When people talk about decentralized finances today, they mostly talk about its growth and the potential of the technology underpinning it. When they talk about the future of DeFi, they talk about how much it can grow and how it can be an alternative system for traditional finance.
However, very few people talk about the primary problem of traditional finance, and how DeFi has solved that. If you're not too knowledgeable about DeFi, you might think that problem is centralization. But you would just be half right. The problem isn't centralization, for that is only a symptom of a bigger problem. The bigger problem is trust.
For the overwhelming majority of human existence, we've operated financial systems based on trust. Even before the existence of banks, we've always put trust in a third party for the security of our finances.
Romans, for example, trusted the state not to
The Romans weren't the only ones subjected to this treatment. A lot of civilizations over the course of history did too. Interestingly, people didn't just have to trust the banks or their state— they also had to trust couriers. Merchants who had to transport large amounts of gold or silver via couriers had to trust the courier not to abscond with the treasure. Even if they were transporting it themselves, they had to trust fellow travelers or even their own family not to rob them.
With the industrial revolution came the need for even more trust. Financial systems were expanding, and banks started to grow. People had to trust banks to verify transactions, and they had to trust central banks not to be irresponsible with monetary policy. It's important to understand that people didn't trust these institutions because they wanted to, but because they had to. There was no choice.
As anyone would expect, these systems of trust continually broke down. The Roman denarii became
But because we had no alternative to a trust-based system, we persevered. It may sound counterintuitive to oppose a system based on trust. That's because trust sounds like a good thing. Unfortunately, in this context, it's not.
There are many reasons why trust-based systems are unstable, but I'll only mention a few important ones.
The first problem with trust is that it can be broken. Even the biggest opponents of trust-based systems have no problems agreeing that in most cases third parties have earned the trust bestowed on them. Regulations mean that these third parties are often good faith players.
But since they can break your trust by manipulating your data or not confirming your transactions, it stands to reason that anyone with access to their systems can do the same. The problem is that because of these same regulations, which presumptively ensure that these third parties are good faith players, also ensure that the state has almost unfettered access to their systems.
Like protesters in Canada recently discovered, if the state wants something hard enough from the banks, it will get it. By placing trust in third parties, people unwittingly make them a target for the state. Sadly, the state isn't the only party that targets these third parties. Even more nefarious actors, like hackers and thieves, target these systems too.
Ergo, it's quite irrelevant whether the third parties are good-faith players or not. They are targets, and since we have zero or no control over just how secure they are against these nefarious actors, we are essentially taking a huge gamble by trusting them.
This isn't a new problem of the trust-based system by any means, and the several economic setbacks we've experienced because of them are testaments to that. The most recent economic setback was probably the 2008 recession which was caused by "good faith" actors holding onto a bunch of bad debt. As expected, these institutions brought the entire global economy crashing down around them. What's more? Most of them got
While one may argue that a vast majority of financial institutions deserve to be trusted, it's clear that if we continue to trust them we will have to adjust to regular unfaithfulness. Sometimes this may be due to their failures, and other times due to circumstances beyond their control.
This inevitability of economic crashes due to trust is the number one problem of traditional finance. And if it's not solved, it may spell doom for our future as the world gets even more interconnected. Thankfully, it's a problem that we can solve.
Today, we can trust algorithms that could not be motivated to breach that trust. The first person to make use of those systems to create a trustless financial framework was Satoshi Nakamato.
And ever since then, we've seen, for the first time in human history, a truly trustless ecosystem. That ecosystem is now called decentralized finance, or DeFi for short. Today, there are many protocols that thrive on the principle of decentralized finance. For example, there are now companies trying to solve the problem of loans, and others trying to solve the liquidity problem of real estate.
The basic premise behind these systems means that a third party doesn't need to like you, love you, or be good to keep your transactions safe. It's a system where there are only two parties in the transaction; you and your peer. That's why DeFi transactions are called peer-2-peer transactions.
But this safety isn't the only benefit of DeFi. Trustless systems don't only solve the problem of trust-based systems, they also make it easier for people to do more with their assets.
Staking, for example, is a unique DeFi protocol that allows users to earn interest on their assets by committing to a validator for a certain period. Ordinarily, people don't have assets in their funds at this time. However, through liquid staking, they can earn derivative tokens that they can spend anyhow they wish. Today, one of the biggest companies allowing people to stake is
As expected, this entire system is trustless, which makes it even a better bet for people than regular interest. It's also safer, as people will never have to worry about doing bank runs since their investment is guaranteed by smart contracts.
While a lot of people still believe in the trustworthiness of traditional finance, many are beginning to see they haven't earned our trust. There have been too many mistakes and breaches of trust by these institutions. They can no longer be trusted, and that's why DeFi will certainly replace them — not just co-exist with them.