Writing a book on decentralized finance is a bit like describing a riddle, wrapped in a mystery inside an enigma, to borrow from Winston Churchill.
Writing a book on decentralized finance is a bit like describing a riddle, wrapped in a mystery inside an enigma, to borrow from Winston Churchill. First, one must summarize the origins of modern decentralized finance, then the mechanics of the blockchain technology that provides the sector’s backbone, and only then do you arrive at DeFi’s infrastructure. It all should be done in 191 pages, too, 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 recapitulating the “five flaws of traditional finance” — inefficiency, limited access, opacity, centralized control and lack of interoperability — they go on to explain how DeFi improves upon the status quo.
Take the problem of centralized control. Governments and large institutions hold a “virtual monopoly” over the money supply, rate of inflation, as well as “access to the best investment opportunities,” wrote the authors. DeFi with its open protocols and immutable properties “upends this centralized control.”
As for how DeFi answers traditional finance’s opacity shortcoming: “All [DeFi] parties are aware of the capitalization of their counterparties and, to the extent required, can see how funds will be deployed,” which mitigates counterparty risk. As goes inefficiency, “A user can largely self-serve within the parameters of the smart contract” in a decentralized application by exercising a put option, for instance.
What about traditional finance’s failing in limited access? DeFi gives underserved groups like the world’s unbanked population direct access to financial services, wrote the authors, offering yield farming as an example, a DeFi process where users are rewarded for staking capital in the form of a governance token that makes them, in effect, part-owners of the platform, “a rare occurrence in traditional finance.”
The authors also described the ways that DeFi protocols can be layered atop one another (i.e., DeFi’s composability, sometimes referred to as “DeFi Legos”), which helps to deal with the interoperability deficit. Once a base infrastructure has been established (to create a synthetic asset, for instance), “any new protocols allowing for borrowing or lending can be applied. A higher level would allow for attainment of leverage on top of borrowed assets.”
Taking a deep dive
Chapter 6 explores eight leading DeFi protocols in depth: MakerDAO, Compound, Aave, Uniswap,Yield, dYdX, Synthetic, and Set Protocol. Each section is accompanied with a very useful table, where the first column describes how traditional finance solves a particular problem, and the second column how a specific DeFi protocol deals with that problem.
For example, in Table 6.3, “Problems that Aave Solves,” the first row deals with “centralized control.” In the incumbent finance system, “borrowing and lending rates [are] controlled by institutions,” whereas in the DeFi approach, Column 2, “Aave interest rates are controlled algorithmically.”
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Traditional finance provides only “limited access” within its legacy systems. That is, “only select groups have access to large quantities of money for arbitrage or refinance” (Row 2, Column 1), while within the Aave protocol, “flash loans democratize access to liquidity for immediately profitable enterprises.”
The third row focuses on “inefficiency,” specifically “suboptimal rates for borrowing and lending due to inflated costs” in traditional finance, while Aave’s solution (Row 3, Column 2) is “algorithmically pooled and optimized interest rates.”
Novel risks
The authors were careful to remind readers that “all innovative technologies introduce a new set of risks.” In the case of DeFi, these are abundant, including smart contract, governance, oracle, scaling, DEX custodial, environmental and regulatory risks.
“Software is uniquely vulnerable to hacks and developer malpractice,” the authors wrote, while recent hacks of bZx and DForce “demonstrate the fragility of smart contract programming.”
Among these new threats, “oracle risk” looms particularly large. DeFi protocols require access to accurate, secure price information to ensure that actions such as liquidations and prediction market resolutions work smoothly. “Fundamentally, oracles aim to answer the simple question: How can off-chain data be securely reported on chain?” Yet, all online oracles as currently constituted “are vulnerable to front-running, and millions of dollars have been lost to arbitrageurs,” they wrote, adding:
“Until oracles are blockchain native, hardened, and proven resilient, they represent the largest systemic…
cointelegraph.com