DeFi – Definancializing productive activity
Current DeFi building blocks include standardized smart contracts forming digital bearer instruments, noncustodial exchanges, decentralized lending markets, and on-chain asset management solutions.
Blockchain VC @ Sustany Capital
As software and hardware engineers around the world unravel the centralization of the internet, a vocal part within the enclave of blockchain-based solutions – generally referred to as decentralized finance – or DeFi for short – has emerged. While blockchains provide the building blocks for reliable information and – to a lesser extent – transport functions – a middleware layer to the broader concept of protocol-mapped cryptographic primitives, current developments are largely focused on native digital assets and their derivatives. However, a first principles view of financial services innovation will focus on the central tenet of technology: increasing the productivity of human activity, freeing people’s attention – measured over time – than those these can affect leisure or higher activities. pursuits of order, such as the accumulation of knowledge. To this end, network technologies, particularly the Internet and the consequent emergence of the World Wide Web, have amplified human productivity by fueling a surge of synchronous and asynchronous methods of coordinating human fertility, as well as a wider distribution economic activity in general.
Until recently, digital coordination was mostly limited to the exchange of information, while the exchange of rights and assets still required multiple layers of rent-seeking third parties, which frequently reduced productivity and profitability. Emblematic of these intermediaries, financial service providers regularly introduce friction into business activities in the form of delays and fees. As research by the Stern School of Business and others has shown, the unit cost of financial intermediation has so far not decreased, despite advances in information technology.
State of Financial Technology
As with government services, financial services are plagued with administrative and regulatory burdens dating back mostly to pre-digital times. Apart from the creation of fiat money through the process of secured lending, commercial banks have been tasked with financial oversight functions through legal, regulatory and procedural means to prevent criminals from disguising illegally obtained funds as legitimate.
The cost of these so-called “anti-money laundering” efforts is passed on to consumers in the form of fees, while the externalities of fiat money creation by commercial banks are expressed primarily in inflation. of the housing market, and secondarily in the reduction in purchasing power due to an overall increase in the money supply. Leaving aside the delegation of these entities for state purposes, legacy regulatory regimes do not deal with the activity of the parties to the transaction but aim to account for the principal-agent problems inherent in financial intermediaries.
Banks most often enter into commercial agreements with parties that extend their position as mere custodians of third party assets. To date, the main technology for recording these agreements is database solutions, which in some cases still use mainframe architecture writing in Cobol, a programming language that has not been taught to software engineers for decades.
One of the first network technologies to facilitate commercial activity over long distances was the pantelegraph, which in 1865 was most commonly used to verify signatures in French banking transactions. However, the origin of the term “Fintech” can only be traced back to a 30-year period and was first introduced by the Financial Services Technology Consortium in the early 1990s. The term was later popularized by solutions built on the World Wide Web, which allowed users to perform financial transactions without having to interact directly with the banking system. Most notably, companies such as Confinity – later renamed PayPal, allowed users to create accounts using email as payment addresses. While providing customers with a better user experience, these Fintech 2.0 solutions are entirely dependent on traditional financial service providers and the infrastructure they maintain.
The term refers to solutions built on the internet and public blockchains. DeFi systems use smart contracts to create automated, financial services-like solutions without the need for a corporate structure. Current DeFi building blocks include standardized smart contracts forming digital bearer instruments, noncustodial exchanges, decentralized lending markets, and on-chain asset management solutions.
DeFi systems do not require intermediaries or centralized organizations. Instead, they are based on open networks and decentralized applications. Agreements are executed by automated software and transactions are carried out in a secure and verifiable manner, i.e. recorded on a public blockchain.
This architecture can in principle create an interoperable system with high transparency, equal access rights and little need for custodians, central clearinghouses or escrow services. However, so far DeFi has a small number of applications, due to its limitation to native digital assets. For example, users can acquire assets pegged to the US dollar, deposit those assets in an equally decentralized lending platform to earn interest, and then add the interest-bearing instruments to a decentralized liquidity pool or investment vehicle. blockchain based investment.
Financialization is a process by which financial markets and financial institutions gain greater influence over economic policy and economic outcomes. The impact of financialization can be observed as a) an increase in the levy rate of the financial sector relative to real productive activity, b) a transfer of income from production to the financial sector, and ultimately an increase in inequality of income. As Thomas Palley and other scholars have pointed out, there is evidence that an overemphasis on financialization puts an economy at risk of debt deflation and prolonged recession (more here). Those findings were confirmed in a hearing earlier this year before the US Senate Committee on Banking, Housing, and Urban Affairs.
Decentralized finance applications will prove to deliver on the promise of solutions promoted under the term fintech. However, economic activity is ultimately based on the provision of tangible goods and services. And, while the number of DeFi solutions and capital traded using these systems continues to grow, at present the space is still largely limited to the use cases of trading, borrowing and the loan of digital native products – namely bitcoin and Ethereum ether, which as of mid-November 2021 together account for almost 60% of the market capitalization of all cryptocurrencies listed on CoinGecko.
A reliable signal for DeFi’s evolution towards true Fintech 3.0 is a significant reduction in financial services participation rates in a country’s gross domestic product. The latter will likely first be seen in countries with less financialized economies than the United States and other modern nation states. Governments and investors should take note when other countries not only skip traditional banking systems, but also ignore simple window dressing solutions to tech debt. Hence the idea that new technologies being discussed by central banks around the world – such as central bank digital currencies (see my previous post here) “will bank the unbanked” – are akin to the expectation that current smartphone users will revert to rotary phones if offered by their local telecommunications provider.