A Faustian Bargain

Decentralized finance (DeFi) can disrupt global finance – but only if Defi systems and central governments cooperate. Yes, sworn enemies cooperating for the greater good.

While each seems to be the sworn enemy of the other, ultimately, a cooperative relationship between decentralized and efficient (versus anachronistic and cumbersome) financial infrastructure and government central banks with stable currencies is absolutely necessary.

Defi transactions, to scale globally, require stable and predictable value. Government-issued currencies are the only reliable and foreseeable foundation. Cryptocurrencies, such as Bitcoin were never currencies. They are a sideshow that will remain a speculative asset, and increasingly unimportant.

It’s Defi and Govcoins.

DeFi could lead to a quicker, cheaper, more transparent financial system less reliant on powerful centralized institutions. It can also be the digital economy’s foundation, decentralizing control away from a few dominant tech giants.

It is still early, and much like the Internet in the 1990s, there are many risks and challenges as business models develop. As in the 1990s, there is excessive speculation, uncertainty, business immaturity, and other specific challenges (such as intense energy use) still to be solved.

DeFi’s opportunity arises because global finance has become centralized behind government central banks, such as the Federal Reserve, and private networks that are dominated by a few large technology firms. Neither of these systems is very efficient, and there is mind-numbing complexity to the various intermediaries associated with government entities and regulations around finance.

Large technology companies have inordinate power and private monopoly networks encouraging anticompetitive behavior and are not on the top of anyone’s list as a desirable solution.

Because We Say So

DeFi is growing tremendously in scale and scope, and that has put this vast category in government regulatory crosshairs. There is a belief that there is no fundamental reliable value to the digital assets or the rat’s nest of tokens generated from them. However, as seen below, there is substantial and growing value captured by DeFi, and confusing entanglements will only expand geometrically. Transactions based on central bank-backed currencies untie this Gordian knot fairly effectively.

Here is why DeFi deserves this attention.

  • The Ethereum blockchain, which underpins much of DeFi, settled $2.5 trillion of transactions in the second quarter of 2021, including payments and transactions to facilitate trading and lending – the same amount as Visa.
  • Collateral for DeFi transactions has increased 100x since 2018 (to almost $100 billion). Many new DeFi applications are rapidly amassing assets. It is reasonable to predict this could increase to $1 trillion in less than 10 years – but only if a reliable value underpins these applications.
  • Innovations, such as automated market-makers, arbitrage systems, and self-stabilizing currency regimes, are at the edge of innovation of financial technology and enhance the development and implementation of DeFi applications.

These innovations, technical breakthroughs, and subsequent services have all been lightly regulated, if at all. That is going to change. A reliable financial system and infrastructure are the most critical responsibilities of the central government.

If value is being exchanged and contractual agreements arranged, government regulation, laws, and systemic verification will not tolerate a freewheeling independent system for the world’s most important industry.

We’re the Government and We’re Here to Help

Payment systems are anachronistic and inefficient. The Fed claims to be close to some version of an instant payment system, but it is nowhere to be seen. Inefficiencies in payment systems have created enormous margins for players like Visa and MasterCard (who have gross profit margins up to 80%).

Tech giants continue to wield anti-competitive market power, and probably cannot be trusted with increasing market power and influence.

Examples of this bad behavior, the vanguard of more to come if nothing is done, include Apple stopping Facebook tracking; Facebook altering its content-delivery algorithms as it pleases; YouTube “demonetizing” content creators on a whim. Each takes the lion’s share of the profits associated with their networks. None are trusted to oversee a disruptive global payment system. Does anyone remember Libra?

This leaves only central governments as enablers of financial disruption.

It’s More Important Than Money

Defi offers interoperable, transparent, and efficient systems distributing control over software and inhibiting the concentration of power. Bitcoin is the vanguard of this decentralization because it is a digital-payments network verified by a blockchain. Although created in 2009 to replace centrally issued money, it has simply become an asset class, not a currency (by any reasonable definition). Technology has evolved and while Bitcoin has demonstrated the viability of the technology, it is a distraction. But it proves a valuable point.

Cryptocurrencies represent an architectural shift in how financial infrastructure and technology interact, and therefore, it is disrupting how the financial industry works globally. It is neither a new kind of money system nor a danger to economic stability. It is more important than that.

Anything from Anyone to Anywhere

A decentralized network must establish trust and enable more than payments. For example, the Ethereum blockchain (established in 2015) transparently and publicly stores and records computer code. That makes it possible to construct smart contracts – self-executing agreements in which a chain of actions follows when certain conditions are met. These are automatically enforced and cannot be tampered with.

This has profound implications. Now “smart contracts” can cover any financial transaction, loan, investment, security transfer, public or private exchange of assets, and trading in any security.

If it can be securitized it can be placed in a smart contract – transparent and accessible to all. Most crucially, any alterations need to be verified and approved. It creates a robust, secure, reliable, transparent, efficient global financial network.

Innovation Comes in 3’s

Once a decentralized foundation to store and execute lines of code has been laid, anything can be built on top – assets or applications. The only limit is the developer’s imagination. All kinds of “tokens”, or digital representations of assets, exist. Some resemble financial building blocks, like shares, bonds, and “stablecoins”, which are typically pegged to conventional currencies (Govcoins). Others are “non-fungible” tokens (NFTs) representing unique assets, like an image or a video ($23 billion worth of NFTs now exist).

All this genuine innovation enables any lender or investor to connect with any borrower, company, or entrepreneur. The power of this innovation leads to the following three innovations.

  1. Decentralized Exchanges.
    1. Blockchain-based exchanges mitigate the vulnerability of centralized exchanges to attacks and theft. Rather than depositing assets at an intermediary to trade on your behalf, execution is carried out directly through smart contracts. Both sides of the trade are performed in one indivisible transaction. This eliminates the need for intermediaries such as escrow services and central counterparty clearing-houses. UniSwap, one of the largest decentralized exchanges, trades tokens worth around $1billion every day.
  2. Govcoins.
    1. Govcoins are stable tokens pegged to a central-bank currency, such as the dollar or euro, facilitating transactions and providing a stable foundation for financial contracts.
      1. The two biggest stablecoins, Tether and USD Coin, have together issued around $100 billion in tokens. The collateral for these, a mix of cash and short-term corporate debt, is held not on a blockchain, but in a bank or brokerage account. Both firms decide how to back their stablecoins and when to publish their accounts.
    1. Soon the collateral will be disclosed on an open transparent blockchain and stored in a smart contract. Anyone will be able to create new tokens, as long as there is sufficient collateral and a smart contract. That collateral will be required to be stable against the dollar or similar currency.
      1. Essentially the collateral will be a Govcoin.
  3. Lending Protocols.
    1. Anonymous users must first deposit some tokens as collateral to borrow from a lender. Once this is done, users can then borrow against that collateral in a different token.
      1. Additionally, developers have come up with a way to avoid such deposits for “flash loans”, which are instantly issued and settled.

Place Your Bets

Transactions on blockchains are finalized only when a new bundle of transactions, called a block, is accepted by the network. Adding blocks takes time, around ten minutes on Bitcoin and 13 seconds on Ethereum. For a flash loan on Ethereum, a borrower requests and repays the funds, plus a 0.09% fee, within the same block. If the borrower fails to repay, the entire transaction is canceled, so that no funds were ever borrowed. The lender takes no risk at all.

These loans are mostly used for arbitrage opportunities between token-trading platforms. Since their creation, the markets for most tokens have become more efficient. Two of the biggest lending protocols on the Ethereum blockchain have lent out over $25 billion collectively.

All these services are efficient and creative solutions to financial problems, but, so far, they are all being used to facilitate a casino. Most of these applications are used to speculate on unstable tokens, including Bitcoin and Ether.

We Need Government. Read That Again If You Must.

This is where Central Bank-governed currency is essential.

If DeFi is to go beyond speculation, it must first expand into conventional finance. Much of the energy in DeFi is spent enabling finance for a universe that is “on-chain.” That is understandable. But those that bridge the gap with the real world, like centralized exchanges and stablecoin issuers, have been the source of hacks and fraud.

To be useful for everyday finance – mortgage lending, commercial finance, venture capital, etc. – DeFi must be connected to both the virtual and real worlds.

For example, NFTs can become much more than digital collectible claims. They can represent ownership claims on homes. Mortgage creation could be wrapped into a single, efficient bundle (“Amen” for anyone who has ever bought or sold a home), and an automated lending platform can create the collateralized lending and automatic transfer of Govcoin tokens from the buyer to the seller. The NFT for homeownership reverts to the buyer when enough Govcoins are deposited with the platform to pay off the loan.

More Govcoins, Fewer Problems

Digital tokens can be representations of nearly anything. They are potentially efficient solutions to all sorts of financial problems. Deposit accounts with banks can be expensive; the stock-settlement system is slow. Govcoin transactions settle almost instantly and incur no or low fees.

DeFi solves real-world problems, but the legal system must enforce on-chain outcomes in the “off-chain” world, and regulation must guard against fraud and misuse.

If DeFi does not merge with off-chain finance, it could instead thrive in a distinct world built on blockchains. Yet DeFi also raises questions about how a virtual economy with its own norms interacts with the real world.

And We’re Back to Central Governments

DeFi requires an external anchor of value to function broadly and be a global disruptive force. Cryptocurrencies don’t meet this test. While they rely on people having a shared expectation of their value, conventional money is also backed by states with a monopoly on legal enforcement and central banks that are lenders of last resort. Without these, DeFi will be vulnerable to market panics and social media-induced trauma. Contract enforcement outside the virtual world is too unreliable. A blockchain contract may say you own a house but only the police can enforce an eviction.

Governance and accountability, enforcement, and legitimate legal claims are essential to making DeFi a global reality. Otherwise, irrevocable transactions that cannot be overridden, coding errors, illegal activity, and disproportionate influence from some programmers will potentially limit or even destroy DeFi’s enormous potential.

Integration is Essential

While digital pioneers prefer DeFi remain autonomous, to succeed it must integrate with the conventional financial and legal systems. DeFi applications run by decentralized organizations should become subject to laws and regulations. The Bank for International Settlements has suggested that Govcoins might be used in DeFi apps. This is not only a good idea it is necessary for the predictability and reliability of a global financial system.

Brave New World

Finance is entering a new era where central governments, big-tech platforms, and DeFi will compete and intermingle. Each embodies a technical architecture and an ideology about how the economy should be run. No one knows where the revolution will end, but the most effective outcome would be the integration of Defi and central bank currencies. This will transform not only how money works, but the entire digital world.