The beguiling promise of decentralized finance

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THE SKEPTIC have a lot of food. The early adopters of Bitcoin, the original cryptocurrency, used it to buy drugs, while cyber hackers are now demanding their ransom. Hundreds of millions of dollars of ether, another digital money, were stolen this year after hackers found a bug in a piece of code. In reality, many “believers” are trying to get rich quick through the global mania where the value of crypto assets has reached $ 2.2 trillion. Others are incredibly devoted. The entrepreneur, who announced in June that El Salvador would adopt Bitcoin as its official currency, sobbed on stage, claiming it would save the nation.

The crooks, fools and missionaries are terrifying. Still, the rise of a financial services ecosystem known as decentralized finance or “DeFi” deserves a hard look. It has the potential to rewire the way the financial system works, with all the promises and dangers that come with it. The spread of innovations at DeFi is comparable to the frenzy of invention in the early phase of the web. At a time when people are increasingly living online, the crypto revolution could even reshape the architecture of the digital economy.

DeFi is one of three technology trends disrupting finance. Tech “platform” firms are pushing for payments and banking. Governments are introducing digital currencies or govcoins. DeFi offers an alternate path that aims to distribute power, not focus it. To understand how, start with blockchains, huge computer networks that keep an open, incorruptible shared record and update it without the need for central authority.

Bitcoin, the first major blockchain created in 2009, is now a distraction. Instead, Ethereum, a blockchain network founded in 2015 on which most DeFi applications are built, has reached critical mass. Its developers consider finance a worthwhile goal. Conventional banking requires huge infrastructure to maintain trust between strangers, from clearinghouses and compliance to capital rules and courts. It’s expensive and often stolen by insiders: think credit card fees and bank yachts. Transactions on a blockchain, on the other hand, are trustworthy, cheap, transparent and fast – at least in theory.

Although the terminology is intimidating (fees are “gas,” the primary currency is ether, and digital asset title deeds are known as NFTs) the basic activities on DeFi are known. This includes trading on stock exchanges as well as the granting of loans and the acceptance of deposits through self-executing agreements, so-called smart contracts. One measure of activity is the value of digital instruments used as collateral: by the beginning of 2018 it had reached nearly $ 90 billion. Another is the value of transactions that Ethereum verifies. In the second quarter, this reached $ 2.5 trillion, about the same amount as Visa processes and a sixth of the activity on Nasdaq, an exchange.

The dream of a low-friction financial system is just the beginning. DeFi is spreading on more ambitious terrain. MetaMask, a DeFi wallet with more than 10 million users, acts as a digital identity. To enter a decentralized “metaverse”, a mirror world with shops run by its users, link your wallet to a cartoon-like avatar that roams around. These digital worlds will become the subject of increased competition as more and more spending shifts to the Internet. Big tech companies could impose heavy taxes on these mini-economies: imagine Apple’s App Store charging fees or Facebook selling your avatar’s intimate secrets. A better alternative could be decentralized networks that host applications and are shared by users. DeFi could provide payments and property rights.

Crypto enthusiasts see utopia. But there is still a long way to go before DeFi is as reliable as JPMorgan Chase or PayPal, for example. Some problems are prosaic. A common criticism is that blockchain platforms are not easily scalable and that the computers that use them use wasteful amounts of electricity. But Ethereum is a self-improvement machine. When demand is high, verification fees may increase, encouraging developers to work to minimize the intensity of their usage. There will be new versions of Ethereum; other, better blockchains could one day replace it.

DeFi also raises questions about how a virtual economy with its own norms interacts with the real world. One concern is the lack of an external value anchor. Cryptocurrencies are no different from the dollar as they rely on people to have a common expectation of their utility. However, conventional money is also covered by states with a monopoly of force and central banks as lenders of last resort. Without this, DeFi is prone to panic. The enforcement of contracts outside of the virtual world is also a concern. A blockchain contract can say you own a house, but only the police can enforce an eviction.

Governance and accountability in DeFi-Land are rudimentary. A sequence of large irrevocable transactions that cannot be overridden by humans could be dangerous, especially since coding errors are inevitable. Money laundering has thrived in the unregulated gray area of ​​services between Ethereum and the banking system. Despite claims of decentralization, some programmers and app owners have disproportionate influence on the DeFi system. And a malicious actor could even take control of much of the computers that run a blockchain.

Alice’s adventures in DeFi land

Digital libertarians would prefer DeFi to remain autonomous – imperfect but pure. However, to be successful, it must integrate with traditional financial and legal systems, as pointed out by Gary Gensler, a crypto expert who is America’s financial watchdog. Many DeFi applications are run by decentralized organizations that vote on some issues; these bodies should be subject to laws and regulations. The Bank for International Settlements, a club for central banks, has suggested that govcoins could be used in DeFi apps to ensure stability.

Finance is entering a new era in which the three novel but flawed visions of technology platforms, Big Government and DeFi compete and mix with one another. Each embodies a technical architecture and an ideology about how the economy should be run. As with the internet in the 1990s, no one knows where the revolution will end. But it will change the way money works and, with it, the entire digital world.

This article appeared in the Leaders section of the print edition under the heading “Down the Rabbit Hole”

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