May 30, 2022
Putting DeFi Into Context
11 min read
The story of decentralized finance is unbelievable. It is true, yet still unbelievable. How has a series of small, unrelated applications grown into a multi-trillion dollar ecosystem that has the attention of every major public and private financial institution in the world? And what does it mean for the future of finance?
The history of finance until recently is the history of decentralization triumphing over centralization. Modern investors have grown up in a world where the power of large, centralized institutions — companies, banks, nations — is such an overwhelming presence that it seems the world must always have been so. Yet we live in an era of global finance that is little more than a 100 years old. The preceding 3,500 years of financial transactions were personal — peer-to-peer in contemporary parlance. The democratic reforms of Athens are famous. Less well known is why those reforms took place. The primary means of accessing credit in much of the ancient world was oneself. If you wanted to buy land, build a house, start a business, you were the collateral. The cost of defaulting on the loan was slavery. Finance was very personal. In Athens, oligarchs were accumulating so many slaves and owned so much land that the viability of Athens as a city-state came into question. The democratic reforms made debt slavery illegal, remitted many outstanding loans and turned excess capital towards investment in trade. An early win for decentralization.
Even in ancient empires like Rome or China, financial centralization was more of a dream than a reality. When Rome conquered a province or large city, they generally allowed the use and minting of local coinage to continue. It was difficult to transport large numbers of coins, so while official Roman coins are present throughout the empire, so are the coins of many other authorities. The struggle of Rome’s leaders to pay the legions in gold and land highlights how even the most successful ancient regimes rarely had stable or sufficiently centralized systems for coordinating economic resources. Though Thales of Miletus could make the first known option trade 2,500 years ago, the centralized networks of trade, knowledge, currency, and communications did not exist that would allow for the establishment of large financial institutions or the exploitation of financial instruments. Finance was local, small and personal.
Then a series of interrelated developments in politics, law, communications, technology and knowledge began to tip the scales towards greater concentration. We call this the Renaissance. While the Renaissance is most often remembered as a flowering of the arts and sciences, it was also an age of increasing centralization. Latin functioned as a common language and culture that created a European-wide community. Improvements in road networks, increased travel and a cosmopolitan sense amongst elites allowed for the creation of large trade and information networks. Represented first by the rise of the Medici family and then the European wide influence of the Fuggers, much of the structure of modern finance sprang into being. Lowly money lenders suddenly became Princes and Popes. This era also saw the rise of early stock markets, bond trading, and other speculative vehicles. Meanwhile, newly emerging nation states came to grips with the currency, taxation and legislation that would slowly erode the power of free cities, local currencies, and informal lending and trade associations. And because information was hugely expensive in a world with low rates of literacy and high costs of delivering letters, only a few families and firms could afford to participate. Jakob Fugger was able to amass a fortune estimated in the hundreds of billions. The Medicis, Fuggers and other large banking houses set the pattern that would grow exponentially in the coming centuries as the development of technology and the rise of nation-states focused power and profit into ever fewer hands.
World Wars I and II supercharged centralization. Nation states, faced with mortal peril, launched themselves into wars of industry and finance. Global networks of resources on a scale never imagined were required to keep armies of millions fighting for years. Mining, refining and the manufacturing of war materials required entirely new levels of coordination and planning. This led to massive increases in productivity. For instance, prior to World War II, merchant vessels generally took in excess of a year to build. However, with allied shipping facing incredible losses, the US commissioned a new Liberty merchant ship. These ships were eventually built at an average speed of 44 days per ship with the record being set SS Robert E. Peary completed in FIVE days. This type of industrial transformation required a similar reworking of the financial sector. Titanic projects required titanic concentrations of capital and small institutions were simply incapable of providing the requisite scale. When the war ended and two global powers entered a protracted struggle, the patterns of size and concentration continued — seemingly a battle to the death that would leave a single dominant player in global power — and finance.
When the wall fell in Berlin, it seemed like the inevitable had happened. The greatest concentration of military and financial power the world had ever known stood dominant. The world economy became de facto dollarized, energy was traded in the petro-dollar, American financial institutions and their sister organizations in allied countries held sway. Concentration of capital was the order of the day. Consider that in the US in 1920 there was about 1 bank for every 1,500 people. Today, there is about one bank for every 75,000 people. Further, GDP per capita has increased five-fold since the 1920s, meaning the capital per bank has increased 2,500%. A single, private organization, the DTCC, clears over $2 quadrillion in trades every year. A number so large it is unthinkable. Seemingly, the order of the financial world was set for all time. It is, after all, hard to argue with two quadrillion dollars.
Then a funny thing began to happen. Technological developments that had enabled centralization began to shift the playing field ever so slightly. Early fintech companies like PayPal and Square were able to leverage digital networks to create new methods of carrying out financial transactions. Considered novelties, or at worst ‘disruptors’, they were not seen as anything but marginal additions to increased efficiency. But they were the harbinger of a future that would be very different. Reducing costs and allowing small players access to the financial services that had been reserved for much larger businesses set an important example. They could not imagine, however, where it would lead.
The advent of non-state currencies was such an heretical notion that, at first, institutional players simply did not take them seriously. It was hard to think they could matter because the system of centralized, state-based fiat currencies traded on global networks controlled by a handful of central banks and exchanges seemed natural, inevitable, even necessary. Essentially, cryptocurrencies could not really exist. This dismissive attitude gave space for DeFi to grow, diversify and prosper. The advent of blockchain networks like Ethereum created a functional environment for secure, non-state financial systems. A new world was launched that functioned outside of the laws and regulatory reach of nation states. Suddenly, billions of dollars of transactions were taking place without bank intermediaries. And now, new markets for futures, currency and derivatives trading are opening up that work outside the financial giants that have dominated these transactions. This technological revolution has grown so quickly that only now are institutional players beginning to comprehend the profundity of this new world. They had assumed that the pillars of their power — concentration, control, market barriers, regulatory protection, currency control, sovereignty — were necessary for financial systems to work. Now, they are discovering that DeFi emphatically calls into question these assumptions.
In theory, such experimentation and questioning is healthy for any system. DeFi can be seen as an addition to existing systems and the value of interfacing with traditional CeFi is recognized by all the market players. Innovation and growth, after all, have always been the rallying cry of financial elites and ‘free’ marketers.
But not this kind of innovation, and not growth by these kinds of people. After ignoring the rise of cryptocurrency and DeFi, state authorities, central banks, and the largest institutional investors are beginning to move, and move quickly. Regulators in Italy, the United States, Hong Kong, and China are passing laws to regulate, restrict or outlaw whole DeFi sectors. Central banks around the world are exploring the possibility of launching state-controlled cryptocurrencies. These actions are directed primarily at preventing DeFi from disturbing the existing structure of global finance. Simultaneously, large banks and investment firms are trying to invest in and take control of whole regions of the DeFi ecosystem to ensure it develops in the ‘right’ way. The days of DeFi flourishing in the shadows have ended.
Why so much interest? After all, even the most generous estimate puts the total value of cryptocurrencies and the DeFi world as at most 2% of the world economy. Clearly, it is not the scale but the potential that matters. Major institutional players have realized, perhaps belatedly, that the core values of DeFi are an existential threat to the existing system. Rather than a single development, CeFi is suddenly feeling pressed on numerous fronts by hundreds of small scale actors. Consider a few of the seemingly harmless core principles of DeFI; Accessibility, Cost Reduction, Governance, Transparency, Privacy, and Open Source.
Accessibility: Strikes at one of the key points of power in the CeFi world — determining who can access what services and at what prices. Not just the unbanked, but those without access to brokerages, loans, or insurance suddenly have potential market access. And with those customers are likely to come millions of others who have barriers to access or who face corrupt institutions that often hold monopolies on banking, as in much of the developing world. Permissionless protocols giving billions of people increased market access is not seen as a boon, but as a threat.
Cost Reduction: Part of the point of restricting access is to protect high fees for services. In 2015, the average cost to a client of an online stock or ETF transaction was $8.90! This is the market niche Robinhood entered. The competition from Robinhood, WeBull and others has cut this fee to less than $1. Banks, trading houses, commodity exchanges, insurance companies, all face a direct threat to their economic model of using dominant positions to extract high fees.
Governance: The central banks of the U.S., E.U., Japan, China, Germany and England have a profound impact on the world economy. Yet, they have fewer than 100 controlling members; none of these members are elected; their decision making processes are opaque, public statements anodyne, and ultimately they answer only to themselves. The notion of something like a governance token that invites both open discussion and broad participation of interested parties (see Accessibility) is a direct threat to this model of control. The DTCC and its $2 quadrillion in trades a year is a private organization that provides no insight into their decision making processes nor asks for input from the general financial community that is forced to use their services. A large financial system that emphasizes participation with diverse mechanisms for user feedback like voting directly undercuts CeFi’s reliance on exclusive and secretive decision making processes.
Transparency: Smart contracts on public networks have an auditable history open to any interested party. Information about financial transactions is currently so difficult to find, even when available, that a Bloomberg terminal costs $24,000 a year on a two year lease (see Accessibility and Cost Reduction). CeFi creates esoteric systems that allow them to both charge high fees and sell expert knowledge based on access to those secrets. Transparency undercuts the market position of insiders and democratizes opportunities for investment by creating more equal access to knowledge.
Privacy: Alphabet, Amazon, Facebook, three of the largest companies in the world, have business models that require the exploitation of their user’s private data. China has a dystopic centralized data collection system on all citizens. The wide scale implementation of user privacy threatens both corporate profits and state control. Privacy may be perceived as the single greatest threat both by corporations and governments.
Open Source: While CeFi traditionally wants to use your data, they wish to keep their models, programs, applications and systems private. By making these systems proprietary, innovation is slowed and market players have a far greater degree of control. By making programs open source, DeFi can innovate much more quickly and efficiently creating a more creative, but also more disruptive, environment that is vastly more difficult to control or predict.
In sum, DeFi represents not one, but a series of potentially existential threats to existing models of control and profit generation.
But what is next? Will DeFi simply be absorbed into the existing system or can a fundamentally new financial system continue to grow and diversify? Can the revolutionary possibilities of DeFi be brought to life in a new world of finance that provides access, efficiency, transparency and most importantly, a viable alternative to the system we have always known? This we do not know. However, what history teaches us clearly is that DeFi will not survive by accident. Having drawn the attention, often hostile, of the most powerful global entities, DeFi’s next phase of growth will require another leap of innovation as great as that which brought it into being. DeFi has begun to change the world and the world has noticed. Now DeFi must change if it is to survive. A new, robust structure that allows for coordination and defense of core values and systems in the face of myriad threats must be considered.