How might crypto-assets transform finance? In their December 2020 paper entitled “DeFi and the Future of Finance”, Campbell Harvey, Ashwin Ramachandran and Joey Santoro examine the potential for decentralized finance (DeFi) to disrupt traditional financial infrastructure. They summarize origins and essential features of DeFi, its potential to improve traditional finance and its risks. They also speculate on future development of DeFi. Based on a review of relevant research and events, they conclude that:
- Demand for the U.S. dollar (USD) derives from its central role in the network that is the U.S. economy (pay taxes, purchase goods and repay debt denominated in USD). The Federal Reserve Bank adjusts USD supply via monetary policy to achieve financial or political goals. Inflation confounds USD ability to store value.
- Gold is a successful inflation hedge due to its practically limited supply, utility and general global trust, but its volatility means that hedging is reliable only at extremely long horizons.
- The DeFi alternative aims to combine open-source financial building blocks into sophisticated products with minimal frictions.
- Blockchains (software protocols that allow multiple parties to share assumptions/data without any other source of trust) are key to DeFi. The most popular blockchain application is cryptocurrency, with Bitcoin the first mover. Bitcoin is a payment network that stores and exchanges bitcoins globally without intermediaries or regulation. Its scarcity and privacy offer a way to store value and hedge political/economic/monetary risks. Its value increases as its network expands, but its design inhibits use for small transactions.
- Smart contracts are encode rules for some kind of transaction between parties without any other source of trust overlaid on a blockchain platform (with Ethereum the prime example).
- dApps are standard smart contracts that support frequently used kinds of transactions/agreements between parties.
- Stablecoins are crypto-assets designed to maintain price parity with some target asset (such as USD or gold) to address the frictions inherent in high cryptocurrency volatilities. An off-blockchain reserve of the target asset held by a routinely audited external entity backs these crypto-assets.
- Incentives within DeFi involve direct crypto-asset payments or fees that encourage or discourage users regarding specific actions to support smooth network functioning.
- DeFi offers improvements to traditional finance infrastructure inefficiency, lack of access, opacity, centralized control and lack of interoperability. Specifically, DeFi potentially offers:
- dApps available for any size transaction accommodating high volumes with low frictions.
- User access to a robust financial infrastructure regardless of wealth or location.
- Open code for contractual agreements that eliminates opacity for users.
- Freedom from governmental controls over infrastructure features such as money supply and rate of inflation, and from institutional restrictions on access to the best investment opportunities.
- Ease of interoperability based on open source code, eliminating such awkward interactions as certified checks and wire transfers.
- Principal current risks for DeFi are smart contract defects, oversight, scaling, oracle, exchange and regulatory risks.
- Formal development practices to suppress risk of smart contract bugs and programming errors are still under development.
- Many DeFi implementations rely on human oversight to manage protocol risk.
- Ethereum is currently capable of handling less than 0.1% of the throughput managed by Visa. To date, all efforts to scale Ethereum to high volume have failed.
- DeFi reliance on external data feeds, or oracles (such as stock prices), introduces a means to attack the DeFi infrastructure externally and is the most serious current systemic threat to DeFi.
- DeFi exchanges now vary considerably in design and carry their own unique risks.
- Government regulation will increase as DeFi markets grow, inhibiting full commitments by many users.
In summary, recent history suggests that, as the regulatory environment becomes clear, traditional finance firms should integrate their services with crypto-assets to provide customers with simple front end access to the DeFi back end.
Both overall conclusions and many specific points in the paper are speculative.
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