Just this month, Bitcoin and Ethereum—two of the most valuable cryptocurrencies—reached all-time highs in prices. The upsurge of cryptocurrencies in recent years has spurred on a new financial ecosystem—one built around blockchain, the same technology used by cryptocurrencies.
Its users call it decentralized finance—DeFi for short—and it promises a financial system without traditional financial institutions, like banks, and other regulations. In essence, DeFi is finance controlled by all yet none of its users.
There are many important innovations in this field of financial technology: DeFi could democratize access to financial resources. It could be more efficient and reliable. Yet it also lacks the regulatory measures that current systems have built over centuries. And that is cause for concern.
Traditional and Decentralized Finance
To understand DeFi, we have to start by characterizing traditional financial systems—and crucially, how they interact with the “real economy.”
The real economy has to do with workers, goods and their prices—what you buy at the store as a consumer, the labour you provide to an employer. The financial economy sits on top of that, shifting money around from place to place.
However, one of the key contributions of the financial economy is how it can enable activities in the real economy. For example, bonds that a government issues help pay for public projects, capital invested in businesses fund their early development, and mortgages allow homebuyers to make their purchases.
These are all part of the traditional financial ecosystem. People go to banks to take out loans—some institution is part of the process.
This is what DeFi wants to cut out. It aims to “disintermediate” finance.
In traditional finance, individuals have to trust financial institutions like banks and governments. In DeFi, trust naturally comes from “smart contracts” that function due to a community of computers engaged in a blockchain.
This means that finance would act on a more community-based level, with person-to-person contracts enforced by everyone else in that blockchain network. This contrasts with current systems of person-to-institution contracts that rely on trust in a specific institution.
Regulation in the Unregulated
DeFi is expanding day by day. More and more individuals are using—for example—Ethereum to buy and sell goods or to borrow and lend cryptocurrency.
What lies ahead is murky: will governments start recognizing cryptocurrencies as legitimate forms of payment? Or will DeFi and traditional finance merge into what some call “centralized finance”, which uses blockchains for efficiency but lacks decentralization?
Some governments and central banks are even developing their own versions of cryptocurrency. How that will play out in a world where people turn to DeFi explicitly to get away from government interference is still to be seen.
Similarly, DeFi has a level of natural anonymity. It is quite literally just a network of computers with many individual users. Anonymity is often retained, and methods to obscure transactions are prevalent. Although fraud may decrease, DeFi opens the door to increased money laundering. It is more difficult to regulate illegal flows of money as well as underground market transactions.
That could very well be a price that is paid by distancing financial systems from governments and traditional institutions. But it could also mean that governments won’t be willing to readily accept DeFi.
A Future of Finance
In the end, this is a nascent technology that should be treated with both enthusiasm and care. The innovations here promise many benefits in helping to democratize finance, yet there is still potential for misuse.
Governments will have to reconcile the need to regulate and stabilize the financial economy with the inherent decentralization of DeFi. Regulators have a lot to do in upcoming years.
But maybe—if DeFi becomes what its proponents idealize it to be and government regulators can coexist with the technology—just maybe, we will have a better ecosystem of finance in the future.
Learn More:
- The Economist
- MIT Sloan
- NYT
- A more technical look at how blockchain actually works, 3Blue1Brown [YouTube]
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