Senator Elizabeth Warren, who frequently lashes out at cryptocurrencies, calls them “the most dangerous part of the crypto world.” She talks about DeFi, or decentralized finance, an obscure area of the crypto world that, if successful, could upend traditional finance. . The New York Times defines DeFi as “an umbrella term for the part of the crypto universe that is geared towards building a new Internet-native financial system, using blockchains to replace traditional intermediaries and trust mechanisms.” (nyti.ms/3K8fHPG).
To exchange money or securities today, you need intermediaries such as brokers, banks, or stock exchanges, and you must trust them to act in your interest. Successive scams, such as the financial crisis of 2008 or the GNP crisis in India, have shown that this is not always true: that their interest is served seems more the exception than the rule. Marc Andreesen, the founder of a16z, wrote how “software is eating the world.” In the case of DeFi, the software “eats” the intermediaries. Instead of trading through stock exchanges, people deal with each other directly peer-to-peer, with blockchain-based ‘smart contracts’ filling the role of intermediaries and creating a ‘crypto stock exchange’.
DeFi goes beyond a stock market and seeks to replace everything in the financial world: prediction platforms, loans, options, derivatives, the works. It is a shadow Wall Street being built by crypto enthusiasts, one that is completely decentralized, user-owned, and open source, with crypto representations of most TradFi (traditional finance) products, and virtually no regulation or bureaucracy. You could trade crypto versions of Microsoft, Google, and Tesla stocks with these chips that mirror real-life equity. As of now, DeFi is nascent but not small; its ‘total locked value’ is pegged at $77 billion, which would make it the 38th largest bank by deposits in the US.
Among its fundamental elements are stable currencies, cryptocurrencies whose value is linked to that of fiat currency. In the DeFi world, stablecoins are what you hold your liquidity in, to trade tokens, lend, and trade. In theory, the typical stablecoin is pegged to a US dollar and therefore needs a one-to-one backing of real reserves. But there is no regulation governing this, so it is difficult to verify if such reservations exist. The uncertainty goes further. DeFi companies issue loans and credit cards and even open savings accounts without much of the protection offered by traditional banks. Almost every regulator on this planet is concerned about this and has started to prosecute these companies. The fact that most of them are intangible entities on the Internet, often without a known physical address, makes this task difficult. No wonder the NYT calls DeFi a “Wild West Wall Street.”
But then why is there so much excitement around it? One technical reason is that blockchain is a superior technology to what banks have, as most lenders still use software written in Cobol, a programming language from the 1960s. Crypto lives on the internet, and so should it. internet banking. DeFi enthusiasts say they want to create a financial system that is free from the ills of today’s half-broken and overly centralized setup.
For many, including myself, the reason is more philosophical: DeFi is the financial system of the Web3 world. It replaces biased human middlemen with trust-building technologies like blockchain and open source software. It makes transactions cheaper and helps more than the profits of the middlemen. It’s almost instantaneous, with T+3 settlements a thing of the past, and much more transparent. Importantly, it is a democratizing force that empowers the end user to do things that only powerful middlemen can do. It has the potential to extend banking to hundreds of millions of unbanked people around the world. It is also brimming with idealism about how to fix what is wrong on Wall Street and reduce its current power over corporations, countries and people. Yes, DeFi has teething problems, but it could ultimately become robust and secure enough to replace banks and exchanges with democratic user-owned collectives, a center-left view that capitalism would scoff at.
While doing research for this article, I discovered that one of the first books on a stock market was written by a Dutch Jewish trader, Joseph de la Vega. He wrote about the inner workings of the Amsterdam Stock Exchange of his time, which he said was sophisticated but “prone to excesses of all kinds”. If he reads this treatise from 1688, you might think he is describing modern DeFi. The title of his seminal book was apt: Confusion of Confusions Hopefully, decentralized systems can resolve some of these.
Jaspreet Bindra is the Lead Tech Expert at Findability Sciences and is learning AI, Ethics and Society at the University of Cambridge.