DeFi - Definancializing Productive Activity

As software and hardware engineers around the world are untangling the centralization of the internet, a new theme within the enclave of blockchain-based solutions - generally referred to as decentralized finance - or DeFi for short - have emerged. While blockchains provide the building blocks for reliable information and - to a lesser extend value - transport functions - a layer of middleware to the larger concept of cryptographic primitives mapped by network protocols (not: blockchains), current developments are largely focused on digitally native assets, and their derivatives. However, a first-principles view on the innovation of financial services will focus on the central tenet of technology: the increase of productivity of human activity, freeing up individuals’ attention — measured in time — that these can assign to leisure activities or higher-order pursuits, such as the accumulation of knowledge. To that end, network technologies, in particular, the internet and consequent emergence of the World Wide Web, amplified human productivity by fueling a surge of synchronous and asynchronous coordination methods of human fecundity, as well as the wider distribution of economic activity in general.

Until recently, unmitigated coordination on the web was mostly limited to the exchange of information, while the exchange of rights and assets still required multiple layers of rent-seeking third parties, frequently curtailing productivity and profitability. Emblematic of these intermediaries are financial service providers which regularly introduce friction to business activities in form of time delays and fees. As research by the Stern School of Business and others has shown, the unit costs of financial intermediation thus far has not decreased, despite advances in information technology. Moreover, evermore 'creative' financial products are entirely disconnected from the real economy. Endeavors such as the high-frequency trading - which trade stocks in Nano-seconds - produce nothing of value, while turning regular stock buyers into non-player-characters within a game dominated by powerful server farms strategically deployed to execute trades faster than a person could react. These technological advantages are amplified by machine learning solutions fed with data generated by human traders. The acquisition of which which - euphemistically labelled as 'payment for order flow', was on display in the widely criticized actions of Robinhood in 2020, resulting in dozens of law suits against the company which claims to be on 'a mission to democratize finance for all' (more on the scandal here).

Financialization is a process whereby financial markets, and financial institutions, gain greater influence over economic policy and economic outcomes. The impact of financialization can be observed as an increase in the take-rate of the financial sector relative to real productive activity, and a transfer of income from production to the financial sector, and ultimately an increase of income inequality. As Thomas Palley and other researchers have pointed out, there is evidence that an overemphasis of financialization puts an economy at risk of debt deflation and prolonged recession (more here). These findings were confirmed in a 2020 hearing before the U.S. Senate Committee on Banking, Housing and Urban Affairs.

As with government services, financial services are plagued with administrative and regulatory burdens mostly dating back to a pre-digital era. Aside from the creation of fiat money via the process of collateralized lending, commercial banks have been tasked with financial surveillance functions via legal, regulatory, and procedural means to stop criminals from dressing up funds obtained illegally as legitimate.

The cost of these so-called 'anti-money laundering' efforts is passed on to consumers in form of fees, while the externalities of fiat money creation by the commercial banks is primarily expressed in the inflation of the housing market, and secondarily in the reduction of purchasing power due to an overall increase in the money supply. Setting the deputization of these entities for state objectives aside, legacy regulatory regimes do not address the activity of the transacting parties but aim to account for principal-agent problems inherent to financial intermediaries.

Banks most often enter into commercial agreements with the parties that extend their position of mere custodians of the assets of third parties to forcing these into a new agreement. While bank customers are often under the impression that they 'deposit' money into their account, this process instead extends an (often) interest free to the bank. To date, the principal technology for recording these agreements is database solutions, which in some cases are still using mainframe architecture writing in Cobol, a programming language not taught to software engineers for decades.

One of the earliest 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 over a period of 30 years and was first introduced by the Financial Services Technology Consortium in the early 1990s. The term was later popularized by solutions built atop 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, enabled users to establish accounts that utilize email as payment addresses. While providing customers with a better user experience, these Fintech 2.0 solutions are entirely dependent on legacy financial service providers and the infrastructure maintained by them. As such these solutions lack the general deflationary requirement of technological progress, exposing the the true nature of companies as mere window-dressing to the legacy financial systems which decentralized finance solutions disrupt.

The term 'decentralized finance' refers to solutions built atop the internet and public blockchains. DeFi systems deploy smart contracts on blockchains to create automated solutions, sometimes resembling those of financial services, without the need for a corporate entity acting as middleman. Current DeFi building blocks include standardized smart contracts forming digital bearer instruments, non-custodial exchanges, decentralized lending markets and on-chain asset management solutions.

DeFi systems generally 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 performed in a secure and verifiable way — i.e., recorded on a public ledger.

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, thus far, DeFi offers a small number of applications, due to being limited to digitally native assets. For example, users can acquire U.S. dollar-pegged assets, deposit these assets to an equally decentralized lending platform to earn interest, and subsequently add the interest-bearing instruments to a decentralized liquidity pool or a blockchain-based investment vehicle.

Decentralized finance applications will prove to fulfill the promise of solutions promoted under the term fintech. However, economic activity is ultimately based on the delivery of tangible goods and services. And, while the number of DeFi solutions and capital exchanged using these systems is steadily growing, at present the space is still largely limited to the use cases of trading, borrowing and lending of digitally-native commodities — namely bitcoin and Ethereum’s ether, which as of mid-November 2021 together make up nearly 60% of the market cap of all cryptocurrencies listed on CoinGecko.

A reliable signal for the evolution of DeFi to true Fintech 3.0 is a significant reduction of financial service take-rates in the gross domestic product of a country. The latter will likely first be seen in countries with economies less financialized than the U.S. and other modern nation-states. Governments and investors alike must take note when other countries not only leapfrog legacy banking systems but also skip over mere window-dressing solutions to technology debt. Hence the notion that new technologies discussed by central banks around the world — such as central bank digital currencies (see my previous article here) will “bank the unbanked” — are akin to the expectation that current smartphone users will return to using rotary phones if offered by their local telecom provider.

P.S These thoughts are excerpts from a forthcoming book on the evolution of currencies which can be pre-ordered here.