What Traditional Finance Can Teach Us About #DeFi

DeFi unites projects creating new ways to trade, leverage, and manage digital assets, but how do they compare with centralized financial tools? Learning about finance can help us think about the effects DeFi might have on the financial sector. Finance may not be for everyone, but it rewards those who respect its teachings. It also provides insight on problems with financial institutions and helps us understand what parts of finance we aim to “decentralize.”

Re-Buidling Finance

The first step to understanding finance is knowing the areas it’s concerned with. Finance encompasses the theory and practice of managing and acquiring money under three different umbrellas: personal, corporate, and public finance.

  • Personal finance involves studying an individual or family’s income and expenses to help determine the best strategies for managing their money.
  • Corporate finance refers to the analysis of how the money flows in a business, from daily expenses and revenue to capital-raising events.
  • Public finance studies the ways that governments collect money through tax and debt issuance and how it gets budgeted and spent.

How might DeFi projects affect personal, corporate, or public finance? John Dantoni of The Block put together a nice graphic grouping DeFi products built on Ethereum by function, but it doesn’t reveal much about target audiences. The majority of DeFi usage has been on a personal basis at this point, but it would be naive to assume that the corporate and public sectors will remain in the dark.

After all, anyone can build on platforms like 0x and Augur. A number of prominent projects in DeFi would actually welcome partnerships from major financial institutions, over the protest of some with libertarian or cypherpunk leanings. I don’t mean to suggest that major financial institutions will build on platforms like 0x or Augur, but they could be adapted for corporate or public uses. Creating financial products and services using decentralized infrastructure means operating in grey markets. If black or grey markets begin to compete with white markets, regulators will take notice and respond. FinTech will revolutionize the management of assets, but the degree to which DeFi influences that management remains an open question.

Issues In Finance

Anthony Pompliano’s mantra, “Long Bitcoin, Short the Bankers” isn't without merit. Financial institutions like banks tend to keep frustratingly short hours and heap fees on those least able to pay them. Financial institutions also fuel the type of rampant speculation that causes financial disasters. Secure wallets with support for stablecoins could be used in place of checking and savings accounts. It would be difficult to create a system for decentralized loans at the scale banks can offer, but lending protocols like ETHLend and crowdfunding platforms like Gitcoin provide interesting opportunities.

In the United States, investors must meet accreditation requirements to access investments not registered with financial authorities. Unregistered securities may pose greater risk to investors, but potentially offer higher rewards as well. Authorities claim to restrict access to investments to protect unaccredited investors, but nothing stops them from buying lottery tickets. DeFi aims to be available to as wide an audience as possible, a fact that will inevitably come to affect traditional financial instruments. The average annual compounded interest rate on ETHLend has been a staggering 82.3% and statistics like this will be hard for financial professionals to ignore.

By definition, finance grapples with theories about the best practices for raising and managing funds in different scenarios. ICO’s can be considered an innovation of DeFi that have affected corporate fundraising and will have implications for corporate and public fundraising in the future. 2017 was a disaster, but the opportunity to use smart contracts to promote accountability to investors remains.

Decentralizing The System

It’s easy to get excited about being your own bank when you get frustrated with your bank or payment processor. It’s also easy to get frustrated with your bank or payment processor. Not everyone wants to, or even understands how to “be their own bank,” however. This is why it’s important to understand what aspects of finance we’re trying to decentralize. Providing access to financial tools and services using decentralized infrastructure is not the same as creating tools and services that decentralize access to financial infrastructure. Many assume that “decentralized” automatically means “inclusive,” but DeFi tools still require a high level of technical ability and financial literacy.

“Decentralization maximalists” might be surprised to realize that banks themselves play a critical role in efforts to promote financial inclusion. As explained in a report entitled “Role of banks in financial inclusion in India”,

“Access to financial services has been recognized as an important aspect of development and more emphasis is given to extending financial services to low-income households as the poor lack the education and knowledge needed to understand financial services that are available to them.”

The movement around financial inclusion recognizes banks as a critical intermediary. Banks provide savings accounts, evaluate creditworthiness, and extend loans that stimulate commercial activity. More importantly, they provide opportunities to educate individuals on financial literacy. If projects in DeFi wants to take on financial inclusion, they will have to get serious about the challenge of educating people about basic finance.

The absence of legal identity and financial literacy across parts of the world remains a significant hurdle to financial inclusion. By 2030, the U.N. aims to provide a legal identity for every individual on the planet and promotes financial inclusion in support of its development goals. DeFi projects may work with stakeholders to develop solutions to financial inclusion or create their own new approach, but the problems decentralization aims to solve have already been recognized. Whether DeFi decides to carve its own path to financial inclusion or works with existing institutions, it will have to do more than create decentralized infrastructure to do so.

Conclusion

Do the projects of DeFi "fit in" with traditional finance? Or do they represent new offerings with their own unique advantages and disadvantages? It’s too early to tell how DeFi will be integrated, and compete with centralized financial products and services, but the movement has solidified a use case for blockchain and distributed ledger technology. One of the critical takeaways from the 2017 ICO craze (and watching tech startups in general) is the importance of understanding the problems you’re trying to solve before holding up a half-baked proof-of-concept as the next “killer app.” While it’s impossible to tell if blockchain’s first “killer app” will come from DeFi or not, the products being introduced by DeFi will certainly shake up the game.