A Historical and Practical Take on Decentralized Finance: part 2

by Giacomo Franzoso
Feb. 18, 2020
8 minutes

In the previous article, we concluded that the term Decentralized Finance (DeFi) has become a buzzword in 2019 concerning the widespread adoption of Ethereum protocols such as MakerDAO and Compound. We tried to historically set the phenomenon called DeFi. We did that most impartially, objectively analyzing the matter, and we recognized Bitcoin as the first real application of Decentralized Finance. We achieved these statements after completing the analysis of common features and frictions between Bitcoin and the theories of the Austrian School.

This article will mostly focuses on the ecosystem of Ethereum and on some of its protocols that became of paramount importance for the expansion of Decentralized Finance and its application in real life. We will make examples of the fictional application of DeFi protocols concerning real events that happened in recent years to understand the degree of benefit derived from the employment of DeFi systems and whether these protocols are truly useful for the average citizen or not. Throughout the article, we will consider protocols that are used the most and possible future scenarios. Towards the end of the article, we will consider the problems related to DeFi that could limit its objectives.

Ethereum: the world computer

As I previously mentioned in the first article, the popularity of the term DeFi drastically increased because some of its protocols offer an inclusive alternative to regular financial instruments. Ethereum is the technological platform that made the development of these protocols possible. This article is fully focused on the way Ethereum unfolded starting from its founding principles and arriving at the emergence of an alternative financial ecosystem that remains concerned about inclusion when it is promoting economic policies.

Ethereum generates from Bitcoin since it replicates the architecture but Ethereum has different goals and it is leveraging the potentiality of the blockchain differently. Ethereum wants to become a decentralized world-computer able to execute complex programs, the smart contracts. Ethereum employs a virtual machine that is the place where smart contracts are executed. It is called the Ethereum Virtual Machine (EVM). The computational power has a cost, this cost is defined into a measurement that is called Gas that is paid in Ether which is the cryptocurrency of the Ethereum blockchain. This system guarantees a stable computation cost and balances the volatility of ETH with the stability of Gas.

Smart contracts were not invented by the Ethereum blockchain community. Smart contracts were mentioned in the first place by Nick Szabo in 1997 in his notorious article “The Idea of Smart Contract”. In his composition, Szabo explains the concept of smart contracts taking the sodas vending machine as an example.

There is a popular misconception in this matter, it is the one about Bitcoin not being able to run smart contracts, that is not true and in fact, that has been possible ever since the birth of
Bitcoin. The difference lies in the programming language used when coding smart contracts: in Bitcoin, the language used is Script which is a complete non-Turing language (Wikipedia link) whose execution is predictable for security reasons. Ethereum uses Solidity, this language is a complete Turing and it allows more flexibility during the coding phase but the execution of the language is less predictable making the appearance of bugs more likely therefore jeopardizing the safety of the smart contract itself (the hacking of “The DAO” due to miscoding in Solidity is an example). The debate is vivid also about this matter although both parties are willing to accept compromises in favor of safety on one hand and favor of flexibility on the other.

Ethereum invested a lot more in the application of smart contracts than Bitcoin. This move by Ethereum proved the dissimilarity between the two blockchain networks and put Ethereum on a different level. Very often the two networks are considered the same from a technical point of view while in fact, they have considerable architectural differences.

As the complexity in the process of coding of smart contracts and the creation of a code security-check grew so did innovation regarding DeFi starting from the deployment of the initial DAOs and terminating with the contemporary DeFi protocols such as MakerDAO, Compound, Uniswap, Sablier, etc. A complete list of DeFi projects can be seen here, the sheer length of the list gives us an idea on the importance and relevance of these new protocols (out of 213 projects 196 runs on Ethereum).

The fact that many DeFi projects are running their smart contracts on Ethereum created a higher demand for Ether. The higher demand drove the price of the cryptocurrency to the upside. For this reason, many businesses started to accept Ether as a form of payment. The only cryptocurrency accepted for payments had been Bitcoin only until Ether gained a reputation as the currency of the valuable blockchain that is called Ethereum.

Austrian School and currency areas

In the previous article, we discussed the differences between the theories derived from a part of the Austrian School and those comparable theories outlined ever since the creation of Bitcoin. We debated many aspects, but we left behind an aspect that is worth mentioning now in this dissertation. That is the topic of regionalism of currencies introduced by Hayek. In his work “Denationalisation of Money” the economist explains the possibility of formation of “currency area,”: in a context characterized by free market of currencies, it may happen that in some regions a specific currency takes over the market because it better suits the stabilization mechanisms of the territory, an example of this would be a currency related to a basket of commodities that corresponds to the necessities of that area. What Hayek wants to say is that it is desirable to have a monetary situation characterized by flexibility instead of a currency imposed by a central bank. In this situation we would have a twofold result: on one hand, it would take monetary power away from the government and the central bank, on the other, it would promote regional price balance rather than national price fluctuations. Whether these two aspects are convenient or not is a matter of debate that is not taken into consideration in this article.

The idea that the government will give up their monetary sovereignty and regional currencies will take over them is very much utopic. The key to interpretation here would be slightly shifted given the recent development of cryptocurrencies. Despite the difficulties, anyone would be facing in carrying out the theory of “currency area“, the concept behind it is more feasible in nowadays world than it could have been before, it is also actually practical in those countries that have huge regional differences such as Russia or China where there are regions that mainly make a living out of agriculture or mineral extraction. The inhabitants of these provinces would probably prefer to use a currency pegged to the commodities produced in the area instead of others native of faraway countries. In case this scenario came true, where many regional currencies are proliferating in many different territories, the real problem would become the implementation of a management system for the interactions of these currencies on a macro level. This aspect as well deserves particular and detailed attention, for now, we will stick to the part of the theory that hypothetically coincides the “regionalism” from Hayek with cryptocurrencies whose stable value (stablecoins) would be pegged to a basket of commodities (this is what Libra intended to do). Stable coins may become popular on a regional level due to the reasons cited above thus becoming the currencies of choice for the populations living in those areas because of the practicality and the stability of their purchasing power over time. There is another way to interpret the whole topic and it is more related to the Ethereum ecosystem. In this context, we can compare all those utility tokens (token with a specific function within a specific project) with the currencies hypothesized by Hayek that are not pegged to regional commodities but specific functions within the ecosystem. In this case the regionalism we refer to is technological and refers to those projects that are shaping Web 3.0.

DeFi today and how Venezuelans could have used it

Let us now move back to the main topic of this article. We will consider the contemporary status of DeFi posing a major focus on the Ethereum ecosystem to frame it in the real world. Before we start to deepen the topic, I would like to highlight that DeFi should find its short-term area of development in those countries whose monetary policies are badly managed, manly dictatorships or highly politically unstable countries. Bad monetary policies can bring high currency volatility and, in the worst cases, hyperinflation. It is unlikely to see DeFi flourish or even just have a significant impact in the west (North America and Europe), at least not in the short term. That is because, in general, westerner countries enjoy relative economic stability.

The main impact would be in those regions of the world where countries do not have internationally strong and/or nationally stable currencies such as Africa, Latin America, and Southeast Asia. Here comes again the topic of monetary sovereignty which is in the hands of the governments and the central banks whose actions are not always beneficial for the population.

Let us take into consideration one of the most famous (infamous) cases that international media paid attention to in recent years: the Venezuelan Bolivar. The currency of this Latin country experienced an outstanding inflationary surge that achieved an all-time-high of + 1,000,000%. Such an inflationary rate is not sustainable but in fact, is not among the worst five cases recorded in history. Such an insane inflationary rate dramatically devaluated the Venezuelan national currency so much so that businesses started to refrain from accepting it in favor of barter. To exemplify the magnitude of this situation we can make an example: AGI (Italian Agency for Journalism) reports that in early 2018 “a cigarette cost the same amount of money of 166 liters of petrol” or that “a soda has the same value of 12% of the minimum wage”. I do not intend to go into a detailed description of the poor monetary choices of the Venezuelan government. Instead, I would like to focus on how Venezuelan citizens could have defended their purchasing power if they had employed modern DeFi protocols.

In the paper by Robert Leonhard, the author explains how any given person in possession of a smartphone can obtain access to this alternative economy that is taking shape thanks to the development of the Ethereum ecosystem.

Contemporary decentralized applications, thanks to their new regulating protocols, can theoretically give access to financial instruments and creditt o those that up to now have not been able to leverage such possibilities. This potentiality offered by DeFi applications can hypothetically dismantle certain economic-social dynamics that are held accountable for the social gap we witness in the world today. The ability to access credit and to accumulate capital that maintains value over time defines also the possibility to make long-term plans and long-term plans are the foundation of prosperity. This vision may sound utopic although it is true that once these barriers are overcome, a whole range of possibilities will materialize.

Let us now go deep into the topic of the parallel economy made possible by those applications running on Ethereum and the ways people can use it to defend themselves from bad choices made by non-caring governments. Some of the technical aspects will be simplified because some DeFi protocols are complicated from an engineering point of view therefor we will explain most easily what these protocols can do. Moreover, we cannot forget that every time we are transacting assets on the blockchain we are dealing with real valuables. These assets, once lost, cannot be retrieved. This is the idea at the foundation of decentralization and disintermediation of the economy where the duty to safeguard assets is a direct responsibility of the owner and not of a third party.

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