Over the last few years, blockchain and its applications – such as Bitcoin – have gone through a cycle of high promise and setback. In September 2017, some commentators argued that blockchain was the most important invention since the internet and electricity. Then, a few months later, governments in China and South Korea declared initial coin offerings (a fundraising practice for blockchain based applications) unlawful, and the industry, as well as Bitcoin’s price, slumped. More recently however, interest in blockchain has revived, aided by Facebook’s attempt to launch their own cryptocurrency, Libra, and the Chinese government’s embrace of blockchain technology. In our new paper, we contextualize blockchain in the financial sector and analyze its potential and limitations therein.
From finance, to fintech, to decentralized finance
Traditionally, financial institutions play an important role in mediating and structuring economic transactions. They reduce transaction costs by connecting market participants and building trust. However, with the move into the digital economy, financial technology (FinTech) has started to fill some of the roles played by these large financial institutions. FinTech has spurred a new wave of innovation because it reduces transaction costs, expands transaction scope, and empowers peer-to-peer transactions. However, though FinTech has reduced the need for financial institutions, it has not eliminated them entirely. Instead, FinTech substitutes one intermediary (e.g., a financial institution) with another (e.g., a technology company). The progress of this substitution and the increase in decentralization suggest that blockchain-based decentralized finance may be the next step in the FinTech revolution.
Recent developments in blockchain technology are creating a new paradigm that can lead to decentralization and disintermediation. Blockchain can eliminate the need for intermediaries to facilitate financial transactions, as the technology facilitates distributed trust and the creation of decentralized platforms. As a result, blockchain technology can turn previously infeasible business models into viable ones. The technology can make financial services more decentralized, innovative, interoperable, borderless, and transparent. Entrepreneurs and innovators have also recognized that blockchain technology has the potential to create an open financial system which could limit (or eliminate) financial intermediaries. Although this movement is still in its early stages, if it continues to gain momentum, it may disrupt existing financial industries and create new opportunities for entrepreneurship and innovation.
Advantages of blockchain-based decentralized finance
In a decentralized financial system, financial transactions are facilitated not by traditional financial institutions, such as banks, but by decentralized peer-to-peer networks. By reducing the involvement of these centralized institutions, decentralized networks reduce transaction costs and create network effects without incurring monopoly costs. Even when a decentralized peer-to-peer network rises to dominance, no single entity can accumulate sufficient power to monopolize the network and exclude others from participating. This allows the users to benefit from network effects and expand transaction possibilities.
A decentralized platform lacks a controlling authority and allows open access and permissionless innovation—that is, developers can freely build and experiment with new applications without asking for permission. Permissionless innovation empowers developers and allows them to evolve decentralized finance freely and quickly. Decentralization also facilitates combinatorial innovation. In a decentralized finance ecosystem, new financial technologies can become the foundation for future innovations, promoting new combinations and new products. Combinatorial innovation can accelerate the pace of financial innovation as well as the degree of market competition, potentially leading to newer, better, and cheaper financial services.
Decentralized finance enhances interoperability. Traditional finance tends to work in silos, driving up transaction barriers. Different financial institutions have to maintain their own ledgers, and one financial service may not be interoperable with another. Decentralized finance is built on public blockchains and open standards, increasing the interoperability across different services. With high interoperability, financial capital and value can flow seamlessly across different services and borders, potentially creating an internet of value.
Traditional finance is tied to specific geographic locations with specific fiat currencies. As a result, moving capital and value across borders encounters friction and delay. By contrast, decentralized finance is inherently borderless and global. Moreover, it does not rely on any specific central bank or government. With decentralized finance, transferring value across the globe may become as easy as sending an email.
Decentralized finance can enhance transparency in the financial system. Centralized finance cannot have full transparency, as access to the ledgers of the financial institutions are restricted. Decentralized finance, on the other hand, secures its ledgers through distributed consensus (e.g. the peer to peer network authorizes a transaction) and radical transparency. It records transactions on public ledgers that can be easily viewed and verified. With public ledgers, decentralized finance generates distributed trust, so parties can confidently transact with each other without pre-existing relationships or a trusted intermediary, expanding the scale and scope of potential transactions. In addition, decentralized finance is often built with open source code, so external parties can check business logic, expressed via code, to expose all hidden risks and biases, assuring and protecting transacting parties.
Decentralized finance business models
Blockchain technology allows the development of new business models that were previously not viable. This model is based on four components: (1) decentralized currencies; (2) decentralized payment services; (3) decentralized fundraising; and (4) decentralized contracting.
(1) Decentralized currencies
As mentioned above, cryptocurrencies are a vital component of decentralized finance.Bitcoin was the first currency that was not issued by any country but rather through a decentralized technology. Unlike traditional currencies, Bitcoin has a supply schedule that is fixed and cannot be changed arbitrarily, making it anti-inflationary. Because of these characteristics, Bitcoin has become the primary store of value in the blockchain industry and is often referred to as “digital gold.”
(2) Decentralized payment services
Decentralized payment networks—such as Libra and Bitcoin Lightning Network—promise to bring low-cost, instant, and global payments. With a minimal fee, for instance, the Bitcoin Lightning Network offers instant, secure, and irreversible payment services. Because of the low fees, merchants can significantly lower their costs and improve their profitability. Interestingly, Square—a centralized platform—plans to incorporate Bitcoin Lightning Network into its payment services in the near future.
(3) Decentralized fundraising
Decentralized fundraising is another opportunity created by blockchain technology. The primary form of this fundraising is an “initial coin offering” (ICO). In an ICO, project developers create a project-specific token on a public blockchain and sell the token to potential investors to raise funds for early-stage developments. Over the past few years, ICOs have enabled entrepreneurs to raise billions of dollars from global investors.A new variant—initial exchange offerings (IEOs)—has recently emerged. IEOs rely on cryptocurrency exchanges to ensure the trustworthiness of potential projects and to connect projects to potential investors. In IEOs, cryptocurrency exchanges conduct due diligence on potential projects, provide detailed information on promising ones, and list the project tokens on their exchange.
(4) Decentralized contracting
Over the past several years, blockchain technology has started to facilitate financial contracting by substituting financial intermediaries with “smart contracts,” leading to the rise of peer-to-peer financial contracting.Smart contracts are blockchain-based code that automatically executes when pre-specified conditions are satisfied. Smart contracts are transparent, immutable, automatic, and programmable, and thus expand the possible scope of contracting. For example, decentralized platforms—such as MakerDAO, Compound, and Dharma—use smart contracts to decentralize lending and borrowing, reducing costs, friction, and delay.
Next steps for developing a decentralized financial system
A number of challenges need to be overcome to realize the full potential of a blockchain-based decentralized financial system. First, decentralized finance can be vulnerable to fraud as well as to the proliferation of untested financial innovations. To succeed, decentralized finance needs to cultivate a healthy ecosystem that encourages responsible innovation and weeds out fraudulent actors.
Second, decentralized finance tends to build on cryptocurrencies that are volatile. Volatility hinders both stability and popular adoption. This problem is currently being solved by stablecoins, whose value is often pegged to fiat currencies.
Third, decentralized finance often follows technology push rather than market pull. To penetrate the mainstream market, decentralized finance has to become more user-centric. Fourth, decentralized finance faces substantial regulatory uncertainty and scrutiny, which can deter entrepreneurship and innovation. For instance, Facebook’s foray into cryptocurrency and decentralized finance has been met with intense regulatory scrutiny, driving some corporate partners to withdraw their support. For decentralized finance to expand into the mainstream, a clear regulatory framework supporting responsible innovation is needed.
Potential limits to blockchain-based decentralized finance
There may be some fundamental limits that are difficult or impossible to overcome. These limits concern the nature of decentralized platforms and distributed trust. First, building distributed trust on decentralized platforms can be costly (e.g. computing power, energy consumption). This can limit the overall applicability of decentralized finance. Second, although transparency is a cornerstone of decentralized platforms and distributed trust, extreme transparency may jeopardize privacy. Third, although the immutability of public ledgers and smart contracts enhance transparency and trust, it can also result in rigidity and inflexibility. This characteristic potentially impedes experimentation, learning, and discovery. Fourth, decentralized finance may lack accountability. With little to no involvement from central entities, it can become unclear who should be held accountable for the wrongdoings on a decentralized financial ecosystem. Fifth, decentralized platforms may not make full use of all available information, because they are more likely to achieve distributed trust on inputs that can be objectively recorded and verified. Lastly, the operations of decentralized finance tend to rely primarily on the rule of code rather than human judgments. The reliance on the rule of code could become a serious limitation, if it fails to leverage human knowledge and subjective judgment.
These limitations must be properly addressed. If not, they may restrict the potential value of blockchain-based decentralized finance.
Although numerous challenges still need to be addressed, entrepreneurs and innovators have been experimenting with new business models that are not viable without blockchain technology. Leveraging blockchain technology, decentralized finance can create an alternative financial system that is more decentralized, innovative, interoperable, borderless, and transparent. As a new area of FinTech, decentralized finance has the potential to reshape the structure of modern finance and create a new landscape for entrepreneurship and innovation.