A Conservative Case for DeFi

Why would shifting economic activity onto public, permissionless blockchains benefit the financial sector and ultimately society? Is DeFi worthwhile?

It certainly isn’t a trivial question: the likes of OHM, almost every NFT collection, UST, the ponzinomics of “DeFi 2.0” and so on (which were given credibility by many of DeFi’s most prominent public intellectuals) cast an illegitimate shade onto the industry. Technologists see a bafflingly roundabout way of speculating on JPEGs and financiers look aghast at a primitive financial system leveraging itself up with endless rehypothecation.

As these zero-sum games decline in this bear market, let’s revisit the fundamental case for DeFi–and why we’re still early in the process of building it. (This is a glass-half-full way of saying that DeFi is still far less sophisticated and efficient than the traditional financial sector.)

There are two popular, vague frameworks that inform arguments for DeFi’s value. As the title of this piece suggests, I find the more conservative and incrementalist one far more appealing. It starts with concrete pain points felt by the traditional financial sector — this perspective doesn’t try to reinvent the wheel.

This piece will focus on replacing current financial infrastructure with a far more efficient and interoperable alternative, disregarding ideology, democratization, and decentralization (for now).

But first, let’s take a look at the more revolutionary perspective.

Showing tardfi how it’s done

Looking through Crypto Twitter, you might come across a bold, ambitious, and even hubristic perspective on the advantages that DeFi enjoys over its TradFi counterpart. What else would you expect when an assortment of math nerds and innovators come together to re-invent finance?

For example, you may encounter the opinion that sophisticated on-chain AMMs will wholly replace orderbooks. AMMs are certainly quite cool and versatile. Uniswap v3 sports impressive flexibility and capital efficiency (in theory) and the design space of no-arbitrage CFMMs is surprisingly broad, including derivatives like options.

Indeed, an empirical analysis concluded that “there are assets for which a liquidity trader would prefer an automated market maker,” primarily for low-volatility assets for which the increased convenience of passive & mutualized liquidity provisioning is worth the impermanent loss (or, put another way, stale order sniping by arbitrageurs).

And then there are various new nifty financial gadgets. Why execute a TWAP order when you can split your execution into infinitely small pieces over a desired period of time using the new TWAMM mechanism introduced by Paradigm?

It doesn’t stop there. Many DeFi analysts would like to see PFOF and the Best Execution Rule replaced with MEV and a freewheeling laissez-faire marketplace of unregulated broker-dealers. Combine that with replacing dated derivatives with perpetuals (futures and options) and a slew of new crypto-native financial instruments like power perpetuals. DeFi natives even re-wrote the playbook on user acquisition by directly incentivizing users with stock rather than using the traditional advertising playbook. The list continues.

I’ve long been skeptical of this revolutionary (revanchist, even!) case for DeFi and prefer a more conservative one. Institutional traders prefer to use orderbooks for the vast majority of products. While primitives like TWAMM and power perpetuals are quite cool, they could just as easily be implemented by the NYSE or FTX, in theory. AMMs, while a cool result of what you can build with permissionless smart contracts, don’t require a blockchain. DeFi is left fighting to justify its value.

Let’s turn to a more conservative case for DeFi.

Poor man’s DeFi

To understand the value of DeFi in a very concrete way, let’s look at the history of “open banking” in the traditional financial sector. Open banking, a term usually used by regulators, is basically a less ambitious, very limited version of what DeFi accomplishes. A “poor man’s DeFi,” if you will.

It generally refers to regulation mandating that financial institutions allow other parties, such as FinTech startups, to access user data and even control their accounts through an API (ideally following a single specification!). It’s a great idea. On Investopedia, it reads without a hint of irony that “open banking is becoming a major source of innovation that is poised to reshape the banking industry.” I wrote a report (unfortunately it’s private) for a think tank saying much the same thing back in 2019 and, to no one’s surprise, the initiative doesn’t seem to have made much progress since then.

For the Brits out there who need some reminder that they live in a proper country, the U.K.’s Open Banking initiative is widely viewed as the best (and perhaps the only successful) model. It’s built atop the EU’s rather toothless PSD2, mandating that banks agree to a single standard and establishing the U.K. as the world leader in open banking regulations. A report by Australia’s Treasurer recommends basing standards on the U.K.’s system and EY proclaimed that “it is widely acknowledged that the UK’s approach is the global benchmark.”

It gets even better! In 2017, the World Bank’s IFC and Singapore’s MAS signed a memorandum of cooperation to develop the ASEAN Financial Innovation Network (AFIN) along with a group of national bank associations called the ASEAN Bankers Association (ABA). If AFIN sounds a lot like some random EVM fork to you, that’s because it kind of is! It shares a lot of the goals of DeFi, from driving broader adoption of fintech among unbanked people in emerging markets to allowing FIs and FinTech firms to seamlessly interoperate through standardized APIs.

This move follows Singapore’s preference for a light regulatory touch, with the hope of encouraging organic adoption over setting deadlines. “You can come and say, ‘thou shall do it’ but then nothing happens effectively,” according to David Hardoon, who was Chief Data Officer at MAS at the time. This worked fairly well in Singapore but not outside its borders due to the massive gap in government quality. AFIN seems to have been a flop, with likely fewer users than the most obscure EVM fork out there.

Let’s piece this all together. For almost a decade, government agencies across the world have been trying and failing to enforce even a tiny portion of the revolutionary interoperability & transparency DeFi offers. However, even with a successful implementation of open banking, against all odds, the question can be raised: why should each bank independently build an internal API that conforms to a central specification instead of simply saving a ton of costs by all using a shared financial settlement layer?

Disintermediation and M(inimal)EV

Porting the financial system over to a single settlement layer with sophisticated scripting capabilities does more than just enable easier interoperability. It disintermediates a whole swathe of middlemen from the financial sector.

Philippon 2015 presents the results of a comprehensive 5-year long study on the costs of intermediation in the entire financial sector. The study finds that the annual cost (which corresponds to the size of the finance industry) has fluctuated around a mean of roughly 2% of all outstanding assets between 1886–2012. This cost is currently well above the lows reached in the 1960s. Most of this variation is due to corresponding changes in the quantity of heavily intermediated assets like equities and real estate, rather than any changes in the efficiency of financial intermediation. (It’s worth noting that there are some shifts that obscure declines in fees in specific sectors. For example, Philippon 2015 notes that, in the asset management sector, “individual fees have typically declined but the allocation of assets has shifted toward high fee managers in such a way that the average fee per dollar of assets under management has remained roughly constant.” See also Gennaioli et al. 2015 on this.)

There are two remarkable things about this finding:

1. The tremendous annual cost of financial intermediation
2. The efficiency of financial intermediation has not increased despite significant advances in technology such as the invention of computers and the internet

If I were writing a pitch deck to raise a seed round for yet another L1, this is the point when I’d say something like “the TAM is $4t with a capital T.”

This intermediated model of conducting financial activity, in addition to its inefficiency, isn’t very robust in extreme market conditions–conditions that, ironically, are often invoked to justify the intermediated model. Recall, for example, when Robinhood had to prevent its users from opening new positions on GME because increased volatility and volume obliged it to post another $2.2b in collateral to the NSCC that it didn’t have (this caused a conspiracy theory that Robinhood was trying to protect the hedge funds shorting GME, notably Citadel). A large amount of collateral necessary simply to clear trades is due to stocks’ 2 business day settlement time (T+2). Largely as a result of this fiasco, the SEC proposed in 2022 to reduce settlement times of securities to T+1. Gary Gensler explained that “as the old saying goes, time is money. Shortening the settlement cycle should reduce the amount of margin that counterparties would need to post with clearinghouses.” Imagine the increased capital efficiency of settlement within a few seconds.

As Sam Bankman-Fried (CEO of FTX) recently noted, when an order is submitted on Robinhood, the dollars are sent to Robinhood’s bank account, then to a PFOF firm for execution, which would likely agree to a trade with another trading firm, which may finally submit an order to a public exchange. The DTCC intermediates each transfer of securities in all of those steps and final settlement doesn’t occur for two days. He goes on: “So in order for your friend to buy one share of AAPL, 11 different entities have to settle with each other over the next few days in 10 payments. And in theory, any one of those settlements could fail.”

The team at FTX US wants to change that. The CFTC recently held a roundtable discussion about non-intermediation of futures settlement, focusing on FTX US’s request to offer direct clearing of futures on its exchange by counting all users as members of its own clearinghouse, disintermediating the futures commission merchants (FCMs). This would prevent a situation like the Robinhood GME fiasco: each user is responsible for the solvency of their own margin account and executes trades directly through the clearinghouse.

Hilary Allen, professor at the American University Washington College of Law, noted at the roundtable discussion that “while I see the rhetorical appeal of the [disintermediated, direct settlement] model, it does not work when you cannot figure out what the actual risk is.” (To be clear, she is referring to margined, digitally settled futures that structurally have well-defined risk with a liquidation buffer, but in practice, the risk flows through multiple parties — brokerage, FCM, clearinghouse — so it’s difficult to pin down.) Ironically, this objection underscores the broader problem that our legacy financial infrastructure grapples with. Many things don’t work when you can’t figure out the actual risk because it’s entangled and obscured between dozens of middlemen and internal ledgers, without a logically centralized accounting that serves as a source of truth.

The importance of this logical centralization has made waves in the cryptocurrency space. Many blockchains, notably Ethereum, have shifted away from this model and towards a system of various self-contained L2s in order to distribute congestion across them. Kyle Samani of Multicoin Capital wrote a pointed reaffirmation of the value of logical centralization when announcing his firm’s investment in Solana. A single layer capable of handling the entire financial sector’s activity and risk management doesn’t just offer some more convenience and composability than a collection of separate layers but is in fact essential to the fundamental value proposition of DeFi.

Multicoin captures the thesis of this essay concisely in their “open finance” thesis, which also alludes to the analogy to the special case of open banking:

“By making units of value — stocks, bonds, real estate, currencies, etc. — interoperable, programmable, and composable on open ledgers, capital markets will become more accessible and efficient. Just as the proliferation of capital markets over the last 100 years enabled staggering levels of wealth creation, open finance will make capital markets more efficient and accessible to everyone on the planet.”

Conclusion

There are various factors credited with differentiating DeFi from CeFi. Qin et al. 2021, for example, emphasize transparency, control / self-custody, and accessibility. I believe the most compelling benefits that DeFi offers to the current financial sector are interoperability and disintermediation–which, ultimately, are all about efficiency. The 2% unit cost of intermediation in the current finance industry shouldn’t last for yet another 130 years.

The financial sector’s desperate need for more robust and complete interoperability standards is far from controversial. Think tanks and regulatory bodies ranging from the World Bank’s IFC to Singapore’s MAS have unsuccessfully pushed for a fraction of the interoperability natively offered by DeFi for about a decade. The primary value of DeFi is to showcase how the financial system can run far more efficiently on a shared, programmable settlement layer.

For a pessimistic view of how the developed world can mess up this opportunity, read Anthony Lee Zhang’s piece “The Market for Promises.” Since intermediation in developed economies works well enough (we have a functional, albeit horribly inefficient, mechanism for reinforcing contracts/promises), “financial innovation in developing countries will rapidly overtake developed countries, because software innovation is always fastest where there is the least amount of regulation and the lowest barriers to entry.”

DeFi, to be clear, isn’t yet ready for this challenge. It lacks many sophisticated features of the financial system but, as an Arabic proverb goes, “what is coming is better than what is gone.”