Writing a book on decentralized finance is a bit like describing a riddle, wrapped in mystery in an enigma, to borrow from Winston Churchill. First you need to summarize the origins of modern decentralized finance, then the mechanics of the blockchain technology that is the backbone of the industry, and only then you get to the infrastructure of DeFi. It should also all be done in 191 pages, including glossary, notes, and index. It is not an undertaking for the faint of heart.
Fortunately, the authors of DeFi and the Future of Finance — Duke University finance professor Campbell Harvey, Dragonfly Capital general partner Ashwin Ramachandran, and Fei Labs founder Joey Santoro — were up to the task. After summarizing the “five shortcomings of traditional finance” — inefficiency, limited access, opacity, centralized control and lack of interoperability — they move on to explain how DeFi is improving the status quo.
Take the problem of centralized control. Governments and large institutions have a “virtual monopoly” over the money supply, inflation and “access to the best investment opportunities,” the authors wrote. DeFi with its open protocols and immutable properties “breaks this centralized control.”
As for how DeFi answers the opacity flaw of traditional finance: “Everything” [DeFi] parties are aware of the capitalization of their counterparties and can, to the extent necessary, see how resources are being deployed”, mitigating counterparty risk. Just like inefficiency: “A user can largely self-serve within the parameters of the smart contract” in a decentralized application by, for example, exercising a put option.
What about the failure of traditional finance in limited access? DeFi gives disadvantaged groups, such as the world’s unbanked population, direct access to financial services, the authors wrote. in fact co-owners of the platform, “a rare occurrence in traditional finance.”
The authors also described the ways in which DeFi protocols can be layered on top of each other (ie DeFi’s composability, sometimes referred to as “DeFi Legos”), which helps to address the lack of interoperability. Once a basic infrastructure is established (to create a synthetic asset, for example), “any new protocols that allow borrowing or lending can be applied. A higher level would allow leverage on top of the borrowed assets.” ”
Take a deep dive
Chapter 6 takes a closer look at eight leading DeFi protocols: MakerDAO, Compound, Aave, Uniswap, Yield, dYdX, Synthetic, and Set Protocol. Each section is accompanied by a very useful table, with the first column describing how traditional finance solves a particular problem, and the second column how a specific DeFi protocol addresses that problem.
For example, in Table 6.3, “Problems that Aave solves,” the first row is about “centralized control.” In the incumbent financial system, “loan and borrowing rates” [are] controlled by institutions,” while in the DeFi approach, column 2, “Aave interest rates are algorithmically controlled.”
Related: Tech Transformation: The Book Review of Don Tapscott’s ‘Platform Revolution’
Traditional financing only provides “limited access” within its legacy systems. That is, “only select groups have access to large amounts of money for arbitrage or refinancing” (Row 2, column 1), while within the Aave protocol, “flash loans democratize access to liquidity for immediately profitable ventures.”
The third row focuses on “inefficiency”, specifically “sub-optimal borrowing and lending rates due to over-cost” in traditional financing, while Aave’s solution (row 3, column 2) is “algorithmically pooled and optimized interest rates” .
The authors were careful to remind readers that “all innovative technologies introduce a new set of risks.” In the case of DeFi, these are plentiful, including smart contract, governance, Oracle, scaling, DEX custodial, environmental and regulatory risks.
“Software is particularly vulnerable to hacks and developer malpractice,” the authors wrote, while recent bZx and DForce hacks “demonstrate the vulnerability of smart contract programming.”
Among these new threats, the “oracle risk” looms very large. DeFi protocols require access to accurate, secure pricing information to ensure actions such as liquidations and prediction market resolutions work smoothly. “Basically, oracles want to answer the simple question: how can off-chain data be reported securely in the chain?” Still, all online oracles as they are currently formed are “vulnerable to front-running and millions of dollars have been lost to arbitrageurs,” they wrote, adding:
“Until oracles are blockchain-native, hardened, and resilient, they pose the greatest systemic threat to DeFi today.”
The creation of “marginalized groups”
“This book is fundamentally about financial democracy,” co-author Harvey told Cointelegraph. The book’s foreword, written by no less than a character like Ethereum creator Vitalik Buterin, reminds readers that “financial censorship remains a problem for marginalized groups,” especially in the developing world — which is why DeFi is important.
The average reader may find this book a bit heavy on the technical side. For example, graphics include superlinear and logistic/sigmoid bond curves, which may cross some heads. Anyone who wants to learn how a flash loan really works will benefit from it; the glossary of the book is extensive and useful.
Related: DeFi: A Comprehensive Guide to Decentralized Finance
However, it would have been enlightening to learn more about how DeFi actually started to change the world, such as offering banking to the non-banking or insurance to the uninsured – although this may be beyond the scope of the book.
One might wonder what percentage of the world’s “unbanked population” actually benefits from “yield farming,” a still esoteric DeFi process that the authors nonetheless cite as an example of how DeFi provides access “to the many who need financial services but who are leaving traditional finance behind.” Not too much, one guesses.
Unfortunately, much of the focus in the DeFi world today still seems to be on ways to gain leverage or arbitrage between markets rather than solving the problems of the poor worldwide. The book also doesn’t pay much attention to defending DeFi from critics in the general business press such as The Wall Street Journal, which noted in September that DeFi “bringed casino capitalism to the crypto masses.”
That is not the authors’ vision for the future. On the contrary, they see in DeFi “the scaffolding of a radiant new city. […] Finance is becoming accessible to everyone. Good quality ideas get funded no matter who you are. A $10 transaction is treated the same as a $100 million transaction. Savings rates rise and borrowing costs fall as the wasteful middle layers are cut away. Ultimately, we see DeFi as the greatest opportunity of the next decade and look forward to the reinvention of finance as we know it.”
These are worthy goals, although they are unlikely to be realized in the near future. Until then, this book should be of interest to anyone looking to unravel the inner workings of DeFi.