Decentralised Finance
Decentralised Finance commonly known as DeFi is an emerging technology that offers financial products without the need for intermediaries such as banks. It uses smart contract technology on a blockchain to record transactions.
DeFi runs on a decentralised network of computers and is connected with blockchain; an immutable, public ledger on which Bitcoin is based. This supports all computers, or nodes on a network to hold a copy of all historical transactions. Blockchain cannot be hacked or tampered with and no single entity has control over the ledger of transactions. DeFi can be used at any time, by anyone regardless of where they are in the world.
In comparison, banks and financial services are controlled by centralised institutions. The service provided can be expensive, reliant on 3rd parties and potentially restricted by trading hours . Banks tend to use single server solutions for their applications. The core systems of most traditional banks and institutions run on monolithic systems running a mainframe such as Oracle, Java, SQL Server or a similar application.
The Global Financial Crisis
The Global Financial Crisis was triggered by rock-bottom interest rates and a relaxed lending criteria. Decisions within this sector were made by centralised institutions and their industry expertise. The finance system at this time was taking on unsustainable risk. The phrase we heard at the time of collapse was ‘too big to fail’. It is believed that those working within these centralised organisations knew the institutions would be safeguarded. Possibly operating in the knowledge that the government would step in with a bailout package in the unlikely event the system started showing signs of weakness.
Even in a highly regulated environment investment banks were still able to offer mortgages to customers with bad credit scores and low income. Collateralised debt obligations were sold during this period which were riskier than mortgage-backed securities and sub -prime loans. Toxic assets were being sold to investors under the misapprehension that they were risk free. The rating agencies did not fully understand the investments being proposed and gave them the lowest rating risk. Despite these bad practices, financial institutions received the most money from the government in the rescue attempts. Millions of people lost their homes, jobs and nest eggs. No one bailed out the retail investor.
As a result, the Dodd-Frank Act was born in 2010 to crack down on risky lending, however bad practice has gradually crept back in.
The ‘Legacy System’
Over the decades, assets continued to rise but wages remained stagnant. The standard of living for average citizens diminished. One theory is living standards started to decline once Nixon unpegged the US dollar to gold thus removing the gold standard. This created a change in relative prices resulting from a change in money supply, otherwise known as the Cantillion effect. As a result, those in receipt of the money are the first benefit and everyone else thereafter suffered.
Another theory is those in traditional finance have been through the same school of economics. An educational program run and decreed by governments. They see inflation as normal and not as a silent tax. It is accepted that adjustments are made to the system from unelected officials at places such as the FED, ECB, and other central banks. Many economists believe that in order for this method to work we need to accept approximately 2% inflation for a productive economy. This narrative is useful if you need to build a society enslaved to debt but the levels of debt are becoming unsustainable and could eventually led to a currency collapse. We have already seen this happen in countries such as Venezuela. Turkey and Argentina are showing similar signs of trouble.
During our lifetime technology has moved quickly to make processes and society more efficient, but our inflation moves against us to drive costs up. These two systems are at loggerheads. We have accepted this flawed structure because no alternative was presented. Inflation impacts all of our lives and we accept it without question.
Governments essentially hide the spending rate in inflation, which has the added advantage of eroding their enormous debts. They then turn to the ‘money printer’ and create more wealth which makes the rich richer and the poor poorer. The poor turn to the government for assistance because wages are not keeping up with inflation. More money again enters the system through fractional lending, the debt cycle continues which exacerbates the rich/poor divide. This cycle has become worse in recent years and now it cannot be stopped.
Raising interest rates to slow growth is the short-term solution, and in turn this is expected to reduce inflation. As a result, the cost of servicing debt increases and GDP is dragged down. Assets will continue to rise; debt will spiral out of control and to keep it all afloat they will keep printing money. There may be a brief reprieve where quantitative tightening is introduced. Inevitably all roads lead back to quantitative easing in order to service the debt which grows when interest rates are increased.
Why is this relevant?
Despite the implementation of legislation and monetary policy, average people are still exposed to excessive risk. They lose as an individual and they lose as a tax payer. The bankers get bailed out, receive bonuses and avoid jail. Is it possible that regulators are in the pockets of Wall Street? The reluctance to give investors the chance to participate in an alternative system may suggest so.
All institutions operate within a centralised and regulated environment yet crashes are still triggered. It could be argued these crashes are cyclical and happen roughly every 12 years. However, this has not always been the case. The Wall Street crash of 1929 was followed by the Great Depression. Financial markets would not see another major crash until 12 October 1987, also known as Black Monday. During these two periods there was relative stability. The biggest shift in monetary policy occurred in 1971 when Nixon announced that the dollar would no longer be backed by gold. As previously mentioned, this allowed the US government to adjust the money supply. Most economists agree the system we have is better today, but the data does not support this. This view point may be born from the widely held view that inflation is to be expected and can be controlled by tweaking interest rates.
Once you allow free markets to be controlled by government bodies, this will ultimately lead to the system destabilising. We have to explicitly trust the abilities and agendas of the professionals put in charge of regulation. It’s a hard sell as Governments do not always act in the best interests of their citizens. Is the political system driving economics or is economics driving the political system?
Financial Conduct Authority - FCA
In January 2020 the FCA deregulated crypto. This was their statement.
The FCA considers these products to be ill-suited for retail consumers due to the harm they pose. These products cannot be reliably valued by retail consumers because of the:
inherent nature of the underlying assets, which means they have no reliable basis for valuation
prevalence of market abuse and financial crime in the secondary market (eg cyber theft)
extreme volatility in cryptoasset price movements
inadequate understanding of cryptoassets by retail consumers
lack of legitimate investment need for retail consumers to invest in these products
The FCA made this decision under the guise of protecting the consumer but instead they effectively drove the industry underground, giving rise to scammers and the industry a bad name. Rather than the innovation being celebrated, encouraged and embraced it was demonised and shunned. The lack of understanding they refer to in their statement makes little sense as we are all encouraged to seek financial advice from a professional before making decisions. The world of investments and equities has been made so complicated that one can only make an informed decision by paying a percentage of their wealth to those in the know. This suggests that the lack of understanding is within Financial Services or even worse, they simply want to keep the middlemen.
Volatility in the markets is also present on Wall Street and recently Bitcoin has held up better than most equities. Boom-and-bust cycles have become more extreme over time as a result of poor monetary policy. Retail investors have lost time and time again in these markets despite seeking professional financial advice. If we operate in a free market, then we should let the free market decide. Why is this innovation being stifled?
Why is DeFi different?
The crypto industry is brutal. There is very little forgiveness for an underperforming blockchain or protocol. Within the crypto industry the fragile and weak die, just like in nature. It seems to be the opposite in the legacy financial system where it does not matter what mistakes are made because the government will bail you out. Remember the phrase ‘Too Big to Fail’? These institutions make poor decisions, can desecrate peoples’ lives and are bailed out without repercussions. The legacy banking system does not prevent fraud and is too slow and expensive. Perhaps this is the normal push-back we get when we try and switch from analogue to digital or are our governments somehow benefitting from the current status quo? DeFi offers a service that is ethical and quick. Retail investors should be given the choice.
However, there are concerns regarding ownership, and this stems from the tenure of Web 2.0 and Web 3.0. Web 2.0 is the current version of the web whereas Web 3.0 represents the next phase, which will be decentralised, open-source, and of greater utility. Web 2.0 was essentially owned by corporations and Web 3.0 may be initially owned by venture capitalist. Asset ownership today may not be representative of asset ownership in the future. In order for Web 3.0 and blockchain to operate as a fairer system it needs to stay largely decentralised.
Could Bitcoin act as a Central Bank?
This sounds like a crazy notion but the idea has merit. It would inevitably come with its own set of issues yet to be identified, however the notion of a global monetary system with the rules already predefined and locked into code feels safer somehow. This could remove the control banks and institutions have on money, financial products, and financial services.
Bitcoin would provide an independent, predictable, transparent and accountable monetary system, which is the expected role of central banks. Bitcoin is decentralised, making it independent. The monetary policy is written in code making it predicable, the open-source ledger makes it transparent and fully auditable. It has all the necessary requirements for a global automated central bank. It would mean everyone on the planet would understand the monetary policy they are governed by now and in the future. This would free up economists and politicians to be more independent.
The Future
It would be naïve to think our monetary system could be solved entirely by decentralised finance. There will be bumps in the road and problems will arise that have not yet been considered. By modernising our financial system in this way, we will force institutions to act in an ethical manner. What history has shown us is the current system is imperfect and at a breaking point. DeFi has the potential to make financial services more efficient and transparent. Interoperability will expand across chains providing new technologies and solutions. This is a new space that has grown exponentially in a short space of time despite the drive by central authorities to halt it progress.
Speed, security & tokenonics will be at the forefront of this innovation and new and improved DeFi solutions will be born. Questions are being asked as to whether our financial system as it stands is ethical and whether it adequately protects its citizens. The next year will be crucial for this industry but I am hopeful for the future and excited to be a part of this brave new world.