DeFi, a shortened version of the mouthful “decentralized finance”, is a hot buzzword these days. The term is often associated with crypto tokens and networks, as well as the applications built on top of them for lending, borrowing, asset trading and other financial contracts to be executed without intermediaries.
Most of today’s financial contracts require central intermediaries which are arguably opaque by design and must be trusted by both parties to execute contracts fairly. Sometimes that trust is broken, like when the largest foreign exchange (Forex) brokers colluded for at least a decade to scam their customers — costing companies, pensioners, investors and savers a yet unknown figure that could easily amount to over $1 trillion. Only one person was arrested and the banks involved were fined a total of $1.7B — around 0.2% of their total earnings from the scam. The reasons we distrust banks, and the governments and central banks standing behind them, are abundant — I’m sure you have your own.
DeFi promises to be a more trustworthy platform, composed of open-source code that’s auditable and transparent. Additionally, DeFi opens the floodgates for innovative ideas. Licensing requirements are replaced with code audits, allowing performance to replace accreditation and opening the financial world to new ideas.
Truly decentralized finance — all the way down to the settlement layer — also promises to be a more sane monetary system. Money is an integral piece of civilization, allowing societies to grow and scale without every individual having to trust one another personally. A decentralized financial system can fix the deeply-ingrained problems of our monetary system today.
A financial system free from many of the burdens and pitfalls created by trusted intermediaries and powerful masters sounds like a beautiful future we should all want to usher in.
What stands in our way?
The Trust Dealers And Their Premium
Much of the reason banks and financial intermediaries exist today is to create trust between parties: they are “trust dealers”.
Escrow services are a very direct example of this: a bank with a reputation to uphold will act as middleman to an exchange of assets, ensuring that both parties stick to their end of the deal. An escrow service can be entirely automated in a DeFi system, leading to lower costs and more predictable execution.
Trust dealers earn a “trust premium” for their services, which makes them a lot of money. DeFi takes that trust premium away, and trust dealers won’t let go of that revenue without a fight.
Even many functions of modern governments exist to create trust between parties who want to make and enforce contracts with each other. The Securities and Exchange Commission (SEC), for example, is partially a trust dealer with a three-part mission:
- Protect investors.
- Maintain fair, orderly and efficient markets.
- Facilitate capital formation.
A large part of this involves ensuring that “those who sell and trade securities — brokers, dealers and exchanges — must treat investors fairly and honestly” (SEC). Today, the SEC and its enforcement apparatus need to go around demanding information from private businesses to check that they are acting fairly and honestly.
In a world where brokers and exchanges are automated pieces of code, open source and auditable by anyone, the need for all those resources required for investigations is greatly reduced. In the SEC’s case, the trust premium is more abstract: not revenue, but power.
Central banks and governments also earn a massive trust premium: we trust them to control money supplies with the best interests of the public in mind.
Today’s governments and financial firms are therefore cautious about, if not openly hostile to, truly decentralized financial systems. These systems threaten their trust premium — whether that’s earned in the form of revenue or power over the financial system.
Trust Dealers Are Powerful
This is not a small group of rogue states or niche asset managers but the core of the mainstream financial system: the wealthiest and most powerful people and organizations in the world today.
These groups and individuals defend their role as trusted intermediaries in the financial system — and therefore the trust premium they earn in cash or power — in a variety of ways. What we think of as high-functioning, fair governments claim they need this power over the financial system to combat money laundering and terrorist financing — nevermind the fact that anti-money laundering (AML) policies have less than 0.1% impact on criminal finances (which is less than the “tax” on the Forex scammers!).
When governments turn more openly oppressive they resort to raw power over factual reasoning, and enforcement starts to look more authoritarian: blacklisting individuals from the economy or simply confiscating money from citizens.
The incumbent trust dealers are attacking decentralized systems from all angles, claiming they are too volatile, they facilitate criminal activity and they consume too much energy. However, they know they won’t be able to succeed simply by slamming new technology — they need to offer an alternative or co-opt a new technology to suit their purposes.
Before we get into how trust dealers are confronting the threat of DeFi, we need to discuss the trade-offs inherent to any decentralized system. This will shed light on how a DeFi platform might evade destruction.
Trade-Offs Of A Decentralized System
One of the founders of the Ethereum protocol, Vitalik Buterin, coined a “trilemma” about networks that helps us better understand the trade-offs necessary to realizing a decentralized financial system.
The trilemma goes like this: a database (or a “blockchain”) must sacrifice in one of these areas in order to gain in another:
Security means the network is resistant to attacks meant to disrupt its normal operation of validating and finalizing transactions. For a financial system, security is paramount. Without it, the system just won’t work.
How much security is “enough” security? This is a tempting question to ask, but a dangerous one to answer or implement. This question assumes we can understand all possible futures and map out their risks. Throughout time immemorial, humans have repeatedly underestimated the potential for future events to exceed the bounds of imagination and engineering. Thinking that we know what “enough” security looks like, and stopping there, is often a recipe for failure.
Decentralization in our context boils down to the ease with which anyone can validate transactions on the network. If it’s very easy for new validators to join, it’s likely that a large set of nodes will develop to validate transactions, limiting the power of any single entity to change the rules of the system.
Decentralization — like security — comes in degrees. The more difficult it is for new validators to join the network, the more likely it is that a centralized entity evolves to specialize in validating transactions. Eventually, this entity can start influencing the rules of the network or serve as an easy target for more powerful forces to take over in order to co-opt the system.
Scalability means the speed with which the network can process data. For a decentralized financial system with lending, escrows and more basic financial services, scalability allows for more complexity and faster experimentation.
Centralized systems — like the hard drive on your computer or the Visa payment network — achieve a high degree of scalability by completely forgoing decentralization. Some blockchain networks, like Ethereum, are able to achieve more scalability by sacrificing security and decentralization.
To think about the best path forward for a DeFi system, we must consider these trade-offs against the strategies incumbent trust dealers may use to topple or co-opt the system. We cannot naively believe that existing institutions will simply roll over and accept the loss of their trust premium without a fight.
Elizabeth Warren, for example, is certainly preparing for war.
The Trust Dealer’s Attack Types
Before we consider how to balance decentralization, security and scalability, let’s consider how incumbent trust dealers might think about attacking decentralized systems.
Most attacks are likely to fit into three categories:
- Brute Force
- Confidence Erosion
Brute Force Attack
The first way is blunt — they will use emotional appeals and, eventually, brute force to discourage or block you and I from interacting with decentralized systems. They are doing this today — using all sorts of misdirection to put down DeFi systems. Some nations have even implemented bans — though none have been of much use, with decentralized systems growing despite the bans.
The brute force attack isn’t working — so they will add on new attacks.
Confidence Erosion Attack
The second involves a bit of subterfuge ˆ with the intent being to disrupt the system in such a way as to damage people’s trust in it. This may come in the form of a hack orchestrated by rogue agents and possibly demonstrating the power of the government to fix it. Powerful financial entities could even use their existing power to create money in order to manipulate prices, destroying confidence in the operation of the markets for assets in the new financial system.
The third attack involves a dash of diplomacy — they may try to co-opt a system with meager decentralization, working closely with blockchain developers to help them achieve better security and scalability. Eventually, the system then steers away from decentralization and ends up looking exactly like the centralized financial system it was meant…