carry their own unique risks.
- Government regulation will increase as DeFi markets grow, inhibiting full commitments by many users.
In summary, recent history suggests that, as the regulatory environment becomes clear, traditional finance firms should integrate their services with crypto-assets to provide customers with simple front end access to the DeFi back end.
Both overall conclusions and many specific points in the paper are speculative.
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Frequently Asked Questions
What is decentralized finance (DeFi) and how does it differ from traditional finance?
Decentralized finance (DeFi) is a financial infrastructure that combines open-source building blocks, such as smart contracts and dApps running on blockchains like Ethereum, into sophisticated products with minimal frictions. Blockchains let multiple parties share data and assumptions without any other source of trust. Harvey, Ramachandran and Santoro (December 2020) present DeFi as an alternative to traditional finance, which they describe as suffering from inefficiency, lack of access, opacity, centralized control and lack of interoperability.
Can DeFi transform or disrupt traditional finance?
DeFi has the potential to disrupt traditional finance, according to Harvey, Ramachandran and Santoro (December 2020), by offering dApps for any transaction size with low frictions, access regardless of wealth or location, open code that removes opacity, and easier interoperability. Their conclusions are conceptual and speculative rather than empirically tested. They suggest that once regulation becomes clear, traditional finance firms should integrate their services with crypto-assets to give customers simple front-end access to the DeFi back end.
How do smart contracts, stablecoins and incentives work together in DeFi?
Smart contracts encode rules for transactions between parties on a blockchain platform such as Ethereum, without any other source of trust, and dApps are standard smart contracts for frequently used transaction types. Stablecoins are crypto-assets designed to hold price parity with a target asset such as USD or gold, backed by an off-blockchain reserve held by a routinely audited external entity, which addresses cryptocurrency volatility. Incentives, in the form of direct crypto-asset payments or fees, encourage or discourage specific user actions to support smooth network functioning.
How does Bitcoin compare to gold and the U.S. dollar as a store of value?
Bitcoin is a payment network whose scarcity and privacy offer a way to store value and hedge political, economic and monetary risks, and its value rises as its network expands. The U.S. dollar derives demand from its central role in the U.S. economy but loses value to inflation and is subject to Federal Reserve supply adjustments. Gold is a successful inflation hedge thanks to its limited supply, utility and global trust, but its volatility makes hedging reliable only at extremely long horizons. Bitcoin's design also inhibits its use for small transactions.
What are the main risks and limitations of DeFi?
The principal current risks of DeFi are smart contract defects, human oversight, scaling, oracle, exchange and regulatory risks. Ethereum currently handles less than 0.1% of Visa's throughput, and all efforts to scale it to high volume have failed to date. Reliance on external data feeds (oracles) is the most serious current systemic threat, and formal practices to prevent smart contract bugs are still under development. Government regulation is expected to increase as DeFi markets grow, and many of the paper's conclusions are speculative.