Tudor Place

TUDOR PLACE: The financial world started talking seriously about dis-intermediation in the 1980’s. Now with the blockchain and crypto, there’s a way to pursue it beyond anyone’s original wildest dreams. And the methodology currently under review – and to a small degree already in use – is Decentralized Finance (DeFi).

Is this the next thing? A panacea? A trap? Something elites will inevitably corrupt and control?

Here’s a precis, including my comments, of an analysis of a study called DeFi Beyond the Hype which The Wharton School put together in May of this year.

THE FUNDAMENTALS

DeFi is a general term for decentralized applications (Dapps) providing financial services on a blockchain settlement layer, including payments, lending, trading, investments, insurance, and asset management. DeFi services typically operate without centralized intermediaries or institutions, and use open protocols that allow services to be programmatically combined in flexible ways.
DeFi leverages blockchain technology to facilitate alternatives to traditional service providers and market structures. It offers the potential for innovation and creation of new services for improving efficiency of financial markets—building upon work being done in financial technology (fintech) and blockchain technology more broadly. Whether it achieves this promise remains to be seen.

DEFI BUILDING BLOCKS

Blockchains: Distributed ledgers serving as the settlement layer for transactions. Currently, most DeFi services operate on the Ethereum network, due to its capabilities and developer adoption. DeFi activity is growing on and across other blockchains as well.
Digital Assets: Tokens representing value that can be traded or transferred within a blockchain network. Bitcoin and other cryptocurrencies were the first blockchain-based digital assets. Others have a range of intended functions beyond payments.
Wallets: Software interfaces for users to manage assets stored on a blockchain. With a non-custodial wallet, the user has exclusive control of funds through their private keys. With custodial wallets, private keys are managed by a service provider.
Smart Contracts: Blockchain-based software code that carries out, controls, and documents relevant events and actions according to predefined terms and rules.
Decentralized Applications (Dapps): Software applications built out of smart contracts, often integrated with user-facing interfaces using traditional web technology.
Governance Systems: Software-based mechanisms that manage changes to smart contracts or other blockchain protocols, often based on tokens that allocate voting rights to stakeholders.
Decentralized Autonomous Organizations (DAOs): Entities whose rules are defined and enforced in the form of smart contracts.
Stablecoins: Digital assets whose values are pegged to a fiat currency, a basket of fiat currencies or other stable-value assets.
Oracles: Data feeds that allow information from sources off the blockchain, such as the current price of a stock or a fiat currency, to be integrated into DeFi services.

TUDOR PLACE: Did you get all of that? This is a TECH-FINANCE world UNTO ITSELF. Something much easier to GROW INTO than learn at an ADVANCED AGE or even in one’s prime.

DEFINING CHARACTERISTICS

Financial services: DeFi directly mediates the transfer and exchange of value. Auxiliary services such as oracles, query systems, and decentralized storage may be important enablers of DeFi activity, but they should be distinguished from DeFi services themselves.
Trust-minimized operation and settlement: DeFi projects generally build on public, permissionless blockchains offering smart contract functionality, such as Ethereum. Transactions are executed and recorded according to the rules of the DeFi protocols. Trust minimization is often extended to the governance structures that establish the conditions for protocol changes.
Non-custodial design: The assets issued or managed by DeFi services cannot in theory be unilaterally expropriated or modified by third parties, even by those providing intermediation and other services. Users retain full control. Thus, centralized cryptocurrency exchanges that have custody over digital assets are not DeFi businesses, though many are developing DeFi offerings.
Open, programmable, and composable architecture: There is broad availability of the underlying source code and a public application programming interface (API). Components can be composed together and programmed to create new financial instruments and services dynamically. For example, a stablecoin may be used as the foundation for a derivative which is used as collateral on a loan and subject to an insurance contract.

TUDOR PLACE: Again, the level of sophistication and technical specificity here is considerable. And since DeFi is precisely about eliminating intermediaries – ALL OF WHOM ARE PROFESSIOALS TO SOME EXTENT – will everyone need an extreme amount of techno-financial training simply to MANAGE THEIR OWN FINANCES? Because by definition, there will no longer be a need for EXPERTS?

Really?

Or will we simply hire these people back to act as OUR AGENTS, thereby RE-INTERMEDIATING.

And that’s just my FIRST question.

COMPARING TRADITIONAL FINANCE TO DEFI

TRADITIONAL FINANCE

Custody of Assets – Held by a regulated service provider or custodian on asset owners’ behalf.
Units of Account – Typically denominated in fiat currency.
Execution – Intermediaries typically process transactions between parties.
Clearing and Settlement – Processed by service providers or clearinghouses, typically after a period of time.
Governance – Specified by the rules of the service provider, marketplace, regulator and/or self-regulatory organization.
Auditability – Authorized third-party audits of proprietary code or potential for open-source code that is publicly verified.
Collateral Requirements – Transactions may involve no collateral, or collateral less than or equal to the funds provided.

DEFI

Custody of Assets – Held directly by users in non-custodial wallets or via smart contract-based escrow.
Units of Account – Denominated in digital assets or stablecoins (which may themselves be denominated in fiat money).
Execution – Via smart contracts operating on the user’s assets.
Clearing and Settlement – Writing transactions to the underlying blockchain completes the settlement process.
Governance – Managed by protocol developers or determined by users holding tokens granting voting rights.
Auditability – Open-source code and public ledger allow auditors to verify protocols and activity.
Collateral Requirements – Overcollateralization generally required, due to digital asset volatility and absence of credit scoring.

TUDOR PLACE: Let’s look at these.

Custody of Assets – Which poses the greater COUNTERPARTY RISK – a traditional financial institution or an electronic wallet or contract-based escrow fund? Is there any way to know until we learn from experience? So, while there’s counterparty risk now, we have no idea of whether with DeFi, it would be greater or not. What we DO KNOW NOW is that until we know more, there will be some degree of unknowable, unquantifiable counterparty RISK in switching from traditional finance to DeFi.
Units of Account – Given the current volatility of digital assets, do we even know yet if they’re a viable unit of account AT ALL? Also, do we even yet know the likely relationship between stablecoins and fiat currency? Will sovereign states require stablecoins to be denominated SOLELY in fiat currency and, if so, how will that affect their stability one way or the other? Again, we simply DON’T KNOW. So again, more, as yet, unknowable RISK. Additionally, if stablecoins are denominated solely in fiat currency, what’s to prevent them and the rest of DeFi technology from becoming swept up into some sovereign directed system?
Execution – As long as DeFi’s technology WORKS and is “sufficiently” impenetrable, it would mark a significant improvement in efficiency. But routine operations must be ERROR FREE to an extremely high degree and the system’s vulnerability to hacking and other forms of attacks, minimal. And what’s the RISK that the blockchain won’t deliver AT SCALE? Again, we have no idea.
Clearing and Settlement – On paper, DeFi looks like a potentially enormous improvement in efficiency. Whether or not that proves out will depend – AGAIN – on the structural integrity of the blockchain’s architecture. Both from the outset and over time. But until we know that, MORE RISK.
Governance – Right now, this seems completely WIDE OPEN as per DeFi. And since it isn’t even clear how it would work, there’s no way yet to determine a potential RISK COEFFICIENT. But, honestly, are we ready to dispense with market practices, a rules based system and regulators? Which, at the same time, is not to say that the existing system can’t be IMPROVED. But at what point does efficiency become the WILD WEST?
Auditability – There doesn’t appear much difference between how outside third-party auditing would work under DeFi than how it does now under traditional finance. So, from a RISK standpoint, a change would unlikely materially affect things.
Collateral Requirements – Insufficient, re-hypothecated, phantom or any other type of inadequate collateral represents a major lending abuse in traditional finance. That DeFi collateralization would require security in excess of 100% might appear at first as an improvement. But in fact, it’s just as bad if not worse given that the over-collateralization required under DeFi is due to “digital asset volatility and absence of credit scoring.” In fact, one might view the RISK posed by these two factors as UNACCEPTABLE.

DEFI OPPORTUNITIES & CHALLENGES AS PER THE WHARTON SCHOOL PLUS TUDOR PLACE CRITIQUE

Opportunity: Reduced friction and transaction costs for creation, distribution, trading, and settlement of financial assets. Challenge: Scalability, throughput, and transaction fees for blockchain settlement platforms are significant limiting factors. Energy usage raises concerns about contributing to climate change.
TUDOR PLACE: With any new product or service, scalability is always the back breaker, while energy usage has now become existential. So, while reduced friction and transaction costs are a plus, what are they ACTUALLY WORTH if the system isn’t scalable or sufficiently energy efficient? Is digital currency worth the RISK of accelerating climate change?

Opportunity: Increased standardization and functional interoperability, allowing reuse and re-composition of financial primitives. Challenge: Limited interoperability across blockchains and with traditional financial services.
TUDOR PLACE: First, what’s a “financial primitive?” Regardless, there’s no question that blockchain functionality appears IN THEORY superior. Yet, it depends on whether or not it can become sufficiently integrated, so as to become UNIVERSAL. If not, much of its advantage DISAPPEARS.

Opportunity: Increased auditability and transparency of transactions through blockchain-based records. Challenge: Privacy considerations may be in tension with transaction transparency.
TUDOR PLACE: WHO GETS TO KNOW WHAT WHEN? And who decides. You can’t have equal measures of transparency and privacy. The way this is normally resolved is through the exercise of CENTRALIZED POWER. But in a DECENTRALIZED SYSTEM who assumes such power? Which then begs the deeper question – CAN THERE BE A DECENTRALIZED FINANCIAL SYSTEM OTHER THAN IN THEORY? POWER doesn’t operate IN THEORY.

Opportunity: Improved accountability for decisions through software-based governance Challenge: Immature governance as high-stakes decisions are made by small, inexperienced teams. Lack of accountability when developers are anonymous.
TUDOR PLACE: Purely decentralized systems are a UTOPIAN FANTASY. Power ALWAYS intervenes. It’s the fuel – the means of getting things done – of human relations. Some controlling entity opts in a SPECIFIC – USUALLY SELF-INTERESTED – DIRECTION. And POWER will simply not tolerate the RISK of “high-stakes decisions” being left to “small, inexperienced teams.” And for developers – a potential POWER BLOC in their own right – to remain anonymous is a complete NON-STARTER.

Opportunity: Greater stakeholder control through non-custodial, disintermediated service provision. Challenge: Hidden centralization of control and low thresholds for governance rights may give certain actors disproportionate power.
TUDOR PLACE: Seriously, under what conditions would control NOT BE CENTRALIZED or certain actors NOT ASSUME DISPROPORTIONATE POWER? This is not AI world. Despite DeFi’s hyper-tech nature, it’s both HUMAN-CREATED AND OPERATED. And where there are HUMANS, there are forces COMPETING FOR ADVANTAGE. Besides, what’s the definition of a stakeholder? One who merely PLAYS the game? Or the ones who ACTUALLY RUN IT? DeFi enjoys no mystical/magical immunity that will enable it to evade control by “CERTAIN ACTORS.” Networks can in theory be self-regulating, but POWER can SIEZE them at will.

Opportunity: Improved market access by providing global, 24/7 availability of services and removing barriers such as bank account requirements. Challenge: Regulatory questions and enforcement challenges in applying national legal requirements to decentralized global networks.
TUDOR PLACE: Ridding the world of bank accounts would in some respects be handy. But how do we totally dismantle the world’s patchwork legal and regulatory apparatus in a way that will satisfy SOVEREIGN STAKEHOLDERS. Again, while the efficiency angle is inarguable, the process management riddle remains unanswered and, in fact, may be UNANSWERABLE. Besides, when in matters of money or finance has any system relied on the IMPLIED UNIVERSAL INTEGRITY of a decentralized, SELF-REGULATING system. Are we ready to apply the HONOR SYSTEM to finance?

Opportunity: Faster settlement, reducing counterparty risks and freeing up capital. Challenge: Immature technology is being used to manage high-value assets. Poor design choices and implementations have led to significant losses.
TUDOR PLACE: Again, the efficiency positives are inarguable. BUT – they depend on a WORKABLE SYSTEM. PRAXIS rather than THEORY. And based on evidence already accumulated, DeFi is NOT YET a PRACTIAL ALTERATIVE. So, what are we to do? Muddle along – adding to economic, credit, market, political and compliance risk – SERIOUS AND ALREADY OCCURRING OPERATIONAL RISK? One has to ask – what greater case for SKEPTICISM is there than THIS?

Opportunity: Greater inclusivity of financial services by making automated tools available to all, with transparent and non-discriminatory execution. Challenge: Extreme short-term returns during DeFi’s early growth stage attract unscrupulous actors and warp user expectations. Limited usability impedes large-scale adoption.
TUDOR PLACE: The opportunity presented sounds almost like a pitch for DIVERSITY, INCLUSIVENESS and EQUITY. But as anyone SERIOUS knows, hardball finance has ZERO to do with any of that agenda and everything to do with ADVANTAGE, ARBITRAGE, LEVERAGE and GREED. Finance’s entire point is not EQUITY but ADVANTAGE-SEEKING and PROFITABILITY. To present DeFi as possessing some communitarian, quasi-socialist component would be to pivot to American lies-in-advertising at its worst. Besides, how practical is making automated tools available to all? First, given our educational system, will the average person be able to use them? And, second, and more importantly, are we to assume that that same person possesses the necessary intelligence, instincts and skills to make complicated CREDIT & FINANCE DECISIONS? NO MORE EXPERTS – just everyone now their own, self-appointed AMATEUR FINANCIER? REALLY?

Opportunity: Permissionless innovation, allowing the creation of novel products and services. Challenge: Potential for the facilitation of financial crime such as money laundering.
TUDOR PLACE: When since at least the 1980’s, has anyone in the US needed permission to innovate in finance? Now, if your innovation is meant to attack the country’s SOVEREIGN FINANCIAL LAWS, CUSTOMS AND PRACTICES – well – that’s ANOTHER STORY. And for that one CANNOT obtain permission. But if that’s not what DeFi’s doing, its right to innovate is not so much an opportunity as a GIVEN. And, yes, the “opportunity” for criminals to money-launder will exist along-side of it — as IT ALWAYS HAS.

TUDOR PLACE: As for the exact point where DeFi now finds itself, the Wharton School concludes as follows:

Despite its rapid growth, DeFi is still at an early stage.
Existing activity is largely speculative and targeted at existing digital asset holders.
Most of its services are nowhere near ready for “mainstream retail market participants.”
All manner of risks faced by all financial systems remain largely untested.
Hacks and attacks to drain funds are common and resulted in 2020 alone in the theft of $120 million, of which only $50 million was recovered.
Ethereum, which supports most DeFi activities, faces major scalability challenges.

What may very well happen is that Sovereigns will issue their own digital currencies, incorporating — as much as possible and/or desirable — as many of the efficiencies and innovations developed by, as yet, still “decentralized” issuers. Which is to say that it will be Sovereigns that dictate regulations, best practices, eligibility rules, concessionary/proprietary functions, transparency, privacy rights/limits and everything else having to do with how finance functions within a system of CENTRALIZED CONTROL as part of the existing NATION-STATE SYSTEM.

If not, the world will have arrived at a state of turmoil I hesitate to even CONTEMPLATE.

The other key determinant BESIDES SOVEREIGN/CONTROL in how this all plays out is RISK. DeFi on its face looks EXTREMELY RISKY and with far more potentially critical unknowns than knowns. Who other than geniuses, zealots, speculators and criminals — or some combination of each — are likely to plunge madly into something like this at the risk of financial self-destruction? Think about it.

CONCLUSION

To be clear, this analysis has addressed only the first-third of the Wharton School’s study. The rest of it deals with the following Defi Service Categories: