From Bitcoin to Decentralized Finance: Why You Should CareBy Juan Montoya | Mon, 03/22/2021 - 13:12
By now, most readers have probably heard of Bitcoin, the cryptocurrency that entered the world stage in 2009, enjoying a volatile but meteoric path to recent new heights (1BTC = close to US$56,000 as of this writing), all on the back of serious corporate and institutional investor interest. There is no lack of topics to write about regarding Bitcoin. One could discuss whether it is a true store of value, or the ultimate inflation hedge in the current Fiat currency printing frenzy, or talk about its chances to prevail as an actual means of exchange. Extending the conversation to its other “crypto cousins” would make that even more interesting, albeit messy and contentious. However, in focusing on those, one may ignore what is perhaps the most relevant aspect of this story: mainly, the massive transformation occurring on the heels of this crypto frenzy and what it could mean for the global financial system.
As is often the case, it all begins with a technology. In this case, it is blockchain technology, a version of which underpins every crypto ecosystem. Attempting a simple definition, blockchain is at its core a database technology, with its distinguishing characteristics being the way in which data is stored within it and the possibility to manage it in a decentralized manner, so that no single person or group, but rather all participants, retain control. In a decentralized blockchain, data is immutable and transactions are visible to all participants. A blockchain allows for distributed, decentralized and secure storage of data as well as transparent, publicly available records.
At first glance this may seem a trivial matter, especially to those of us who are less technically inclined. Looking at it closer though, this technology, coupled with a few others such as Smart Contracts (self-executing contracts written in computer code that permit transactions between unknown parties), is nothing short of a key enabler for the reinvention of many of the systems that govern our lives. This is because, in a nutshell, the most important byproduct of any blockchain and smart contract-based system is trust, or, viewed differently, the elimination of the need for trust to successfully execute transactions between parties. In turn, it can be said that the need for trust at scale is the key driver behind our existing governance systems. That is, the structure of our political and economic systems largely responds to the need to generate trust. As a result, we have erected a system in which large centralizing institutions, from governments to private regulated entities, act as trust brokers that hold sensitive information, define rules and enforce them. These systems have enabled the advancement of our society, but, like any system, have flaws that can be addressed through innovation and must be revisited as more tools become available to improve or rethink them.
In the case of the financial system, trust is built and managed through multiple institutional layers, starting with regulations created by officials and enforced by a wide array of governmental bodies. These bodies, in turn, charter and regulate financial institutions which centralize the various key components of the system, facilitating every transaction from payments to lending, borrowing and investment. They often act as gatekeepers, following a business model highly reliant on centralization and high barriers to entry. At its best, the system is a virtuous circle where market signals inform capital allocation and prices, powering the economy and generating wealth for those who can access it. At its worst, the system is exclusive, plagued with inefficiencies and prone to systemic collapse. Ultimately, access remains an important challenge: about 1.7 billion people remain unbanked, according to the World Bank and many more are underbanked and only able to access expensive, subpar financial products.
There are, of course, some interesting immediate trends transforming the financial landscape, as I discussed in a prior article. In a slightly more distant future decentralized systems, at scale and more thoroughly developed, can further transform this landscape, eliminating or reframing the need for trust while at the same time more efficiently generating access to financial services and their wealth generation effects.
So what might such a system or systems look like?
Welcome to the world of Decentralized Finance, or “DeFi.” DeFi is, in my opinion, the most revolutionizing ongoing development in the world of finance. Powered by technology, entire decentralized, peer-to-peer financial ecosystems are active or being developed. This combination of decentralized applications, cryptocurrencies and smart contracts can essentially put any financial service at anyone’s fingertips. Within them, participants can both offer and consume these services without interacting with a traditional financial institution. As an example, a more mature case is lending and borrowing protocols such as Compound where users are able to offer crypto assets as lenders or borrow them from other participants. Lenders earn interest rates, which are determined via smart contracts and algorithms, while borrowers can access leverage for other operations. Smart contracts dictate collateralization amounts and are self-executing, thus guaranteeing trust. Anything from derivatives creation and trading to automated wealth management and even digital art marketplaces can be found in the world of DeFi.
The implications of this are far-reaching. As they develop and scale, decentralized, self-governing financial systems, unconstrained by the structures of the traditional financial system, have the capacity to bring the benefit of financial services to many more people. Within them, users can participate as both suppliers and consumers and even vote on system regulations and decision-making, generating more wealth and equitable distribution for participants. Financial innovation is also exponentially increased as it becomes possible to create, fund, and execute a wide array of user generated, customized products, further increasing reach, impact, and relevance.
It is also true, however, that DeFi is in its infancy. As of this writing, only about US$43 billion is estimated to be locked into its different protocols, though it has risen exponentially from the US$1 billion estimated last June. Still, it will take time to fulfill its promise. Technologies must improve, especially scalability and transactional costs. Access and products are still largely limited. Furthermore, as these applications mature, the question of regulation looms larger and will likely take center stage soon, affecting development in different geographies.
Regardless, as we have seen with cryptocurrencies already, if there is a real value and use case, all the pieces start falling into place. I would argue that, rather than discounting DeFi or sitting on the sidelines, businesspeople and policymakers in our region should embrace and understand its potential early, charting the course to what business and government interactions with decentralized financial applications may look like and how they may leverage them to generate value and achieve policy goals and impact. What would a world in which the most important financial institutions are funded and controlled directly by consumers look like? How would that affect large businesses and what opportunities for innovation may this present today? What if governments and regulators in the region got ahead of the curve, setting up experimental regulatory frameworks and attracting capital and talent to the region? It is hard to predict all the possible scenarios, of course, but if it’s enough to get you thinking, then I’ve done my job.