Chapter 1:

Context

… and here’s where DeFi comes in.

Chapter 2

DeFi Foundations

ZacharyZachary
25 July 2022
Jul 2022

Rather than dive into an analysis of the issues with permissioned and opaque TradFi (traditional finance) systems, this chapter breaks down the role that DeFi (decentralized finance) can and does have in developed, emerging and frontier markets.

Today’s Agenda

Money

Money as a concept is not that complicated. It has just three value propositions.

Money’s Value Propositions

  1. store of value
  2. unit of account
  3. medium of exchange

An economy can function as long as it has something that serves those three purposes but without it, there’s no choice but to resort to a barter system where goods and services are traded for goods and services. In theory, a barter system could work on a small scale but it can’t support global trade or commerce. For the last century or so, the US dollar (USD) has become the standard store of value, unit of account, and medium of exchange for the whole world. Along with the world’s largest military, the status of the world reserve currency, and straw within the dollar milkshake theory, the US dollar carries a lot of baggage – mainly the American financial system.

Finance, and the US

According to the IMF‘s 2022 estimates, The United States GDP accounts for 24% ($25.3 trillion) of the global GDP ($104 trillion) while only accounting for only 5% of its population. Considering the relative position of every other country in the world, it’s easy to understand why the US is so influential in world affairs. The US simply has more money to spend than any other country and has the world’s largest military presence backing it up.

While the US isn’t even close to being the country with the most wealth inequality, 1% of the country still owns 30% of the wealth and 16x more than the bottom 50%.

To support the massive amount of assets within the American financial industry, there needs to be a massive amount of infrastructure – and there is. There’s Wall Street, the Federal Reserve (12 branches), the US Treasury, the SEC, the CFTC, the ACH network, the SWIFT network, banks, credit bureaus, insurance companies, more regulatory agencies, auditing firms, securities brokers, the buy side, the sell side, short sellers, the NYSE, CBOE, CME, and more. Then there’s the human layer atop that includes the Senate Finance Committee, Federal Reserve Chairmen, bankers, accountants, auditors, RIAs, CFAs, CFPs, FRMs, CAIAs, CFOs, hedge fund managers, family offices, insurance salespeople, and the list goes on.

Behind all the acronyms is American academia. Federal employees and global news pundits will cite economic theories and papers from reputable universities written about, for example – Modern Monetary Theory (MMT) – as a basis for their policy choices. MMT includes justifications for excessive money printing which has directly aligned with the Federal Reserve’s strategy of quantitative easing and economic stimulus packages. It is strongly contested by proponents of other economic perspectives such as proponents of the Austrian school of economics. Finance and economics, like medicine, is a science that doesn’t require one to have a lot of knowledge to sound smart, jargon will do just fine.

Bretton Woods

The position of the US in the global economy is only 78 years old. In 1944, the US, Canada, Australia, Japan, and a number of western European countries convened in Bretton Woods, New Hampshire to configure a new monetary order. The US was by far and away in a position of dominance since the European powers were fragile as a result of WW2 battles and bombings taking place on their soils. Representatives from around the world were essentially consensually coerced into agreeing to the US’s pitch of how global monetary relations should function. The consequences of Bretton Woods were the beginning formations of many reconstruction efforts such as the World Bank, the International Monetary Fund (IMF), and the US dollar) becoming the de facto reserve currency for US-protected global trade.

This global world order has benefited billions but has caused all sorts of negative second-order effects. The financial markets and financial services industries were not exempt from such effects. As markets expanded, so too did their opaqueness due to more financial intermediaries/middlepeople being introduced. When compared to the immutable transparency possible with blockchain technology today, modern traditional financial practices feel obsolete.

Benoit Mandelbrot observed that based on their relative ages, you can compare finance now to where chemistry was in the 16th century from an evolutionary perspective. Since that’s the case, it’s fair to say that a portion of what goes on within traditional finance is financial alchemy. Alchemy was the pseudoscience and speculative philosophy which was the medieval forerunner to modern chemistry. In other words, some of what goes on behind the scenes is not in your best interest.

In the past 78 years, countries like the US, Germany, China, and Singapore have risen to become world powers while the majority of other economies have yet to become fully developed. Economists often break the world down into 3 parts – developed, emerging, and frontier. Crypto’s role drastically differs in each, for now.

Crypto’s Role

Developed Markets

It’s true that crypto is a bet on new technologies changing the world but for some, it’s a bet on the old world breaking with no recourse. In other words, you don’t have to think the world’s financial system is going to crumble if you believe in crypto but more often than not, people who do think that also do believe in crypto. It’s a nuance that’s not easy to explain but makes a major difference. If you peruse Twitter, Reddit, or other online threads about crypto, it’s easy to find people talking about either how the USD will be debased, how BTC will become the world’s future reserve currency, or how dumb people in crypto are for thinking these things.

Gold bugs have felt this way for centuries. If you’re a gold bug in a country like Argentina or Turkey, where your domestic currency experiences hyperinflation on a recurring basis, then you’re hailed as a genius. If you’re a gold bug in the US where you can safely store your USD in a bank controlled by arm guards, then you’re a wackadoodle. When Bitcoin hit the scene in 2008, along with the enshrined headline by a British daily that read, “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks” in Bitcoin’s Genesis Block, it made waves. This was the first asset that was effectively un-seizable (without a $5 wrench) and from its very first moment, it absorbed and created the underlying counterculture to traditional finance.

Because of the complicated nature of developed markets, developed financial systems are bureaucratic and on the whole, are difficult to change. Both the obsolete and practical assortments of systems that have been in place for decades are generally skeptical when it comes to change. It’s perfectly natural for large systems to reject change as it is essentially a threat to the market participants within the prevailing system. Unless the US financial system fails, any outright alternatives like DeFi will likely remain a fringe activity for the foreseeable future. There will likely be DeFi integrations across many sectors within the US economy but in terms of a total overhaul of the payment rails for the whole world, that’s quite the uphill battle.

Even if the dollar went to zero tomorrow, there are still trillions in American real estate, intellectual property, weapons, and physical goods that underly the US economy. These assets would still have their value they would just need to be valued in a new currency.

For these reasons and many more, DeFi’s largest impacts are likely going to be felt within the emerging and frontier markets.

Emerging & Frontier Markets

While the US financial system may be slow, skeptical, or biased as to adopting blockchain technology and decentralized finance (DeFi), emerging and frontier markets won’t have to operate with those same restrictions. It’s in these regions where DeFi is already proving its use case although unfortunately, not enough of the world who needs it are using it. For those who do, it’s serving as the only option to properly utilize money’s 3 value propositions.

DeFi is positioned to provide banking and investment services for those who need it most while helping emerging and frontier markets navigate global trade and commerce.

Without a stable mechanism like the USD to perform those duties, individuals and corporations are subject to volatile fluctuations of their assets and net worth which prevent an economy from functioning properly. According to the US Federal Reserve, the US had 22% of its adults unbanked or underbanked in 2019. That’s 63 million people in the richest country in the world without access to adequate financial services. The rest of the world is even more underbanked and less financially literate.

Unbanked – Not having or having never had savings, checking, or another account with a bank.

Underbanked – Having inadequate access to financial services and banking facilities.

Anyone who is unbanked or underbanked is not able to partake in earning interest on deposits, investing in the stock market, paying bills online, purchasing goods or services over the internet, accessing credit, or a number of other valuable financial activities. Without standard banking, there is also the need to use alternative financial services like money orders and prepaid cards which are inefficient and rack up fees.

DeFi’s Role

While banking isn’t a perfect system, there’s no doubt that using a good one gives an individual more financial freedom and ability when compared to being unbanked. The problem is, that not all banks are good ones and not all currencies are reliably fulfilling the three functions of money. While DeFi does seek to provide banking and investment services to its users, it does so without the need for banks or investment firms. The only way to do this is to not have to trust a counter-party.

Not wanting to trust a counter-party may sound counter-intuitive but if there is no counter-party, then there is no counter-party riskIf there are no ethics, there is no misbehavior. It’s a technical philosophy embodied in the code behind decentralized systems and it’s all possible because of the underlying consensus methods that enable blockchains to operate. To be clear, consensus methods are algorithms that an incentivized network of computers use to participate in collective transaction verification. The process of how this works varies from method to method.

Because of immutable, interoperable, capable, and permissionless blockchains, DeFi can do operate in ways that weren’t possible before. Its ambitions span that of enhancing developed financial markets and building the financial infrastructure for emerging and frontier ones. Among many goals, it seeks to onboard fiat currencies to the burgeoning digital blockchain economies through the use of globally transferable stablecoins. At the time of writing, Solana alone has already transferred over $300 trillion worth of value on-chain.

This would be a huge first step for emerging and frontier economies that deal with volatile domestic currencies and interest rates. DeFi also serves as the bedrock underpinning the NFT, DAO, and Web3 movements.

Opportunities to Enhance and Rebuild

When compared to what the established financial industries have to offer, DeFi presents alternatives that are opportunities to rebuild and enhance obsolete or convoluted processes and technologies.

While blockchain detractors claim it’s a solution looking for a problem, blockchain proponents understand that there are many real-world use cases blockchains can address that cannot be or have not been addressed with incumbent systems.

DeFi, unlike Bitcoin, is not an argument for a new reserve currency, it’s an argument for a new form of digital commerce.


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