Why decentralized finance isn’t just the Wild West of Wall Street

Senator Elizabeth Warren, who frequently inveighs against cryptocurrency, calls it “the most dangerous part of the crypto world.” She is talking about DeFi, or Decentralized Finance, a dark area of the crypto world, which, if successful, could upend traditional finance. The New York Times defines DeFi as “an umbrella term for the part of the crypto universe that is geared toward building a new, internet-native financial system, using blockchains to replace traditional intermediaries and trust mechanisms.” (nyti.ms/3K8fHPG ).

To exchange money or securities today, you need intermediaries like stockbrokers, banks or stock exchanges, and you need to trust them to act in your interest. Successive scams such as the 2008 financial crisis or the PNB crisis in India have shown that this is not always true—your interest being taken care of seems more an exception than the rule. Marc Andreesen, the a16z founder, famously wrote how “software is eating the world”. In the case of DeFi, software ‘eats’ middlemen. Instead of trading through stock exchanges, people deal with one another directly peer-to-peer, with blockchain-based ‘smart contracts’ fulfilling the role of intermediaries and creating a ‘crypto stock exchange’.

DeFi goes further than a stock exchange and seeks to replace everything in the financial world: prediction platforms, lending, options, derivatives, the works. It is a shadow Wall Street that is being built by crypto enthusiasts, one that’s completely decentralized, user owned and open sourced, with crypto-renderings of most TradFi (traditional finance) products, and virtually no regulation and bureaucracy. You could trade in crypto versions of Microsoft, Google and Tesla stock with these chips mirroring real-life equity. As of now, DeFi is incipient but not small; its ‘total value locked’ is pegged at $77 billion, which would make it the 38th largest bank by deposits in the US.

Among its foundational elements are stablecoins—cryptocurrencies whose value is pegged to that of fiat currency. In the DeFi world, stablecoins are what you keep your liquidity in, so as to trade tokens, lend and exchange. In theory, the typical stablecoin is pegged to one US dollar, and therefore needs a one-to-one backing by actual reserves. But there is no regulation governing this, so it’s hard to verify if such reserves exist. The uncertainty goes further. DeFi firms issue loans and credit cards and even open savings accounts without much of the protection that traditional banks offer. Almost all regulators on this planet are concerned about this and have begun prosecuting these firms. That most of them are intangible entities on the internet, often without a known physical address, makes this task difficult. No wonder NYT calls DeFi a “Wild West Wall Street”.

But then why is there so much excitement around it? A technical reason is that blockchain is a technology superior to what banks have, as most lenders still run on software written in Cobol, a 1960s programming language. Crypto lives on the internet, and so should internet banking. DeFi enthusiasts say they want to create a financial system that is free of the ills of today’s half-broken and over-centralized set-up.

For many, including me, the reason is more philosophical: DeFi is the financial system of the Web3 world. It substitutes biased human intermediaries with trust-building technologies like blockchain and open-source software. It makes transactions cheaper and helps more than intermediaries profit. It is almost instantaneous, with T+3 settlements a thing of the past, and much more transparent. Importantly, it is a democratizing force that empowers the end user to do things that only powerful intermediaries could. It has the potential to spread banking to hundreds of millions of the world’s unbanked. It is also brims with idealism over how to fix what is wrong with Wall Street and reduce its current power over corporations, countries and people. Yes, DeFi has teething problems, but ultimately it could turn robust and safe enough to replace banks and exchanges with democratic user-owned collectives—a left-of-centre vision which capitalism would scoff at.

As I researched this article, I found that one of the first ever books on a stock exchange was written by a Dutch-Jewish trader Joseph de la Vega. He wrote about the inner workings of the Amsterdam Stock exchange of his time, which he said was sophisticated but “prone to excesses of all kinds”. If you read this 1688 treatise, you might think he is describing modern DeFi. The title of his seminal book was apt: Confusion of Confusions. Hopefully, decentralized systems can sort some of these out.

Jaspreet Bindra is the chief tech whisperer at Findability Sciences, and learning AI, Ethics and Society at Cambridge University.