and Managing Partner, ParadigmCo-founder, Coinbase
PREFACE
Decentralized finance (or DeFi) has always been a big part of what I hoped to see people build on Ethereum. Ideas around user-issued assets, stablecoins, prediction markets, decentralized exchanges, and much more had already been at the top of my mind as well as the minds of many others trying to build the next stage of blockchain technology in those special early days of 2013–14. But instead of creating a limited platform targeting a set of known existing use cases, as many others did, Ethereum introduced general-purpose programmability, allowing blockchain-based contracts that can hold digital assets and transfer them according to predefined rules, and even support applications with components that are not financial at all.
People in the Ethereum community started working on applications such as on-chain stablecoins, prediction markets, and exchanges almost immediately, but only after more than five years did the ecosystem truly start to mature. I believe that DeFi will create a new, easy-to-use and globally accessible financial system for the world. For example, applications like stablecoins are some of the most valuable innovations to come out of DeFi so far. They allow anyone in the world to benefit from the censorship resistance, self-sovereignty, and instant global accessibility of cryptocurrency while having the purchasing power stability of the dollar—or, if the dollar ever stops being stable, they enable people to quickly move their funds into another asset that does a better job of maintaining stability.
So why is DeFi important? Financial censorship continues to be a problem for marginalized groups, with restrictions and imposed hardships often going far beyond what is actually required by any law. This is doubly true once we start looking beyond the relatively safe bubble of developed countries. DeFi greatly reduces the cost of experimentation, making it much easier to build a new application, and smart contracts with verifiable open-source code greatly reduce the barrier of needing to trust the founding team to manage funds. DeFi offers “composability,” allowing new applications to easily and immediately interoperate with any other applications that already exist. These are serious improvements over the traditional financial system, and ones that I believe remain under-appreciated.
In the book DeFi and The Future of Finance, the authors discuss many of the additional improvements DeFi offers over the traditional financial system. The authors also explain the in-depth workings of many of the most important DeFi protocols today, including stablecoins, automated market makers, and more. I recommend this book to anyone interested in learning more about Ethereum and DeFi protocols.
Vitalik Buterin
Co-founder of Ethereum
I INTRODUCTION
We have come full circle. The earliest form of market exchange was peer to peer, also known as barter.1 Barter was highly inefficient because supply and demand had to be exactly matched between peers. To solve the matching problem, money was introduced as a medium of exchange and store of value. Initial types of money were not centralized. Agents accepted any number of items such as stones or shells in exchange for goods. Eventually, specie money emerged, a form in which the currency had tangible value. Today, we have non-collateralized (fiat) currency controlled by central banks. The form of money has changed over time, but the basic infrastructure of financial institutions has not.
However, the scaffolding is emerging for a historic disruption of our current financial infrastructure. DeFi, or decentralized finance, seeks to build and combine open-source financial building blocks into sophisticated products with minimized friction and maximized value to users utilizing blockchain technology. Given it costs no more to provide services to a customer with $100 or $100 million in assets, we believe that DeFi will replace all meaningful centralized financial infrastructure in the future. This is a technology of inclusion whereby anyone can pay the flat fee to use and benefit from the innovations of DeFi.
DeFi is fundamentally a competitive marketplace of decentralized financial applications that function as various financial “primitives” such as exchange, save, lend, and tokenize. These applications benefit from the network effects of combining and recombining DeFi products and attracting increasingly more market share from the traditional financial ecosystem.
Our book details the problems that DeFi solves: centralized control, limited access, inefficiency, lack of interoperability, and opacity. We then describe the current and rapidly growing DeFi landscape and present a vision of the future opportunities that DeFi unlocks. Let's begin with the problems.
FIVE KEY PROBLEMS OF CENTRALIZED FINANCIAL SYSTEMS
For centuries, we have lived in a world of centralized finance. Central banks control the money supply. Financial trading is largely done via intermediaries. Borrowing and lending are conducted through traditional banking institutions. In the last few years, however, considerable progress has been made on a much different model: decentralized finance. In this framework, peers interact with peers via a common ledger not controlled by any centralized organization. DeFi offers considerable potential for solving the following five key problems associated with centralized finance: centralized control, limited access, inefficiency, lack of inoperability, and opacity.
1 Centralized Control. Centralization has many layers. Most consumers and businesses deal with a single, localized bank, which controls rates and fees. Switching is possible, but it can be costly. Further, the U.S. banking system is highly concentrated. The four largest banks have a 44 percent share of insured deposits compared with 15 percent in 1984.2 Interestingly, the U.S. banking system is less concentrated than other countries, such as the United Kingdom and Canada. In a centralized banking system, one consolidated entity attempts to set short-term interest rates and to influence the rate of inflation.This phenomenon reaches beyond the legacy financial sector to tech players like Amazon, Facebook, and Google, who now dominate industries like retail sales and digital advertising.
2 Limited Access. Today, 1.7 billion people are unbanked, making it very challenging for them to obtain loans and to operate in the world of internet commerce. Further, many consumers must resort to payday lending operations to cover liquidity shortfalls. Being banked, however, does not guarantee access. For example, a bank may not want to bother with the small loan that a new business requires. Instead, it may suggest a credit card loan, which carries with it a borrowing rate well above 20 percent per year – a high hurdle rate for finding profitable investment projects.
3 Inefficiency. A centralized financial system has many inefficiencies. Perhaps the most egregious example is the credit card interchange rate that causes consumers and small businesses to lose up to 3 percent of a transaction's value with every swipe due to the payment network oligopoly's pricing power. Remittance fees are 5–7 percent. Time is also wasted in the two days it takes to “settle” a stock transaction (officially transfer ownership). In the Internet age, this seems utterly implausible. Other inefficiencies include costly (and slow) transfer of funds, direct and indirect brokerage fees, lack of security, and the inability to conduct microtransactions, many of which are not obvious to users. In the current banking system, deposit interest rates remain very low and loan rates high because banks need to cover their brick-and-mortar costs. The insurance industry provides another example.
4 Lack of Interoperability. Consumers and businesses deal with financial institutions in an environment that locks interconnectivity. It is well-known that the U.S. financial system is siloed and designed to sustain high switching costs. Moving money from one institution to another can be unduly lengthy and complicated.
