An Historical and Practical Take on Decentralized Finance

by Giacomo Franzoso
Dec. 13, 2019
12 minutes

Nowadays, the global economic situation appears to be characterized by never ending dizziness. Continuous dizziness, over time, has progressively pushed common people away from reasoning on the value and purpose of money: the economy based on finance ultimately stroke a significant blow to this matter, creating a gap in both knowledge and possibilities that is difficult to fill. This widening gap is mainly caused by precarious access to education that remains a critical issue in many parts of the world but it is also caused by scarce access to credit which represents the first step towards financial independence. A type of independence that is regarded by many as the vital part of someone’s individual freedom. The real problem here is that even people who have access to credit, often, cannot obtain it. Either because the citizen is not considered “creditworthy” by financial institutions or because financial institutions have been tightening up regulatory policies since the 2008 financial crisis until now. Financial institutions have progressively become more unwilling to issue loans. More collaterals are required. This situation widens the financial gap between people being able to get access to credit and those that are not eligible. SMEs heavily suffered from the scarcity of access to credit and the subsequent lack of liquidity. Retail customers as well are still facing, in many nations of the world, loan denials and are struggling to obtain credit to finance their investments.

Inequality extends from a micro perspective to a macro embracement. Financial gap and financial exclusion are widening on a national level as well as internationally. Just think of those 1.7 billion people currently unbanked, people that do not have access to any kind of basic bank service such as a checking account. 30% of human population is out of the game by not having access to basic financial services: to live below the extreme poverty line ($1.90 per day) has the direct economic consequence of not being able to plan long-term, without mentioning that there are also obvious struggles over personal health and nutrition. We can nevertheless frame a positive datum within this scenario which is the reduction of people living below the extreme poverty line. Indeed, around five hundred thousand people exit this condition on a weekly basis, on the global scale, poverty is diminishing.

Decentralized Finance: between buzzword and use cases

Brand new Decentralized Finance (DeFi) protocols developed on Ethereum are aiming at the creation of an alternative (and, why not, future-mainstream) economic system different to the current one. This new system seeks to provide access to financial instruments to anyone in the possession of a smartphone. This communication device is widely available even in third world countries.

The adoption of a radical new system is backed by the intention to provide financial services to those that, until now, have been precluded from access. In theory, this type of approach should lead to a gap between rich and poor although today we are witnessing this process going the other way around (for instance or considering the Italian case).

Blockchain has the possibility to establish itself as driver in this kind of evolution, firstly through the process of tokenization of assets that, theoretically and ideally, allows the creation of a more inclusive and participative economic model. Until recently, financial instruments sold by intermediaries were prerogative of those actually able to obtain them. The requisites for access were a checking account and a deposit of securities and enough balance to spare. Financial instruments usually have a minimum denomination.

Decentralized Finance gives us the possibility to create fractional ownership of an asset, broken into multiple tokens: as an example, we can consider a bond that has a minimum denomination of $1000. Ideally, we can tokenize this bond, assign to the token whatever number of decimals (or issue x tokens to be worth it) and sell it partitioned, allowing a much lower minimum denomination. Once again, this aspect may sound ridiculous to a westerner but financially weak sections of the population could benefit from this kind of small financial investment. It could be an historic change. In this framework a smartphone and an internet connection would be enough to allow an individual to make an investment.

In the scenario where DeFi protocols and more inclusive economic systems take over the contemporary financial system, a systemic change might rise where central banks would experience loss of power over monetary policies which is partly carried out through the issuance of financial services to the public. The toughest obstacle to overcome is the one concerning the cultural aspect. In these terms, it refers to the guidance of people towards the enhancement of financial literacy and towards the realization of the concept that personal freedom also means financial freedom: it may sound utopic to most but this scenario would represent the first leap towards the separation of state and currency.

These ideas may sound like sci-fi and Decentralized Finance has become a buzzword spread all over the news. Nevertheless, when considering projects such as Cipher or Status, it is easy to visualize the extent of their revolutionary vision in case of mass adoption.

The main issue about DeFi literature is the monotonous narrative explanatory approach that articles constantly unfold without taking into consideration historic and cultural context: what is the root and the origin of DeFi? Is it a contemporary revolution or otherwise, it has historic basis we can hold on to in order to better extract the essence of the phenomenon?

The objective of this article is twofold: on one hand I focus on framing DeFi from an historic perspective regarding it as a comprehensive phenomenon embracing the whole world of cryptocurrencies, on the other I want to stimulate, in conceited way, a productive debate that support the establishment of DeFi in a healthy and cognizant way. DeFi should evolve leaving aside the initial utopic enthusiasm and should focus on the issues that are arising whenever approaching a complex subject such as finance and/or world economy.

An historical overview: bitcoin and the Austrian school

The history about the birth of bitcoin is well known: after the whitepaper had been published in a mailing, the network was initiated with the release of the first client on January the 3rd 2009. Bitcoin was the result of a series of moves made towards the creation of a distributed digital currency that could prevent double spending. The cryptocurrency is designed to be resilient to cyberattacks through the appliance of complex economic features made possible by Game Theory mechanisms. That’s how the first digital currency was born, peer-to-peer and tradable in an open distributed network.

I won’t spend more time over the technological evolution path that ended with the creation of Bitcoin, this subject is very well documented (Bitcoin Wiki). The subject of my analysis regards the economic situation in which Satoshi Nakamoto was encouraged to create Bitcoin.

It is of common knowledge that the main reason that encouraged Nakamoto to create Bitcoin was the financial crises related to the subprime loans that triggered the collapse of the investment bank Lehman Brothers and the subsequent global crises.

It is not clear whether the subprime crises itself was the trigger of Bitcoin or whether the crises was just a pretext to launch the project he had been working on for a long time. What is clear, beside the doctrinaire debate, is that Bitcoin finds its root value in the school of thought called the Austrian School.

There is a very interesting book that truly frames Bitcoin within the Austrian School which is “The Bitcoin Standard” (S. Ammous). In this book digital currencies are contextualized within a possibilistic scenario where the creation of alternative currencies, detached from the traditional economic system, is contemplated.

I was able to highlight some aspects that resemble the philosophy behind Bitcoin in the Austrian School of economic thought. One of these aspects is the purely anti-government nature of the asset (perfectly explained by Andreas Antonopoulos in some of his interventions available on his YouTube channel), another aspect is the advent of different positions to be found in the works by Hayek. This author expresses some thoughts in strong opposition to some of the features of Bitcoin.

At first glance, when studying theories such as “free banking” and “competitive currencies” introduced in books like “Denationalisation of Money” (F. von Hayek) or ”Theory of Free Banking” (G. Selgin), if Bitcoin and other cryptocurrencies present in nowadays economy came to our mind, the fact would not be such a surprise. The main point of this article is not the process of highlighting similarities between the Austrian School and the contemporary configuration of Bitcoin, but rather to focus on the discrepancies between them so to assess the extent of autonomy digital currencies are enjoying in comparison to the economic system in force.

In this regard we have an article written by the Italian economist Michele Cantarella in 2014. The article has a purposely provocative title: ”Why Hayek would have hated Bitcoin“. Here is a quote from the book.

“It is true though that Bitcoin and the Austrian School, in spite of appearances, cannot be considered as compatible. […] Bitcoin cannot neither replace other legal currencies nor guarantee its stability. It is a parasitic currency that lives off the contemporary monetary system whose desirability lies in its volatility. […] In light of these considerations, we can declare that yes, Bitcoin, most likely, would not be appreciated by Hayek”

The sentences I decided to quote imply a certain degree of negativity inherent with the article. The reality is that, in general, the article is rich in interesting insights and it wants to be an overall reflection about what Bitcoin does not want to be, rather than what Bitcoin is not, in relation to the theories of the Austrian School.

Although the article is quite dated and, in the meanwhile, Bitcoin has further evolved both technologically and community wise, it is possible to trace interesting possibilities that are still valid and relevant nowadays.

If considering Bitcoin’s present situation and the job carried out by its community, it seems to be projected toward the shaping of the currency based on certain dictates theorized by Austrian economists that are well laid out by Ammous in his book. Bitcoin’s function as medium of exchange is limited by its fundamental constraints that are to be found at the core of the protocol such as the excessive slowness of the Proof-of-Work in the validation process of transactions which represents the conditio sine qua non of the public Bitcoin blockchain ( we don’t debate over Proof-of Stake because its ability to sustain and protect a network and data inside of it while being able to guarantee a certain level of decentralization is still to be proved efficient). The community along with core developers are aware of this limitation. For this reason, they are developing so-called payment channels like Lightning Network in order to compensate for the limited speed of transaction improving transactions output.

One of the problems that casts serious doubts about the employment of Bitcoin (as substitute to existing fiat currencies instead of an alternative to them) is the issue regarding the excessive volatility of it. This characteristic of bitcoin is the one that made it notorious but it is also the aspect that makes it hard to accept as a store of value. Volatility of bitcoin is one of the conditions that collides the most with the arguments presented by Hayek in “Denationalisation of the currency”. According to the Austrian economist, volatility disqualifies the currency as such and dooms its existence leading it to its failure. What Hayek hopes for, within a framework where multiple currencies are competing to gain adoption on the same market, is indeed the unwavering stability a currency should have. The more a currency is stable in volatility, the more people are willing to use it in the ways a currency is believed to be used: medium of exchange, reserve of value, unit of account and reference for deferred payments. The condition characterized by extreme volatility experienced by Bitcoin has a double impact: on one hand that is one of the main reasons of Bitcoin’s popularity that was able to attract investors ready to capitalize on it, on the other hand volatility prevents Bitcoin from stabilizing its value which would make it more attractive for adoption as daily currency.

Beside volatility there is another problematic aspect about Bitcoin that has been argued by Hayek which is the money supply. Hayek theorized that the supply is provided by the central institution itself that is increasing or diminishing it depending on the situation relative to the demand for it. Controlled supply is regulated in order to keep the value of the currency stable avoiding excessive appreciation or depreciation. When we take Bitcoin protocol into consideration, it is easy to understand why Bitcoin cannot be in compliance with the theories previously described: we know already the exact total number of Bitcoin that are or are going to be mined and the way Bitcoin is awarded,

Another stark difference that is intuitively noticeable is the one regarding the socio-cultural aspect of the comparison between Hayek’s thoughts and the Bitcoin protocol. In the model theorized by Haynek there are various currencies that are trying to obtain as many users as possible. The community of Bitcoin, instead, sees all other coins as “shitcoins” which are not worth the existence because of their “intention” to emulate Bitcoin. In this regard, we can say that the statement is partly true (especially when considering all those coins that turned out to be scams) but it is also true that some other cryptos differentiate themselves from Bitcoin and proposed new solutions and opportunities.

In a world made up of many different currencies (in this regard, Hayek wants to support the usage of the word currencies instead of money because currency has the function of being “exchangeable currency”), there cannot be one currency taking over all the others. Instead, we need mechanisms of self-balance similar to those present in the regular money market. This framework would allow counterbalance among cryptocurrencies. What is actually happening in the crypto world is the de facto approach of the Bitcoin community that can be described as challenger to the contemporary system where the ultimate objective is the monopoly of transactions. What Bitcoin enthusiasts are aiming at is a shift from a Keynesian model based on a currency issued by a central institution to another model where a single currency issued by a distributed entity is not in competition with others. This type of approach is directly in conflict with the theories of the Austrian School. Moreover, there is confusion about the role Bitcoin should and could have in this society. This aspect as well is against the methodology regarding the issuance of new currencies undertaken by private entities described by Hayek. The author foresaw a direct and immediate shift from the traditional system to this new one. This shift would create numerous initial problems that would be mitigated by consolidation initiated by social mechanisms derived from the usage of the new currency itself. From this perspective, Bitcoin has undergone an involution because, despite gaining disruptive popularity, its main objective remains faded and the context it is moving in is unclear, all these aspects are slowing down mass adoption. The attempt to gradually impose itself over other currencies is going to be a failure according to Hayek: “People would learn to trust the new money only if they were confident it was completely exempt from any government control”. According to this vision, every attempt to regulate Bitcoin turns into another barrier to its diffusion and its recognition as currency because nations should accept new currencies the way they are so to avoid casting a negative shadow over them that may disqualify them in the perspective of the citizen.

While we move towards the end, I want to reaffirm that my article has not the intention to criticize Bitcoin or its community, nor it wants to disqualify the project: the king of cryptos is establishing itself as digital gold rather than regular daily currency and community and developers are moving in that direction because Bitcoin suits this kind of role.

The Bitcoin Effect

The radical change bitcoin brought is manifesting and evolving into new ways of thinking and realizing an alternative world to ours. This revolutionary economic and financial change is a palingenesis of a radically new approach derived from the figurative and practical weakening of the paramount value of a society that is currency. Before Bitcoin was given birth, the monopoly central banks were enjoying was taken for granted and practically nobody ever questioned it. The cryptocurrency awoke the interest over these topics in the public opinion, many people before the arrival of Bitcoin never questioned themselves over the individual’s knowledge of the structure of the global economy. The Bitcoin revolution is firstly social and cultural and secondly, economic. In this respect, much more time is needed before we can see a decentralized kind of money taking over governmental currencies. One reason to that is the high volatility, which makes the asset speculative rather than functional. Perhaps new types of more efficient and valid cryptos will come up and establish themselves as mainstream medium of exchange.

Bitcoin has been the first real application of Decentralized Finance in history. Bitcoin proved the applicability of the theories elaborated by the economists of the Austrian School. The birth of Bitcoin showed to the world that value creation is possible even without the presence of an intermediary validating and controlling the supply, Bitcoin represents the first leap towards the creation of a new economic world.

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