New Money Review: What DeFi Needs To Succeed
This piece was co-authored with Anish Mohammed
The average cryptocurrency investor is about to gain access to a powerful suite of tools and opportunities that are currently only available to a select few financial institutions.
There is a movement under way to build “decentralised finance” (DeFi), a foundation of technologies to rewrite the rules of how assets are exchanged online. At this core of this effort is a promise to make finance more open, transparent and accessible. That’s done by replacing our current financial instruments with cryptography, protocols and networks that can handle huge amounts of transactions quickly and cheaply.
If successful, DeFi could remove most of the intermediaries standing between investors and the assets they acquire: in theory, anybody with a phone could participate in funding and trading the $80trn-plus of global assets that are currently in the hands of professional fund managers.
The democratisation of investing that we’ve seen in the last decade—through ETFs, low-cost trading platforms and the like—could pale in comparison to the level of value that DeFi’s suite of capabilities can unlock.
With DeFi, fund managers would keep their capital advantage but lose the information asymmetries that breed unfairness. Complicated financial instruments would be converted into smart contracts and decentralised autonomous organizations, blockchain-based instruments that can be scrutinised and verified by outsiders.
The stock exchange would cease to exist as we know it. Bots would complete their takeover of trading and the role of the human would change from operating a centralised intermediary to building and maintaining a decentralised system.
But we need more than just a bright vision to build this future; and thus far, the DeFi industry is off to a rocky start. Despite explosive growth, DeFi has ignored three key areas that are necessary for its advancement: scaling transaction throughput, innovations in collective decision-making, and overhauling the current approach to security. Each represents a massive challenge that will have to be overcome, and all are necessary in order for DeFi to stand a chance of fulfilling its objectives.
Scaling transaction throughput
Right now, DeFi is like a bustling city with limited infrastructure. Every day, thousands of residents are moving in and the city can barely keep up with the new demand. The lack of urban planning, which initially allowed for experimentation, has now become a serious problem. Nobody likes a long commute, congested streets or constant surge pricing, but that’s what we have with the ethereum cryptocurrency network today (ethereum is the platform upon which most DeFi projects are currently built).
In the early days of DeFi, investors with limited amounts of capital could get a lot further. That has changed with the emergence of “yield farming.” This practice, which took off in June 2020, has been described as a shorthand for clever strategies where putting crypto temporarily at the disposal of some startup’s application earns the crypto owner more currency.
Because of yield farming, the cost of transactions on ethereum has gone up to unsustainable levels, creating a bottleneck and hampering growth. Due to the limited capacity of the network, the current transaction pricing mechanisms are prioritising those investors that send the highest-value trades. In other words, participation is being limited to those with large amounts of capital, leaving small-time traders behind. As new investors get priced out, adoption stalls, and eventually promising ideas languish because of this distortion. Over time, this type of situation can lead to ruin.
Innovations in collective decision-making
An effective governance system creates certainty through fairness and even enforcement. A broken governance system, however, does the opposite. It breeds distrust by putting the interests of those in control over those of everyone else.
Right now, there exists a complicated tangle of methods used to run a blockchain-based project. These include technical tools to execute agreements automatically between parties, organisations that are capable of policing themselves to varying degrees, and a series of different approaches to automating business processes. The DeFi community needs to think carefully about the implications of the power and control it creates.
In a short time, there have been some alarming examples of how DeFi can go wrong. In one instance, an entrepreneur had his/her protocol hijacked by outsiders. In another case, the CEO of a major protocol took control over voting power in order to change the rules determining what each person could do with their tokens.
Given their focus on data, verification, and technical measurement, DeFi projects should actually be far more secure than their counterparts in the traditional world. Instead, what we are seeing are errors of planning, judgement and decision-making by the leaders of these projects. If left uncorrected, these sorts of mistakes will destroy the economics of DeFi entrepreneurship.
But it doesn’t have to be this way. An upgraded approach would involve greater accountability and disclosure on the part of protocol owners. That might include publishing a policy structure and allowing others to scrutinise it. It should state up front who is allowed to do what, how assets can be moved and what the penalties are for breaking the rules.
More advanced methods of blockchain governance could involve quadratic voting, a decision-making procedure which allows participants to express their degree of preference, potentially making resolutions more representative. Bonding curves, meanwhile, could help mediate the supply of tokens and create economic levers to reduce cheating. Enforcement, communication and rigour are the key to better collective outcomes.
Overhauling the current approach to security
Each headline about data breaches and theft erodes the credibility of the entire cryptocurrency space. The reason this keeps happening is that blockchain-related projects often lack a security culture. This means that sloppy practices, poor planning and projects going online without proper audits are all commonplace.
Ironically, to address these shortfalls, DeFi may have to look to the very people it is trying to make obsolete: the much-maligned banks, payment processors and financial intermediaries of today.
Established financial institutions are often out of touch with consumer needs. They offer us no compelling vision for the future and are rarely open to new ways of doing things. But where they excel is maintaining a low rate of fraud across an enormous volume of transactions. That’s quite an accomplishment and it’s worth understanding how they got it right.
These companies build cultures where expertise is valued and information is handled as if a regulator might be watching. That starts with placing a high premium on rules and norms. These organisations also value predictability, which creates trust and allows for greater participation. There is also a strong focus on developing and adopting standards and methodology, which brings a measure of stability. Costs decrease when players no longer to have figure out how to convince others of their credibility. All of this is supported by an industry of professionals solely devoted to protecting financial data.
It’s certainly possible to build this sort of meticulousness into DeFi as well. It comes down to the quality of processes in place at each step in the development process and how products are tested before they are released. The examples are currently few and far between, but protocols such as Cardano show us that it is possible to take a professionalised approach. Alternatively, we see investors themselves pooling funds and attempting to perform their own external reviews. Security is non-negotiable in finance.
Causing or preventing the next crisis?
It is reasonable to be sceptical that the players involved in DeFi can get their act together before the world’s attention moves on. The Initial Coin Offering (ICO) boom and bust that began in 2017 is reason enough for anybody to be wary of the hype and bold claims of cryptocurrency enthusiasts. And if the current trajectory continues, DeFi will leave behind a legacy of scams, short-sighted thinking and dashed expectations. There is a limited window of time to fix, adjust and recalibrate.
That would be a major loss. What’s at stake is more than just creating a well-performing asset class or expanding the skills of financial software. If implemented correctly, DeFi could help stave off the next major crisis by removing large single points of failure from the current financial system. When all of the ecosystem’s parts are taken together, what you have is a way to strengthen finance by enhancing trust with mathematics.
As we saw in the last decade, when debt-based, synthetic financial products are created, risk is easily masked. But in a DeFi world, products like this would undergo far greater analysis and could not make it as far. Claims could be evaluated based on their mathematical proofs, and transactions could be shared and scrutinised without being revealed. We could greatly increase the credibility of our financial systems, while creating a more level playing field for all investors.