take three days to complete.In an attempt to mitigate this issue within the world of centralized finance, in 2019 Visa tried to acquire Plaid,3 a product that allows any company to plug into an institution's information stack with the user's permission. Though this was a strategic move to help Visa buy some time, it did not address the fundamental problems with the current financial infrastructure.5 Opacity. The current financial system is not transparent. Bank customers have very little information on the financial health of their bank and instead must place their faith in the limited government protection of FDIC insurance on their deposits. Further, it is difficult for them to know if the rate they are offered on a loan is competitive. Although the consumer insurance industry has made some progress with fintech services that offer to find the “lowest” price, the loan market is very fragmented – yet competing lenders all suffer from the system's inefficiencies. The result is that the lowest price still reflects legacy brick-and-mortar and bloated back-office costs.
IMPLICATIONS
The implications of these five problems are twofold. First, many of these costs lead to lower economic growth. For example, if loan rates are high because of legacy costs, high-quality investment projects may be foregone, as explained previously. An entrepreneur's high-quality idea may target a 20 percent rate of return – precisely the type of project that accelerates economic growth. If the bank tells the entrepreneur to borrow money on their credit card at 24 percent per year, this seemingly profitable project may never be pursued.
Second, these problems perpetuate or exacerbate inequality. Across the political spectrum, most people agree there should be equality of opportunity: a project should be financed based on the quality of the idea and the soundness of the execution plan and not by other factors. Importantly, inequality also limits growth when good ideas are not financed. Though purported to be the land of opportunity, the United States has one of the worst records in migrating income from the bottom quartile to the top quartile.4 Inequality of opportunity arises, in part, from lack of access to the current banking system, reliance on costly alternative financing such as payday lending, and the inability to buy or sell in the modern world of e-commerce.
These implications are far-reaching, and, by any calculations, this is a long list of serious problems endemic to our current system of centralized finance. Our financial infrastructure has failed to fully adapt to the digital era in which we are living. Decentralized finance offers new opportunities. The technology is nascent, but the upside is potentially transformational.
Our book has multiple goals. First, we identify the weaknesses in the current system, including discussion of some early initiatives that challenged the business models of centralized finance. Next, we explore the origins of decentralized finance. We then discuss a critical component of DeFi: blockchain technology. Next, we detail the solutions DeFi offers and couple this with a deep dive on some leading ideas in this emerging space. We then analyze the major risk factors and conclude by looking to the future and attempt to identify the winners and losers.
NOTES
1 1. See Alan White, “David Graber's Debt: The First 5000 Years,” Credit Slips, June 24, 2020, https://www.creditslips.org/creditslips/2020/06/david-graebers-debt-the-first-5000-years.html.
2 2. Dean Corbae and Pablo D'Erasmo, “Rising Bank Concentration,” Staff Paper #594, Federal Reserve Bank of Minneapolis, March 2020, https://doi.org/10.21034/sr.594 .
3 3. Plaid, http://plaid.com.
4 4. R. Chetty, N. Hendren, P. Kline, and E. Saez, “Where Is the Land of Opportunity? The Geography of Intergenerational Mobility in the United States,” Quarterly Journal of Economics 129, no. 4 (2014): 1553–1623; Amber Narayan et al., Fair Progress?: Economic Mobility Across Generations Around the World, Equity and Development, Washington, DC: World Bank, 2018.
II THE ORIGINS OF MODERN DECENTRALIZED FINANCE
A BRIEF HISTORY OF FINANCE
Even as today's financial system is plagued with inefficiencies, it is far better than those of the past, where market exchanges were peer to peer and bartering required two parties' needs to match exactly. Out of this, an informal credit system emerged in villages whereby people kept a mental record of “gifts.”1
Modern coinage came much later, first emerging in Lydia around 600 BCE and providing what we think of as today's functions of money: unit of account, medium of exchange, and store of value. Important characteristics of money included durability, portability, divisibility, uniformity, limited supply, acceptability, and stability. Bank notes, originating in China, made their way to Europe in the thirteenth century.
Nonphysical transfer of money originated in 1871 with Western Union. Figure 2.1 shows a copy of an early transfer for $300. Notice how the fees amount to $9.34, or roughly 3 percent. It is remarkable that so little has changed in 150 years: money transfers are routinely more expensive, and credit card fees are 3 percent.
Figure 2.1 Western Union transfer from 1873
Source: Western Union Holdings, Inc.
The last 75 years has seen many firsts in the financial world: credit card in 1950 (Diners Club); automated teller machine (ATM) in 1967 (Barclays Bank); telephone banking in 1983 (Bank of Scotland); Internet banking in 1994 (Stanford Federal Credit Union); radio-frequency identification (RFID) payments in 1997 (Mobil Speedpass); chip-and-pin credit cards in 2005 (Mastercard); and Apple Pay with a mobile device in 2014 (Apple).
Importantly, all these innovations were built on the backbone of centralized finance. While there have been some technological advances, the structure of today’s banking system has not changed much in the past 150 years. That is, digitization still supported a legacy structure. The high costs associated with this legacy system has spurred further advances known as fintech.
FINTECH
When costs are high, innovation will arise to capitalize on inefficiencies. Sometimes, however, a powerful layer of middle people can slow this process. An early example of decentralized finance emerged in the foreign currency (forex) market 20 years ago. At the time, large corporations used their investment banks to manage their forex needs. For example, a U.S.-based corporation might need €50 million at the end of September to make a payment on some goods purchased in Germany. Its bank would quote a rate for the transaction. At the same time, another client of the bank might need to sell €50 million at the end of September. The bank would quote a different rate. The difference in the rate is known as the spread – the profit the bank makes for being the intermediary.
