Can decentralised finance lay the foundations for an open digital economy?
The avatars are mostly cartoon versions of people. They are all milling around a swimming pool built like a funnel, with virtual water sliding out of sight through its navel. To move, users manipulate keyboard controls familiar to anyone who misspent their youth playing computer games: w, a, s, d to walk forwards, left, backwards and right; space bar to jump. A sign next to the pool reads “diving allowed”. Your correspondent presses w and her flaxen-haired simulated self climbs up and over the edge of the red diving board, plunging into the pool’s centre.
This is what it is like to enter Decentraland, a virtual-reality platform built on the Ethereum blockchain, also known as a “metaverse”, where virtual shops sell digital collectables and tokens. The disorientating “down the rabbit hole” feeling of diving in is all too similar to what you feel when you first hear of developers’ efforts to “decentralise” everything you do online. A growing number of them are seeking to rebuild both the financial system and the internet economy using blockchains—databases distributed over many computers and kept secure by cryptography. The ultimate goal is to replace intermediaries like global banks and tech platforms with software built on top of networks that direct the value they generate back to the users who own and run them.
DeFi has grown tremendously in scale and scope in recent years. The Ethereum blockchain, which underpins much of DeFi activity, settled $2.5trn-worth of transactions in the second quarter of 2021, including payments and transactions to facilitate trading and lending. (Visa, a payments giant, settled about the same amount in the same period; Nasdaq, a stock exchange, traded six times as much.) Around $90bn of collateral is being used for various DeFi functions, compared with less than $1bn in early 2018. More than half is held in the five most popular DeFi applications, but developers are working on more than a hundred others, dozens of which are rapidly amassing assets. Innovations, such as automated marketmakers, arbitrage systems and self-stabilising currency regimes, are already pushing the boundaries of financial technology.
The promise of DeFi is that it could lead to a better kind of finance: a system that is quicker, cheaper, more transparent and less reliant on powerful centralised institutions. It could also underpin a digital economy that is less dominated by a handful of tech giants. But there are plenty of pitfalls in the way, not least the huge amount of speculation taking place in the world of DeFi and the risk that it becomes colonised by dirty money or sullied by blockchains’ vast energy use.
DeFi’s opportunity comes about because centralisation brings problems. True, it is cheaper to build a financial-settlement system run by an entity everyone trusts, such as the Federal Reserve, than to get a diffuse group of individuals to verify transactions. But government infrastructure ossifies. Private networks can tend towards monopoly, encouraging anti-competitive behaviour and rent extraction.
Once a decentralised foundation to store and execute lines of code has been laid, anything can be built on top—assets, say, or applications (see chart 2). The only limit is the developer’s imagination. All kinds of “tokens”, or digital representations of assets, exist. Some resemble financial building-blocks, like shares, bonds and “stablecoins”, which are typically pegged to conventional currencies. Others are governance tokens, which work as votes determining how daos are run. And “non-fungible” tokens (nfts) represent unique assets, like an image or a video. The market for these has boomed over the past year. Some $23bn-worth of nfts now exist.
More read: https://www.economist.com/briefing/2021/09/18/adventures-in-defi-land