Decentralised finance is booming, but it has yet to find its purpose

By Alice Fulwood: Wall Street correspondent, The Economist, New York

IT IS COMMON, in the minds of economists, academics and most regular folk, to think of the real economy and the financial economy as separate but interlinked spheres. This is the essence of the “classical dichotomy” at the heart of the neoclassical school of economics, which considers money “a mere veil” obscuring real underlying activities. Those labouring in the real economy grow wheat, write articles and build houses. Financiers simply shuffle money around on top of that. Yet at its best financialisation makes possible real activity that could not otherwise occur. This is apparent for a loan made to a startup, or a bond that enables the building of a new factory. But it is also often true of more complex areas of finance, such as exchanges and derivatives. It is here that 2022 will see exciting innovations.

Over the past two years, many of the functions of the financial system have been recreated as applications and protocols on the Ethereum blockchain, an open blockchain that can store and verify lines of code. Activities are mostly carried out via “smart contracts”, which self-execute according to predetermined conditions. Many things have been written into open-source code using smart contracts, including wallets and payment systems, deposit and lending applications, and even investment funds and systems to self-stabilise currency regimes.

Collectively, this array of functions is known as decentralised finance, or “DeFi”—and it is booming. From less than $10bn in early 2020, some $100bn-worth of tokens are now locked up in financial smart contracts for use on decentralised exchanges or deposited to earn yields. Demand for DeFi apps is driving up usage of the Ethereum blockchain. It settled $116bn-worth of transactions in early 2020, but that boomed to $2.5trn-worth in the second quarter of 2021, including payments and transactions to facilitate trading and lending. (Visa, a payments giant, settled about the same amount in the same period; Nasdaq, a stock exchange, traded six times as much.)

The system has many advantages over traditional finance. Payments are often cheap and are almost instant. By pre-determining the rules of transactions in ways that are impossible to mess with, DeFi can eliminate things like settlement risks. By locking up collateral for a loan in a smart contract, the risk of a counterparty defaulting can also be eliminated.

The barriers to entry are low by comparison with traditional finance, so DeFi has quickly become the arena where the most exciting innovation is occurring. For example, an entirely on-blockchain stablecoin (a token pegged to a government currency, like the dollar) called dai lets anyone create new dai tokens by depositing collateral in a smart contract. If the value of the collateral drops below the minimum threshold of 150% of the value of the outstanding dai, the smart contract automatically auctions the collateral to cancel the debt. Dai is remarkably stable against the dollar and solves many of the problems associated with previous stablecoins.

The problem is that all this fancy financial engineering has, as yet, no “real” economy to service. Instead it underpins an incorporeal casino: most of those using DeFi do so to facilitate or leverage their bets on one of many speculative tokens. That might change in 2022. There are three plausible paths for marrying up the DeFi economy with a real one. First, it might supplant the established financial system, perhaps by the adoption of a token as a means of payment. El Salvador adopted bitcoin as legal tender in September, introducing its 6.5m people to decentralised tokens. But this is less likely in stable, developed countries.

Second, DeFi may begin to merge with conventional finance. Assets typically handled by the financial system—houses, shares and bonds—might find their way onto a blockchain system. Previous attempts to do this using “enterprise blockchains” (run by a single institution) offered some efficiency gains, but missed out on many of the benefits of decentralisation, such as interoperability and transparency. By exploring ways to move assets such as shares onto an open-blockchain system, and to ensure that real-world outcomes can be enforced, DeFi could become more useful for all.

Third, the development of a real economy on top of a blockchain might flourish. Economic activities such as creating videos, images, music and text are wholly digital, which is why media can be distributed online, mostly by giant, centralised tech platforms. But decentralised, on-blockchain platforms to distribute these kinds of content are nascent and flourishing. If digital content can be purveyed on a blockchain system, DeFi will have found its real economy.

Alice Fulwood: Wall Street correspondent, The Economist, New York■

This article appeared in the Finance section of the print edition of The World Ahead 2022 under the headline “High five, DeFi”