The dream that decentralized finance – or “DeFi” – could free the monetary system from the clutches of governments and banks has launched 20,000 cryptocurrencies.
But with 2022 proving to be more of a crypto nightmare – including for the vaunted “stablecoins” that held the most promise as rivals to central bank-issued currencies – questions now arise as to whether DeFi really has a stake. coming.
There are predictions that the cryptocurrency market, having lost more than half of its value in the first six months of 2022, could crash further – or be on the verge of rebounding. This speaks to the fact that crypto is great for gambling, but still lousy as a usable currency. It also lacks other useful attributes.
To assess the prospects for DeFi, it is useful to consider how finance became centralized in the first place.
Origins of money
Money is a feature of increasingly sophisticated human networks. When we lived in bands of hunter-gatherers, we hardly needed it. An informal tally of favors owed could be kept.
With the greater complexity of settled communities, in which people specialize in activities that match their skills and preferences, the barter system becomes the norm.
But barter required a double coincidence of needs. Someone who had too much food and wanted help building a house had to find a hungry builder. They then had to haggle over how many hours of work constituted a fair exchange for a meal.
So “money” was invented.
Money could be shells or a useful storable good. It could be a tally of debts recorded safely somewhere (the earliest forms of writing, dating back to 3000 BC, were cuneiform financial documents). Then came man-made tokens, which led to rare metal coins.
The origins of the bank
Money meant that people could save the fruits of their labor and loan them to others. But bringing lenders together with borrowers and assuring lenders that borrowers would repay was a challenge. This is why banks have developed.
Banks did not just issue convenient currency in the form of coins and notes. They also provided four basic banking services:
- Grouping: by gathering lots of small deposits, they could make big loans
- Diversification: by lending to a range of borrowers, a default mattered much less
- Risk assessment: specialized skills in reliability assessment reduced payment defaults
- Maturity transformation: they could offer loans for longer periods than most depositors wanted to keep their money in the bank.
The oldest bank still in operation today is the Monte dei Paschi di Siena in Italy, founded in 1472.
But private banks with their own currencies were not a stable system. So-called “bank runs” occurred when depositors lost faith in a bank and sought to withdraw their funds. When a bank was unable to repay all requested notes or deposits, panic ensued.
Bank runs were often contagious. People had a hard time distinguishing whether a bank had an idiosyncratic problem (like a fraudulent manager) or suffered from a general problem (like an economic downturn leading to bad debts). A race on one bank would often trigger races on the others.
In the 20th century, most countries solved these problems by having a central bank issue currency owned by the government and by regulating private banks to assure depositors of their solvency. These regulations required banks to keep a minimum proportion of their assets available for withdrawals and to purchase deposit insurance.
Decentralized finance movement
This process of banking centralization, however, was not universally applauded. Libertarians are wary of the system’s reliance on government-issued monopolies and licensed banks. They hate banks almost as much as governments. They see centralized finance as both inefficient and coercive.
Their dream: decentralized (or disintermediated) finance, allowing direct transactions, without the need for banking intermediaries. By eliminating the “middleman”, their argument has been, transaction costs will be lower and the power of the state over individuals will be limited.
Together with the internet and blockchain technology, these dreams have launched over 20,000 cryptocurrencies, the first, and still the most important, being Bitcoin.
“The Illusion of Decentralization”
But as the massive losses in the cryptocurrency markets over the past few months demonstrate, DeFi has yet to prove itself to be a viable alternative to centralized banking. It is still unclear how the four banking services discussed above can be provided without trusted financial intermediaries.
Indeed, according to economists at the Bank for International Settlements (the central bank of central banks): “While the primary view of DeFi proponents is intermediation without centralized entities, we argue that some form of centralization is inevitable. As such, there is an “illusion of decentralization”.
As BRI economists note, decentralized finance still has little use in the real economy. Above all, it facilitated speculation. But what attracts speculators – wildly fluctuating prices – makes bad money.
A salutary lesson comes from the experience of two (former) top ten cryptocurrencies, TerraUSD and its stablemate Luna. TerraUSD was supposed to be a “stablecoin”, with its value set at $1. This was true until the beginning of May. At the end of May, it was trading at less than 3 US cents. During the same period, the price of Luna fell from $82 to 0.02 US cents.
These examples illustrate how cryptocurrencies such as Bitcoin, lacking any fundamental value, are speculative bets.
So central bank currencies still have no rivals for day-to-day activities of buying and selling things, and are still much safer stores of value than crypto, even with inflation eroding their power. of purchase.
John Hawkins is a senior lecturer at the Canberra School of Politics, Economics and Society at the University of Canberra.
This article first appeared on The Conversation.