The dream that decentralized finance – or “DeFi” – being able to free the monetary system from the clutches of governments and banks has helped launch 20,000 cryptocurrencies.
But with 2022 proving to be more of a crypto nightmare — including for the vaunted “stablecoins” that held the most promise as rivals for central bank-issued currencies — questions are now being raised as to whether DeFi really has a future.
There are predictions that the cryptocurrency market, which has lost more than half of its value in the first six months of 2022, could collapse further – or be on the brink of recovery. This speaks for the fact that crypto is great for gambling, but still worthless as a usable currency. It also lacks other useful attributes.
To assess DeFi’s prospects, it’s helpful to consider how finances were centralized in the first place.
Origin of money
Money is a feature of increasingly sophisticated human networks. When we lived as hunter-gatherer groups, there was little need for this. One could keep an informal record of the favors owed.
With the increased complexity of established communities, in which people specialized in activities that matched their skills and preferences, the barter system became the norm.
But barter required a double confluence of desires. One who had surplus food and wanted help building a house had to find a hungry builder. They then had to negotiate how many hours of labor was a fair exchange for a meal.
So “money” was invented.
Money can be shells or a useful good that can be kept. It may be a count of debts recorded somewhere safe (the earliest forms of writing, dating back to 3000 BC, were cuneiform financial administration). Then came man-made tokens, leading to coins of rare metals†
The origins of banking
Money meant that people could save the rewards of their labor and lend it to others. But it was a challenge to bring lenders and borrowers together and assure the lenders that the borrowers would repay. That’s why banks were created.
Banks not only issued a convenient form of money in the form of coins and bills. They also offered four basic banking services:
- bundling: by accumulating many small deposits, they can make large loans
- diversification: by lending to a series of borrowers, one default mattered much less
- risk assessment: specialized skills in assessing reliability reduced defaults
- maturity transformation: they could make loans for a longer period of time than most savers wanted to keep their money in the bank.
The oldest bank still active is that of Italy Monte dei Paschi di Sienafounded in 1472.
Tackling problems with banks
But private banks with their own currencies was not a stable system. So-called “bank runs” occurred when depositors lost confidence in a bank and tried to withdraw their money. When a bank was unable to exchange all the requested notes or deposits, panic ensued.
Bank runs were often contagious. People found it difficult to discern whether a bank had a quirky problem (such as a fraudulent manager) or a general problem (such as an economic downturn leading to bad debts). A run on one bank often led to runs on other banks.
In the 20th century, most countries solved these problems by issuing a government-owned central bank and regulating private banks to ensure depositors’ solvency. These regulations implied, among other things, that banks were obliged to keep a minimum part of their assets available for withdrawals and to take out deposit insurance.
The Decentralized Finance Movement
However, this process of bank centralization has not been universally welcomed. Libertarians are suspicious of the system’s reliance on government-issued monopolies and licensed banks. They hate banks almost as much as they hate governments. They view centralized finance as both inefficient and coercive.
Their dream: decentralized (or disintermediate) financing, allowing instant transactions, without the need for intermediaries. Eliminating the ‘middleman’ will lower transaction costs and limit the power of the state over individuals.
The ‘decentralization illusion’
But as the massive losses within the cryptocurrency markets in recent months demonstrate, DeFi has yet to prove that it is a viable alternative to the centralized banking system. It remains unclear how the four banking services discussed above can be provided without trusted financial intermediaries.
Indeed, according to economists with the Bank of International Settlements (the central bank of central banks):
While the main view of the DeFi proponents is mediation without centralized
entities, we argue that some form of centralization is inevitable. As such, there is a “decentralization illusion”.
Few uses other than speculation
As the BIS economists point out, decentralized finance still has few real economic applications. Most of the time it has facilitated speculation. But what attracts speculators – wildly fluctuating prices – makes for a bad currency.
A salutary lesson comes from the experience of two (former) top ten cryptocurrencies, TerraUSD and its stablemate Luna. TerraUSD was believed to be a “stablecoin”, with a value pegged to US$1. That was true until early May. By the end of May, it was trading at less than 3 cents. In the same period, the price of Luna fell from $82 until 0.02 US cent†
These examples illustrate how cryptocurrencies such as Bitcoin, without any fundamental valueare speculative gambling games.
So central bank currencies still have no rivals for the day-to-day business of buying and selling things, and are still much safer stores of value than crypto, even with inflation eroding their purchasing power.
- 1 Origin of money
- 2 The origins of banking
- 3 Tackling problems with banks
- 4 The Decentralized Finance Movement
- 5 The ‘decentralization illusion’
- 6 Few uses other than speculation