DeFi and the Future of Finance. Campbell R. Harvey

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FOREWORD

      DeFi is a cute acronym for “decentralized finance,” but it obfuscates its true potential: a new financial system built from the ground up. While DeFi is small today—containing, as of this writing, tens of billions of dollars in assets relative to the hundreds of trillions in the traditional financial system—it is growing rapidly. And while its rise will take decades, I believe DeFi will be the primary financial system of the world.

      Why? DeFi is a true “internet of money.” The internet showed the power of a universal, open network for information. In 40 years the idea of a similarly open, global network for value transfer will seem obvious, which makes this a truth hiding in plain sight today.

As with any new technology, crypto and the new decentralized financial system built atop it will be different from its old-world analogue. DeFi is unique relative to the traditional financial system because it is permissionless, open access, global, composable, and transparent. No longer are centralized institutions needed for basic financial actions. In DeFi, you can be your own bank and get credit from code on a blockchain—no institution required!

      Yet so little of the infrastructure of this ecosystem has been built. We are perhaps 1 percent, likely less, into DeFi as a phenomenon. A burgeoning ecosystem of developers around the world is currently constructing the financial building blocks of tomorrow. At our crypto investment firm Paradigm, we often ask ourselves, “If there were a periodic table of financial primitives, what has been built today and what is left to fill in?” That is the opportunity for entrepreneurs.

      DeFi, like the internet, will likely make financial services cheaper, faster, secure, personalized, and more. If YouTube grew the breadth of video content by orders of magnitude because it was free and easy for anyone to both create and use videos, what will DeFi do for financial products as it similarly allows anyone to create and use anything at near-zero cost?

      That future has yet to be written. This book provides a peek into that future, and you, the reader, hold the power to create it.

      Fred Ehrsam

      Co-founder and Managing Partner, Paradigm

      Co-founder, Coinbase

PREFACE

      Decentralized finance (or DeFi) has always been a big part of what I hoped to see people build on Ethereum. Ideas around user-issued assets, stablecoins, prediction markets, decentralized exchanges, and much more had already been at the top of my mind as well as the minds of many others trying to build the next stage of blockchain technology in those special early days of 2013–14. But instead of creating a limited platform targeting a set of known existing use cases, as many others did, Ethereum introduced general-purpose programmability, allowing blockchain-based contracts that can hold digital assets and transfer them according to predefined rules, and even support applications with components that are not financial at all.

People in the Ethereum community started working on applications such as on-chain stablecoins, prediction markets, and exchanges almost immediately, but only after more than five years did the ecosystem truly start to mature. I believe that DeFi will create a new, easy-to-use and globally accessible financial system for the world. For example, applications like stablecoins are some of the most valuable innovations to come out of DeFi so far. They allow anyone in the world to benefit from the censorship resistance, self-sovereignty, and instant global accessibility of cryptocurrency while having the purchasing power stability of the dollar—or, if the dollar ever stops being stable, they enable people to quickly move their funds into another asset that does a better job of maintaining stability.

      So why is DeFi important? Financial censorship continues to be a problem for marginalized groups, with restrictions and imposed hardships often going far beyond what is actually required by any law. This is doubly true once we start looking beyond the relatively safe bubble of developed countries. DeFi greatly reduces the cost of experimentation, making it much easier to build a new application, and smart contracts with verifiable open-source code greatly reduce the barrier of needing to trust the founding team to manage funds. DeFi offers “composability,” allowing new applications to easily and immediately interoperate with any other applications that already exist. These are serious improvements over the traditional financial system, and ones that I believe remain under-appreciated.

In the book DeFi and The Future of Finance, the authors discuss many of the additional improvements DeFi offers over the traditional financial system. The authors also explain the in-depth workings of many of the most important DeFi protocols today, including stablecoins, automated market makers, and more. I recommend this book to anyone interested in learning more about Ethereum and DeFi protocols.

      Vitalik Buterin

      Co-founder of Ethereum

I INTRODUCTION

We have come full circle. The earliest form of market exchange was peer to peer, also known as barter.¹ Barter was highly inefficient because supply and demand had to be exactly matched between peers. To solve the matching problem, money was introduced as a medium of exchange and store of value. Initial types of money were not centralized. Agents accepted any number of items such as stones or shells in exchange for goods. Eventually, specie money emerged, a form in which the currency had tangible value. Today, we have non-collateralized (fiat) currency controlled by central banks. The form of money has changed over time, but the basic infrastructure of financial institutions has not.

However, the scaffolding is emerging for a historic disruption of our current financial infrastructure. DeFi, or decentralized finance, seeks to build and combine open-source financial building blocks into sophisticated products with minimized friction and maximized value to users utilizing blockchain technology. Given it costs no more to provide services to a customer with $100 or $100 million in assets, we believe that DeFi will replace all meaningful centralized financial infrastructure in the future. This is a technology of inclusion whereby anyone can pay the flat fee to use and benefit from the innovations of DeFi.

      DeFi is fundamentally a competitive marketplace of decentralized financial applications that function as various financial “primitives” such as exchange, save, lend, and tokenize. These applications benefit from the network effects of combining and recombining DeFi products and attracting increasingly more market share from the traditional financial ecosystem.

      Our book details the problems that DeFi solves: centralized control, limited access,