What we think we know about defi

This essay follows an RMIT Blockchain Innovation Hub workshop on defi. Contributions by Darcy WE Allen, Chris Berg, Sinclair Davidson, Oleksii Konashevych, Aaron M Lane, Vijay Mohan, Elizabeth Morton, Kelsie Nabben, Marta Poblet, Jason Potts, and Ellie Rennie. Originally a Medium post.

The financial sector exists solely to smooth economic activity and trade. It is the network of organisations, markets, rules, and services that move capital around the global economy so it can be deployed to the most profitable use.

It has evolved as modern capitalism has evolved, spreading with the development of property rights and open markets. It has grown as firms and trade networks became globalised, and supercharged as the global economy became digitised.

Decentralised finance (defi) is trying to do all that. But just since 2019, and entirely on the internet.

Any business faces the question of “how do I get customers to pay for my product?” Similarly consumers ask the question, “Where and how can I pay for the goods and services I want to buy?” For the decentralised digital economy, defi answers this question. Defi provides the “inside” money necessary to facilitate transactions.

But what in traditional, centralised finance looks like banks, stock exchanges, insurance companies, regulations, payments systems, money printers, identity services, contracts, compliance, and dispute resolution systems — in defi it’s all compressed into code.

From a business perspective trade needs to occur in a trusted and safe environment. For the decentralised digital economy, that environment is blockchains and the dapps built on top.

And as we can see, defi doesn’t just finance individual trades or firms — it finances the trading environment, in the same way that taxes finance regulators and inflation finances central banks. If blockchain is economic infrastructure, defi is the funding system that develops, maintains and secures it.

These are heavy, important words for something that looks like a game. The cryptocurrency and blockchain space has always looked a little game-y, not least with its memes and “in-jokes”. The rise of defi has also had its own cartoonified vibe and it has been somewhat surreal to see millions of dollars of value pass through tokens called ‘YAMs’ and ‘SUSHI’.

Games are serious things though. A culture of gaming provides a point around which all participants can coordinate activity and experimentation — what we’re seeing in defi is the creation of a massive multiplayer online innovation system. The “rules” of this game are minimal, there are no umpires, and very little recourse, where the goal is the creation and maintenance of decentralised financial products, and willing players can choose (if and) to what extent they participate.

Because there is real value at stake, the cost of a loss is high. Much defi is tested in production and the losses from scams, unethical behaviour, or poor and inadequately audited coding are frequent.

On the other side, participation in the game of defi is remarkably open. There are few barriers to entry except a small amount of capital that players are willing to place at risk. Once fiat has been converted into cryptocurrency, the limit on participation in decentralised finance isn’t regulatory or institutional — it is around knowledge. (Knowledge is a non-trivial barrier, excluding people who could be described as naive investors. This is important for regulatory purposes.)

This is starkly different from the centralised financial system, where non-professional participants have to typically go through layers of gatekeepers to experiment with financial products.

The basic economics of defi

The purpose of defi is to ensure the supply of an ‘inside money’ — that is, stablecoins — within decentralised digital platforms and to provide tools to manage finance risks.

In the first instance defi is about consumer finance. It answers basic usability questions in the blockchain space: How do users of the platform pay native fees? Which digital money is deployed as a medium of exchange or unit of account on the platform?

In the second instance defi concerns itself with the operation of consensus mechanisms — particularly proof of stake mechanisms and their variants. The problem here is how to capture financial trust in a staking coin and then how to use that trust to generate “trust” on a blockchain. Blockchains need mechanisms to value and reward these tokens. Given the (potential) volatile nature of these tokens, risk management instruments must exist in order to efficiently allocate the underlying risk of the trading platform.

As we see it, the million yam question is whether the use of these risk management tools undermine trust in the platform itself. It is here that governance is important.

Which governance functions should attach to staking tokens and when should those functions be deployed? Should they be automated or should voting mechanisms be used? If so, which voting mechanisms and what level of consensus is appropriate for decision making.

Finally defi addresses the existence of stablecoin and staking tokens from an investor perspective. Again there are some significant questions here that the defi space has barely touched. How do these instruments and assets fit into existing investment strategies? How will the tax function respond? How much of existing portfolio theory and asset pricing applies to these instruments and assets?

Of course, we already have a complex and highly evolved centralised financial system that can provide much of the services that are being built from the ground up in defi. So why bother with defi?

The most obvious reason is that the blockchain space has a philosophical interest in decentralisation as a value in and of itself. But decentralisation addresses real world problems.

First, centralised systems can have human-centric cybersecurity vulnerabilities. The Canadian exchange QuadrigaCX lost everything when the only person with access to the cryptographic keys to the exchange died (lawyers representing account holders have requested that the body be exhumed to prove his death). Decentralised algorithmic systems have their own vulnerabilities (need we mention yams again?) but they are of a different character and unlike human nature they can be improved.

Second, centralised systems are exposed to regulation — for better or worse. For example, one of the arguments for UniSwap is that it is more decentralised than EtherDelta. EtherDelta was vulnerable to both hackers (its order book website was hacked) and regulators (its designer was sued by SEC).

Third, digital business models need digital instruments that can both complement and substitute for existing products. Chain validation instruments and the associated risk management tools presently do NOT have real world equivalent products.

Fourth and finally, the ability to digitise, fractionalise, and monetise currently illiquid real-world assets will require a suite of instruments and digital institutions. Defi is the beginning of that process.

In this sense, the defi movement is building a set of financial products and services that look superficially familiar to the traditional financial system using a vastly different institutional framework — that is, with decentralisation as a priority and without the layers of regulation and legislation that shape centralised traditional finance.

Imagine trying to replicate the functional lifeforms of a carbon-based biochemical system in a silicon based biochemical system. No matter how hard you tried — they’d look very different.

Defi has to build in some institutions that mimic or replicate the economic function provided by central banks, government-provided identity tech, and contract enforcement through police, lawyers and judges. It is the financial sector + the institutions that the traditional finance sector relies on. So, initially, it’s going to look more expensive, relative to “finance”. But the social cost of the traditional finance sector is much larger — a full institutional accounting for finance would have to include those courts and regulations and policymakers and central banks that it relies on.

Thus defi and centralised finance look very different in practice. Consider exchanges. Traditional financial markets can either operate as organised exchanges (such as the New York Stock Exchange) or as over-the-counter (OTC peer-to-peer) markets. The characteristics of those types of market are set out below.

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Defi exchanges represent an attempt to combine the characteristics of both organised exchanges and over-the-counter markets. In the very instance, of course, they are decentralised markets governed by private rules and not (necessarily) public regulation. They aim to be peer-to-peer markets (including peer-to-algorithm markets in the case of AMM).

But at the same time they aim to be anonymous (in this context meaning that privacy is maintained), transparent, highly liquid, and with less counterparty risk than a traditional OTC market.

Where is defi going?

Traditional finance has been developing for thousands of years. Along with secure private property rights and the rule of law, it is one of the basic technologies of capitalism. But of those three, traditional finance has the worst reputation. It has come to be associated with city bros and the “Wolf of Wall Street”, and the Global Financial Crisis. Luigi Zingales has influentially argued that the traditional finance system has outgrown the value it adds to society, in part because of the opportunities of political rent seeking.

This makes defi particularly interesting.  Defi is for machines. Not people. It represents the automation of financial services.

A century ago agriculture dominated the labour force. The heavy labour needs of farming are one of the reasons we were poor back then. As we added machines to agriculture — as we let machines do the farming — we reduced the need to use valuable human resources. Defi offers the same thing for finance. Automation reduces labour inputs.

Automation of course has been increasingly common in financial systems since at least the 1990s. But it could only go so far. A lot of the reason that finance (and many sectors, including government and management) resisted technological change and capital investment, was at the bottom, there had to be a human layer of trust. Now that we can automate trust through blockchains, we can move automation more deeply into the financial system.

Of course, this is in the future. Right now defi is building airplanes in 1902 and tractors in 1920. They’re hilariously bad and horses are still better. But that’s how innovation works. We’re observing the creation of the base tools for entrepreneurs to create value. Value-adding automated financial products and services comes next.

Blockchain is (now) a competitive industry

With Sinclair Davidson, Jason Potts and Ellie Rennie. Originally a Medium post.

With the anniversary of the Bitcoin whitepaper looming on October 31, it is remarkable how far and fast this industry has come since it was anonymously launched on a crypto bulletin board just ten years ago. Ethereum, which gave us smart contracts and ICOs, was only started in 2015. The Consensus conference, only in its fourth year, packed over 8500 attendees into the New York midtown Hilton with representatives from most major corporations and industries being present.

Blockchain is quickly becoming mainstream. The industry is entering the phase of industrial competition — and this is happening on a global scale.

Consensus is the centerpiece of Blockchain Week in New York City, and the main global industry conference for cryptocurrency and blockchain technology. It is also increasingly a platform for major industry announcements. Two clusters of announcements in particular are propitious markers of where we’re up to in the development of the industry.

In politics, David Burt, Premier and Finance Minister of Bermuda, announced his country’s Parliament had tabled the Digital Asset Business Act, staking an ambition and claim to be the world’s leading crypto-regulator. On Tuesday, Eva Kaili, Chair of European Parliament Science and Technology Options Assessment, announced the Blockchain Resolution had passed the European Parliament.

In enterprise, Fred Smith, CEO of FedEx called blockchain the next big disruption in supply chains and logistics with the potential to completely revolutionise the global trade system. Circle, a Goldman Sachs backed crypto finance company, announced it will be issuing a fiat stablecoin, which is to say a crypto-version of the $USD. And buried in the announcement by Kaleido — a blockchain business cloud — of a partnership with UnionBank i2i (a Philippines Bank specializing in rural banking), was a joint partnership with Amazon Web Services.

These announcements indicate that we have entered a new industry phase, moving well beyond the first entrepreneurial phase of highly speculative market-making start-ups operating entirely in a disruptive mode, and are now at the onset of a second phase of industrial dynamics, that of industrial competition. While still incredibly young, because of the speed and scale at which it has developed, the blockchain industry has now entered the phase of market competition.

The Bermuda announcement is a competitive response to the innovative regulatory frameworks built by jurisdictions such as Singapore, Zug (CryptoValley), Estonia, Gibraltar, Isle of Man, and other crypto-havens. The Bermuda announcement clearly signals that we’re now in the phase of global regulatory competition, and that crypto-regulation and legislation in countries such as the US and Australia will be held by the competitive pressure of exit-options from departing too far from the competitive equilibrium.

The announcement by Kaleido is in itself less significant than that of the AWS partnership, which signals the new shape of competition in cloud computing. Technology companies such as Microsoft, Oracle and IBM are competitively positioning themselves to provide foundational infrastructural services and standards in this new space, and the Fred Smith’s pronouncement signals that the logistics industry is about to be competitively disrupted again.

The difference between the first and second phase of industrial dynamics is that in the first phase entrepreneurs are inventing new technology, disrupting existing markets, and seeking to create new business models. It’s a process of de-coordination of an existing economic order. But this is not generally well described as a competitive market process, usually because markets themselves are still forming, and uncertainty is very high. Cooperation in networks and innovation commons is the predominant institutional form.

Competition emerges when uncertainty begins to clear as the outlines of how the technology works and what it will be used for, which markets are affected and how, and which firms will be involved, and a speculative game turns into a strategic game because it becomes clear who the players are and what they are doing. Investment is not just for R&D, for discovery of new technology; but is strategic investment to compete for market share, and ideally for market dominance.

This is where we are up to now: the phase of global market competition.And further evidence of this is that the main concern of industry participants is global regulatory uncertainty, which is to say the rules of the competitive game.

Now to be clear, crypto and blockchain is still an experimental technology. But we’re now past the early innovation phase — the start-up phase — and have investment is now a C-suite concern, and a parliamentary agenda item.

What does competition mean for Web 3.0?

So blockchain is being absorbed into the economy and global political system. But what does this mean for the future of the internet?

The other big question arising from the Consensus 2018 announcements was the extent to which the involvement of incumbent internet platforms, such as Microsoft and AWS, will affect the distributed nature of the emergent blockchain ecosystem.

Joseph Lubin, co-founder of Ethereum, argued that the technological foundations for a distributed future have been built and that the essential task now is to achieve scalability. Data storage is an important aspect of scalability that will be essential to the success of decentralised applications (dapps), and more radical solutions (such as the InterPlanetary File System, IPFS) are apparently not ready for widespread adoption.

The involvement of AWS in Kaleido enables enterprise participation in the Ethereum blockchain whilst ensuring that the data (including oracles) are housed securely. While numerous self-sovereign identity dapps are available (as displayed through Civic’s identity-checking beer vending machine at the conference), common standards are necessary for those providing verified information.

Microsoft’s partnership with Blockstack and Brigham Young University is a development towards these standards that is potentially significant for this new approach to online privacy.

Neither development necessarily threatens Web 3.0, but this is now being driven by a competitive logic of market forces.