Senator Elizabeth Warren, who often goes against cryptocurrency, called it “the most dangerous part of the crypto world”. , the new York Times Defines DeFi as “an umbrella term for the part of the cryptocurrency universe that is poised to replace traditional intermediaries and trust mechanisms by building a new, internet-native financial system using blockchain.” (nyti.ms/3K8fHPG).
To exchange money or securities today, you need intermediaries such as stock brokers, banks or stock exchanges, and you need to trust them to act in your best interest. Frequent scams such as the 2008 financial crisis or the PNB crisis in India have shown that this is not always true – prying your interest seems more the exception than the rule. A16z founder Mark Andreesson famously wrote about how “software is eating the world. In DeFi’s case, the software ‘eats’ the middlemen. Instead of trading through stock exchanges, people interact with each other directly. Dealing peer-to-peer, blockchain-based ‘smart contracts’ fulfill the role of middlemen and create a ‘crypto stock exchange’.
DeFi goes beyond a stock exchange and seeks to change everything in the financial world: prediction platforms, lending, options, derivatives, functions. This is a shadow Wall Street build by crypto enthusiasts, fully decentralized, user-owned and open source, with crypto-rendering of most TradeFi (traditional finance) products, and virtually no regulation. And there is no bureaucracy. You can trade crypto versions of Microsoft, Google and Tesla stocks with these chips that represent real-life equities. So far, DeFi is early but not small; Its ‘total value locked’ is estimated at $77 billion, which would make it the 38th largest bank by deposits in the US.
Among its fundamentals are stablecoins – cryptocurrencies whose value is pegged to fiat currency. In the DeFi world, stablecoins are what you hold your liquidity in, so that tokens can be traded, borrowed and exchanged. In theory, the typical stablecoin is pegged to one US dollar, and therefore requires one-to-one support by real reserves. But there are no rules governing this, so it is hard to verify whether such reserves exist. Uncertainty increases even more. DeFi firms issue loans and credit cards and even open savings accounts without the security provided by traditional banks. Almost all the regulators of this planet are worried about this and they have started prosecuting these firms. Most of them are abstract entities on the Internet, often without any known physical addresses, making this task difficult. No wonder the NYT calls DeFi “Wild West Wall Street.”
But then why is there so much excitement around it? One technical reason that blockchain is a technology that is better than banks is because most lenders still run on software written in the 1960s programming language COBOL. Crypto lives on the Internet, and so must Internet banking. DeFi enthusiasts say they want to create a financial system that is free from the evils of today’s half-baked and hyper-centralized set-ups.
For many, including me, the reason is more philosophical: DeFi is the financial system of the Web3 world. It replaces biased human middlemen with trust-building technologies such as blockchain and open-source software. This makes transactions cheaper and helps middlemen more than benefit. It’s almost instantaneous, a thing of the past with T+3 settlements, and a lot more transparent. Importantly, it is a democratic force that empowers the end user to do things that only powerful intermediaries can do. It has the potential to take banking to the millions of people in the world who do not have a bank. It is also full of idealism about how to fix what is wrong with Wall Street and reduce its current power over corporations, countries, and people. Yes, DeFi has its initial problems, but eventually it may be strong enough and secure enough to replace banks and exchanges with democratic user-owned collectives—a left-wing vision that capitalism would ridicule.
As I researched this article, I discovered that one of the first books on the stock exchange was written by Joseph de la Vega, a Dutch-Jewish trader. He wrote about the inner workings of the Amsterdam Stock Exchange of his time, which he said was sophisticated but “prone to all kinds of excesses”. If you read this 1688 treatise, you might think that he is describing the modern DFI. The title of her seminal book was apt: Confusion of Confusion. Hopefully, decentralized systems can solve some of this.
Jaspreet Bindra is Chief Technical Whisperer in Findability Sciences, and learning AI, Ethics and Society at Cambridge University.