DeFi and the Future of Finance. Campbell R. Harvey

are many examples from history whereby currency emerged without any backing that had value.

A relatively recent example is the Iraqi Swiss dinar. This was the currency of Iraq until the first Gulf War in 1990. The printing plates were manufactured in Switzerland (hence the name), and the printing was outsourced to the United Kingdom. In 1991, Iraq was divided, with the Kurds controlling the north and Saddam Hussein the south. Due to sanctions, Iraq could not import dinars from the UK and had to start local production. In May 1993, the Central Bank of Iraq announced that citizens had three weeks to exchange old 25 dinars for new ones (Figure 2.2). Afterwards, the old dinar would be unredeemable.

The old Iraqi Swiss dinar, however, continued to be used in the north. In the south, the new dinar suffered from extreme inflation. Eventually, the exchange rate was 300 new dinars for a single Iraqi Swiss dinar. The key insight here is that the Iraqi Swiss dinar had no official backing – but it was accepted as money. There was no tangible value, yet it had value. Importantly, value can be derived from both tangible and intangible sources.

Figure 2.2 Iraqi Swiss dinars and new dinars

      Source: Central Bank of Iraq

The features of Bitcoin that we have mentioned – particularly scarcity and self-sovereignty – make it a potential store of value and possible hedge to political and economic unrest at the hands of global governments. As the network grows, the value proposition only increases due to increased trust and liquidity. Although Bitcoin was originally intended as a peer-to-peer currency, its deflationary characteristics and flat fees discourage its use in small transactions. We argue that Bitcoin is the flagship of a new asset class, namely, cryptocurrencies, which can have varied use cases based on the construction of their networks. Bitcoin itself, we believe, will continue to grow as an important store of value and a potential inflation hedge over long horizons.¹¹

      The original cryptocurrencies offered an alternative to a financial system that had been dominated by governments and centralized institutions such as central banks. They arose largely from a desire to replace inefficient, siloed financial systems with immutable, borderless, open-source algorithms. These new currencies can adjust their parameters such as inflation and mechanism for consensus via their underlying blockchain to create different value propositions. We will discuss blockchain and cryptocurrency in greater depth later on but for now will focus on a particular cryptocurrency with special relevance to DeFi.

ETHEREUM AND DeFi

Ethereum (ETH) is currently the second largest cryptocurrency by market cap ($260b). Vitalik Buterin introduced the idea in 2014, and Ethereum mined its first block in 2015. Ethereum is in some sense a logical extension of the applications of Bitcoin because it allows for smart contracts – which are code that lives on a blockchain, can control assets and data, and define interactions between the assets, data, and network participants. The capacity for smart contracts defines Ethereum as a smart contract platform.

      Ethereum and other smart contract platforms specifically gave rise to the decentralized application, or dApp. The backend components of these applications are built with interoperable, transparent smart contracts that continue to exist if the chain they live on exists. dApps allow peers to interact directly and remove the need for a company to act as a central clearing house for app interactions. It quickly became apparent that the first killer dApps would be financial ones.

The drive toward financial dApps became the DeFi movement, which seeks to build and combine open-source financial building blocks into sophisticated products with minimized friction and maximized value to users. Because it costs no more at an organization level to provide services to a customer with $100 or $100 million in assets, DeFi proponents believe that all meaningful financial infrastructure will be replaced by smart contracts, which can provide more value to a larger group of users. Anyone can simply pay the flat fee to use the contract and benefit from the innovations of DeFi. We will discuss smart contract platforms and dApps in more depth in Chapter 3.

      DeFi is fundamentally a competitive marketplace of financial dApps that function as various financial “primitives” such as exchange, lend, and tokenize. They benefit from the network effects of combining and recombining DeFi products and attracting increasingly more market share from the traditional financial ecosystem. Our goal in this book is to give an overview of the problems that DeFi solves, describe the current and rapidly growing DeFi landscape, and present a vision of the future opportunities that DeFi unlocks.

NOTES

      1 1. Alan White, “David Graeber's Debt: The First 5000 Years,” Credit Slips: A Discussion on Credit, Finance, and Bankruptcy, June 18, 2020, https://www.creditslips.org/creditslips/2020/06/david-graebers-debt-the-first-5000-years.html.

      2 2. Ibid. See also Euromoney. 2001. “Forex Goes into Future Shock.” (October), https://faculty.fuqua.duke.edu/~charvey/Media/2001/EuromoneyOct01.pdf.

      3 3. PayPal, founded as Confinity in 1998, did not begin offering a payments function until it merged with X.com in 2000.

      4 4. Other examples include Cash App, Braintree, Venmo, and Robinhood.

      5 5. C. R. Harvey, “The History of Digital Money,” 2020, https://faculty.fuqua.duke.edu/~charvey/Teaching/697_2020/Public_Presentations_697/History_of_Digital_Money_2020_697.pdf.

      6 6. Satoshi Nakamoto, “Bitcoin: A Peer-to-Peer Electronic Cash System,” 2008, https://bitcoin.org/bitcoin.pdf.

      7 7. Stuart Haber and W. Scott Stornetta, “How to Time-Stamp a Digital Document,” Journal of Cryptology, 3, no. 2 (1991), https://dl.acm.org/doi/10.1007/BF00196791.

      8 8. Adam Back, “Hashcash – A Denial of Service Counter-Measure,” August 1, 2002, http://www.hashcash.org/papers/hashcash.pdf.

      9 9. Paul Jones and Lorenzo Giorgianni, “Market Outlook: Macro Perspective,” Jameson Lopp, n.d., https://www.lopp.net/pdf/BVI-Macro-Outlook.pdf.

      10 10. C. Erb and C. R. Harvey, “The Golden Dilemma,” Financial Analysts Journal, 69, no. 4 (2013): 10–42, shows that gold is an unreliable inflation hedge over short- and medium-term horizons.

      11 11. Similar to gold, Bitcoin is likely too volatile to be a reliable inflation hedge over short horizons. While theoretically decoupled from any country's