This week, when the team at MIT Technology Review put me into a fireside chat with journalist Charlotte Jee during their Emtech MIT conference, the
This week, when the team at MIT Technology Review put me into a fireside chat with journalist Charlotte Jee during their Emtech MIT conference, the assigned title for the session – “Demystifying Decentralized Finance” – got me thinking.
It occurred to me that before we demystify DeFi, or for that matter the wider ecosystem of blockchains and digital assets, we need to first demystify traditional finance (TradFi).
Most people don’t have a solid understanding of how our capitalist system of payments, credit and asset transfers works. Getting to that understanding, I believe, requires looking into the deep historical roots of money and the social system of trust that has evolved around it. Only then can we develop a framework for talking about the traditional financial system and how the crypto industry seeks to disrupt it.
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That’s what I’ll attempt to do with this column. First, I’ll categorize what I see as the architectural components of the traditional, centralized, fiat- and banking-based financial system, explaining how each came into being and the purpose it serves. Then I’ll map those components to their equivalents in the new, decentralized, crypto- and smart contract-based system.
A caveat: This is just one way of looking at this issue. It inevitably will have inconsistencies and contradictions. Feel free to email me with feedback, especially if some of my analogies and explanations are off.
The Money Stack
This framework starts with what I’m calling the “money stack” – no, not a stack of money, but an analog to the idea of a software stack.
Let’s look at each part of the stack, its historical antecedents and its role in the financial system.
The Ledger
Historically, the accounting profession has been the butt of jokes, a byword for “boring.” But the humble ledger-keeper is actually the foundation of human society.
It is no coincidence that the very first known examples of writing are the cuneiform records displayed on clay ledger tablets from ancient Mesopotamia, the cradle of civilization. One of those tablets includes what is thought to be the very first name ever recorded: that of a Sumerian accountant by the name of Kushim.
To create a functioning system of exchange, one in which people across a larger community than just a small village could enter into contracts for trading goods and services, societies needed a trustworthy system of record-keeping to keep track of the delivery and settlement of those agreements. That’s what those ancient tablets enabled.
The technology for recording and storing those transactions has, of course, evolved tremendously from clay tablets to giant data farms. But in TradFi, the core governing principle for creating and keeping that trustworthy record hasn’t changed: it’s centralized, maintained by a trusted third party. Once it was Sumerian accountants like Kushim. Now it’s institutions such as banks, internet platforms and applications, or government agencies.
Currency
The true “money” part of the money stack emerged alongside the accounting tablets, at least in the form we currently recognize: currencies. Currencies gave people a medium of exchange, a commonly recognized unit of account with which to measure the worth of a good or service and store of value that can be converted in the future into those things of real value.
To me, money is best understood as a social technology. It’s a system that we all collectively believe in, one that requires a shared foundation of trust in the commonly recognized value of the currency. Getting that trust to scale across large communities required coordination. So, in the absence of a decentralized governance system to achieve that, the state seized that role. The relationship between government and money was formed early on.
A big leap in the technology of money occurred in the late 15th century when the Medici family took double-entry bookkeeping, a version of ancient ledger-keeping first developed in Arabia, and applied it to banking. That enabled a massive scaling of the payments and exchange function of money as it was no longer dependent on transfers of the underlying physical currency. It also forged a deep, symbiotic relationship between banks and the issuers of that physical currency, creating two sides of a centralized system of money.
Debt
Those same banks powered the development of credit. As they became pivotal to monetary systems, they began to accumulate society’s savings, amassing from people with surplus funds a giant pool of otherwise dormant liquidity to repurpose into loans for those with a deficit of funds.
Out of this grew a complex machine for generating credit, a system of interlocking institutions driving economic activity and…
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