Decentralised Finance (DeFi) only can be made possible because finance was centralised. It was not always this way. Long before banks and central banks, there were local credit markets. In the 17th and 18th centuries, these markets comprised local businessmen and merchants in groups such as societies but in more or less hermetic circles. Why a hermetic circle? How else would you know who to trust unless you operated in a closed environment? Lending and credit were person to person based upon the references of other people. The credit reporting agency was the sum total of all participants and local references.
Larger groups began to take the form of credit cooperatives or building and loan organisations. As the pools of money grew, so did the ability to assess risk and efficiently manage the funds. The key to the growth and management was better communication. Bank agents would travel far and wide to trade fairs. At these trade fairs, the balancing of credits and debits between the banks would be addressed, and their lists of “desirables and undesirables” would be exchanged.[i] The first credit reporting agencies were indeed decentralised and cooperative, crafted out of necessity to manage the risk of lending. To know who was a good risk and who were known credit defaulters – blacklisted.
The centralisation of finance and the accompanying economies of scale were built on communications technology. Fast, efficient communication by telegraph, telegrams, teletypes, and international telephony gave banks and insurance companies an asymmetrical information advantage. The computer age permitted banks to digitise record collection and permit the deeper analysis of market information. The market information came from the sentiment of their clients through the analysis of their client’s transactions. Observing grain elevators paying more for grain in Kansas than in Minnesota may provide insight into the future of grain prices or the arbitrage opportunity. As finance globalised, these discrepancies could now include pricing differentials in grains between Argentina, the US, and Europe. Advance knowledge of the market made available through fast communication and the ability to analyse the data from transactions gave centralised finance the advantage.
In 2001 the internet produced double the amount of information of all previous human history, going back to the cave paintings and the dawn of culture. In 2002 the amount of information was twice the amount generated in 2001.[ii] This information explosion laid the foundation for what would become the great disintermediation. The professions that relied on asymmetric information began to fall by the wayside. Travel agents, bookstores, video rental, telephone books including the yellow pages, newspaper and magazine publishing, local guide books, local specialty stores, any business that relied on the asymmetry of knowledge was put under intense pressure. The information technology revolution is the seed for today’s decentralised financial markets.
The landmarks in decentralised finance began with the first peer-to-peer lender Zopa in 2006, then Lending Club and Prosper (2006), Kenya’s launch of M-Pesa (2007), a mobile payment system, and the financial crisis of 2008-2009. The financial crisis led to the banks facing survival issues, let alone putting more capital at risk. During this time, people and businesses unable to find credit from traditional finance and investors looking for greater returns began to find each other through formal and informal networks. Peer-to-Peer lending (P2P) began to explode.
During 2008-09 I asked my banker if I could get a signature loan to buy home foreclosures at auction and resell the homes. He was very honest and said the bank had too many rules and regulations with which to comply to make them an effective lender. My banker referred me to a pension plan lending on any home if the borrower had 20 per cent skin in the game. With the lender, a large physician's pension plan, I was able to buy and sell seven homes in four months. No bank, no mortgage company, a pension fund lending to a borrower.
The event that many refer to as the beginning of DeFi was the founding of Bitcoin in 2009. Billions were already being borrowed and lent in peer-to-peer organisations before Bitcoin arrived. Bitcoin is not DeFi, it is just a digital currency.
DeFi today is broken down into three categories:
The platforms are crafting unique exchanges to introduce lenders to borrowers, risk transfer through unique instruments, prediction markets, ease of creating derivatives through smart contracts, and so much more. One unique use I was exposed to was a chain hotel using a predictive market to hedge the price of future hotel rooms. The hotel chain had several hotels near a baseball park in a big city. That city’s baseball team had a good record, and it was expected to play in baseball's postseason. The hotel could block off those rooms during the days of postseason home games and world series to rent them out at a much higher rate, or they could not block off rooms, keep the current rate, and raise the rates on unsold rooms when and if the team succeeded in entering postseason play. The hotel chain chose to block off all rooms and bet on the opposition. If the opposition won, they would have made what they predicted to have made by keeping the rooms open. If they lost, they predicted they would make five folds the cost of the losses on the hedge.
Creating utterly unique products such as smart contracts is a fascinating space. A builder of homes created a series of smart contracts between all subcontractors for the construction of 89 homes over one year. The contracts had several functions. They acted as a communication tool between all the subcontractors, suppliers, owner, and sales force to adjust their schedules if there were delays due to weather, supplier issues, and if inspections failed or passed. The contracts provided both rewards and penalties to all involved. Payments were made the same day or the next day as work proceeded. Since the field crew assessed the benchmarks, more incremental payments could be made to the subcontractors. The impact required less bank financing for the subcontractors, and the builder needed fewer people to administer the payment side of the build. The project came in just a bit ahead of schedule and on budget. All participants said they wanted all future work to be done in this fashion. The benefit, they wasted less time on communication and had no difficulties knowing when their crews and supplies had to be onsite. I have seen Non-Fungible Tokens used in concert with Cell Limited Liability Companies (LLCs) to underwrite different insurance policies. The risk (a completion bond) was put to a market of insurance investors and sold through participation in an NFT issuance. No insurance company in the middle is making the most of a platform and a resalable NFT digital token until the expiry of the contract.
A small experiment was the funding of a patent research and application process for US$100,000 through the sale of NFTs on a platform. The owners of the NFT had a 45 per cent ownership of the patent. The first US$100,000 in revenue would go to repay their investment, and afterward, they would receive 45 per cent of the revenue generated by the patent.
Offshore is playing a critical role in DeFi. IFCs lack the blocking or broad licensing legislation of legacy financial centres. London, New York, Singapore, Tokyo and Paris have a great deal of gravitas. But innovation in large financial firms and well-established financial centres only occurs when better ideas have been crafted and vetted elsewhere.
Much like the spirits industry, large financial firms are terrible at innovation. They have to survive the fear of failure and pass the opinions of the new products committee, so what comes out the other end is – blech - same old, same old brands. It takes entrepreneurs with real skin in the game and a fire in the belly to create utterly unique new brands. Thousands of new brands are created every year, only a handful survive. As soon as a spirits brand starts to gain traction, a major brand house will give it time and look to acquire the new brand. As one brand manager said, it is cheaper to overpay for a good new brand than to try and come up with something in-house.
The DeFi experiments need to continue. More sandboxes for innovation should be established. The lead will probably go to the centres that lead in gaming, insurance and have established custodial services. DeFi is the creation of utterly unique contracts and opportunities that have a great deal to do with odds and keeping it real with streamlined custodial supervision. The market in any financial instrument thrives with good information and transparent practices. When necessary, permission should be liberal, failure tolerated and understood, and chicanery punished.
DeFi is a fast-growing finance segment and it remains an immature market with many unsolved problems – economic, technical, operational and regulatory. The frustration of traditional inflexible legacy markets fosters growth. Frustration combined with a fascination with the new creates an environment for utterly new, unique and compelling products and services.
[i] For history purists, I know I have sent your skin crawling. That trade fairs and local credit circle have existed for centuries alongside each other from the Phoenicians forward and even backward. I am going for a linear referent of financial evolution to simplify points made.
[ii] Martin Gurri on Econtalk with Russ Roberts discussing his book "The Revolt of The Public."
L. Burke Files DDP CACM
Mr. Files is an international financial investigator and due diligence expert who has run cases in over 130 countries and has visited over 100 countries. Mr. Files has tackled investigations running from a few hundred thousand dollars to over 20 billion. Along the way, he became familiar with the knowledge of what people need to do, for due diligence, preventing corruption, and to avoid helping criminals launder money. He brings this experience of hands-on investigating and problem-solving experience to his lectures on Due Diligence, AML, and Anti-Corruption. Prior to founding FE&E, Inc., he served as the Director of Corporate Finance for American National an investment bank focused on development stage venture capital. He was also employed by Oppenheimer/Rouse as a commodities specialist trading customer accounts in Agri-Business, 24-hour gold and silver, and foreign currencies. Mr. Files has authored six books, and many white papers and articles. He has been quoted in major publications including The Guardian, The Financial Times, Forbes, US Newsweek, and more. He is the author of the award-winning book Due Diligence For The Financial Professional 2nd Edition. Mr. Files serves on the board of directors for several private companies, funds, and non-profits. The companies include Unicus Research a specialty advisory service for fund managers and family offices, SGS Glazing a specialty glazing design and estimating firm, and NSI a premium spirits company.