THE SCEPTICAL have a lot of forage. Early users 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 currency, were stolen this year after hackers discovered a bug in a code. Many “believers” are actually trying to get rich quick from the global craze that has seen cryptoassets rise in value to $ 2.2 billion. Others are terribly dedicated. The entrepreneur who announced in June that El Salvador was adopting bitcoin as its official currency sobbed on stage, saying it would save the nation.
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Crooks, fools and proselytes are off-putting. Nonetheless, the rise of a financial services ecosystem, known as decentralized finance, or “DeFi,” deserves sober reflection. It has the potential to reprogram the functioning of the financial system, with all the promises and dangers that entails. The proliferation of innovation in DeFi is akin to the invention frenzy in the first phase of the Web. As people increasingly live their lives online, the crypto-revolution could even reshape the architecture of the digital economy.
DeFi is one of the three tech trends disrupting finance. Technology “platform” companies focus on payments and banking. Governments are launching digital currencies, or govcoins. DeFi offers an alternative path that aims to distribute power, not concentrate it. To understand how, start with blockchains, vast networks of computers that keep a common, open and incorruptible record and update it without the need for a central authority.
Bitcoin, the first large blockchain, created in 2009, is now a distraction. Instead, Ethereum, a blockchain network created in 2015 on which most DeFi applications are built, is reaching critical mass. Its developers see finance as a juicy target. Conventional banking requires a huge infrastructure to maintain trust between foreigners, clearing houses and compliance with capital rules and the courts. It’s expensive and often captured by insiders: think credit card fees and bankers’ yachts. In contrast, transactions on a blockchain are reliable, cheap, transparent and fast, at least in theory.
Although the terminology is intimidating (fees are “gas”; the primary currency is ether, and title deeds to digital assets are known as TVNs), the basic activities that take place on DeFi are familiar. These include trading on the stock exchange, issuing loans, and accepting deposits through self-executing agreements called smart contracts. One of the indicators of the activity is the value of the digital instruments used as collateral: from almost nothing at the beginning of 2018, it reached 90 billion dollars. Another is the value of transactions that Ethereum verifies. In the second quarter, that reached $ 2.5 billion, about the same amount Visa trades and the equivalent of a sixth of activity on the Nasdaq, an exchange.
The dream of a low friction financial system is just the beginning. DeFi extends to more ambitious fields. MetaMask, a DeFi wallet with over 10 million users, acts as a digital identity. To enter a decentralized “metaverse”, a mirrored world with user-run stores, you tie your wallet to a cartoonish avatar that roams around. These digital worlds will be subject to increasingly intense competition as online spending increases. Big tech companies could impose huge taxes on these mini-savings: imagine Apple’s App Store charging a fee, or Facebook selling your avatar’s intimate secrets. A better alternative might be decentralized networks that host applications and are mutually executed by users. DeFi could provide payments and property rights.
Crypto enthusiasts see it as a utopia. But there’s a long way to go before DeFi is as reliable as, say, JPMorgan Chase or PayPal. Some problems are prosaic. A common criticism is that blockchain platforms don’t scale easily, and the computers they run consume unnecessary amounts of electricity. But Ethereum is a self-improvement machine. When it is in high demand, the fees it charges for verification can escalate, encouraging developers to strive to minimize the intensity with which they use it. There will be new versions of Ethereum; others, better blockchains could one day replace it.
Yet DeFi also raises questions about how a virtual economy with its own standards interacts with the real world. One of the concerns is the lack of a valuable external anchor. Cryptocurrencies are no different from the dollar, in that they are built on people with a common expectation of their usefulness. However, conventional currency is also supported by states holding a monopoly on force and central banks which are the lenders of last resort. Without it, DeFi will be vulnerable to panics. Enforcement of contracts outside of the virtual world is also a concern. A blockchain contract can say you own a home, but only the police can force an eviction.
Governance and accountability in DeFi-land is rudimentary. A sequence of large, irrevocable transactions that humans cannot bypass could be dangerous, especially since coding errors are inevitable. Money laundering has flourished in the unregulated gray area of services between Ethereum and the banking system. Despite claims of decentralization, some programmers and application owners exert a disproportionate influence on the DeFi system. And a malicious actor could even take control of the majority of computers that run a blockchain.
Alice’s Adventures in DeFi-land
Digital libertarians would prefer DeFi to remain self-contained, imperfect but pure. Yet to be successful it must integrate with mainstream financial and legal systems, as Gary Gensler, a crypto expert who is America’s financial watchdog, pointed out. Many DeFi applications are managed by decentralized organizations that vote on certain issues; these bodies should be subject to laws and regulations. The Bank for International Settlements, a club of central banks, has suggested that govcoins could be used in DeFi applications, thus ensuring stability.
Finance is entering a new era in which the three new but imperfect visions of technology platforms, big government and DeFi will clash and intertwine. Each embodies a technical architecture and an ideology of how the economy should be run. As with the Internet in the 1990s, no one knows where the revolution will end. But it is transforming how money works and, in so doing, the entire digital world. ■
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This article appeared in the Leaders section of the print edition under the title “Down the rabbit hole”