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The Economist Cover Story: Down the Rabbit Hole – The Promise and Risks of DeFi

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Looking at the Emerging Decentralized Financial System from the Perspective of Traditional Economics

Original title: "Down the rabbit hole, The beguiling promise of decentralized finance, And its many perils"

Original source: The Economist

Original compilation: Nanfeng, Unitimes

Skeptics have plenty of excuses. The earliest adopters of bitcoin (the original cryptocurrency) used it to buy drugs, and now cyber hackers use it to hold ransoms. This year, hackers discovered a bug in some code and hundreds of millions of dollars in ETH, another digital currency, was stolen. In fact, many “believers” are trying to get rich quick from the $2.2 trillion global frenzy in crypto assets. Others are extraordinarily loyal. In June, President Nayib Bukele of El Salvador sobbed from the podium when he announced that the country would adopt bitcoin as its official currency, claiming that bitcoin would save the country.

Liars, fools and apostates are certainly a nuisance. However, the emerging ecosystem of financial services, so-called Decentralized Finance (DeFi), is worth pondering. With all the promise and risk it brings, DeFi has the potential to change the way the financial system works. In DeFi, the surge of innovation is similar to the frenzy of invention in the early days of the internet. In an age where people are increasingly living on the internet, this cryptocurrency revolution may even reshape the architecture of the digital economy.

DeFi is one of the three major technological trends subverting finance. Tech “platform” companies are scrambling to get into payments and banking; governments are launching digital currencies. And DeFi offers another avenue, aiming to decentralize rather than centralize power. To understand how DeFi does this, we can start with the blockchain. A blockchain is a vast network of computers that maintains an open, immutable public record and updates it without the need for a central authority.

Bitcoin, the first major blockchain network born in 2009, is a distraction these days. Conversely, Ethereum, a blockchain network created in 2015 and upon which most DeFi applications are built, is reaching critical mass. Ethereum developers see finance as a lucrative goal. Traditional banking requires a vast infrastructure to maintain trust among strangers, from clearinghouses and compliance to capital rules and courts. This infrastructure is expensive and is often captured by insiders: think credit card fees and bankers' yachts. By contrast, transactions on the blockchain are reliable, cheap, transparent and fast — at least in theory.

Although the related terminology is a bit daunting (the fee is called "Gas", the main currency is ETH, the ownership of digital assets Contracts are called NFTs), but the basic activities that take place on DeFi are familiar to everyone, including trading on exchanges and issuing loans and taking deposits through self-executing agreements called smart contracts. One measure of these activities is the value of digital assets used as collateral: from almost nothing in early 2018 to $90 billion; another is the value of Ethereum-verified transactions: in the second quarter of this year, this At $2.5 trillion, the figure is roughly the same as Visa's and one-sixth of Nasdaq's trading volume.

The dream of a low-friction financial system is only the beginning. DeFi is expanding into more ambitious areas. MetaMask is a DeFi wallet with over 10 million users that acts as a user's digital identity. In order to enter a decentralized “metaverse,” a virtual world of stores run by its users, you need to connect your wallet to a cartoon avatar that can roam around. As more and more consumption moves online, the digital world will be the subject of increased competition. Big tech companies can impose huge fees on these small economies: imagine Apple’s app store fees, or Facebook selling the privacy of your avatar. In contrast, a better option may be a decentralized network, where applications are hosted and the network is run by users, DeFi can provide payment and property rights.

Cryptocurrency enthusiasts see a utopian world. But there is still a long way to go before DeFi is as reliable as JPMorgan Chase or PayPal. Some questions are commonplace. A common criticism is that blockchain platforms do not scale easily, and that the computers in the blockchain network consume a lot of electricity. But Ethereum is a self-improving machine. When demand on the Ethereum network is high, the verification fees it charges rise, which encourages developers to work on reducing the intensity with which it is used. There will be new versions of Ethereum; other better blockchains may replace it someday.

However, DeFi also raises the question of how a virtual economy with its own norms interacts with the real world. One concern is the lack of external value support. Cryptocurrencies are indistinguishable from the U.S. dollar in that they rely on shared expectations of their utility; however, traditional currencies are also backed by states with monopoly power and central banks as lenders of last resort. Without these supports, DeFi would be vulnerable to panics. In addition, contract execution outside the virtual world is also an issue. A blockchain contract might say you own a house, but only the police can enforce an eviction order.

In the DeFi space, governance and accountability are not yet perfect. A sequence of transactions that cannot be overthrown by a human being can be dangerous, especially given the inevitability of coding errors; money laundering thrives in the uncontrolled gray area of services between Ethereum and the banking system; despite claims to be decentralized, Some programmers and application owners have disproportionate control over DeFi systems; a single malicious attacker may even control the majority of computers running a certain blockchain network.

Alice's DeFi Adventure

Digital Liberalism Investors would prefer that DeFi remain autonomous - not perfect but pure. However, as U.S. financial regulator and cryptocurrency expert Gary Gensler points out, to be successful, DeFi must integrate with traditional financial and legal systems. Many DeFi applications are run by decentralized organizations that vote on issues; these institutions are subject to laws and regulations. The Bank for International Settlements, a club of central banks, has hinted that government digital currencies may be used in DeFi applications to provide stability.

Finance is entering a new era in which three novel but flawed triads of tech platforms, big government, and DeFi Visions will compete and converge, each embodying a technical architecture and ideology about how the economy should work. Like the internet in the 1990s, no one knows where this revolution will end, but it will change the way money works, and it will change the entire digital world.