In January, during a taping of the “Tonight Show,” everyone in the audience received an NFT. The segment started out in a familiar fashion: Jimmy Fallon congratulates his guest — DJ and famous person Paris Hilton — on her recent wedding; showed the audience cardboard blowups of photos from said wedding (the dress was by Oscar de la Renta, Paris tells us); we learn the wedding will be airing that coming Thursday on her show, “Paris in Love.”
This banter carries on for a while when, somewhat awkwardly, the conversation pivots to nonfungible tokens, or NFTs. “Last time you were on the show, I asked you to explain NFTs. And you did so in a great way. That was a very hard thing to really explain to a lot of people,” Fallon says. “But since then, Forbes has named you one of the 50 Most Influential People in the NFT space.”
“I’m so proud,” Hilton responds. “I love being part of this community and being a voice and sharing my platform and just getting the word out there, because I think it’s just such an incredible thing to be a part of.”
The conversation turns to Hilton’s bored ape — an NFT she purchased that is an image of an ape with glasses and a biker hat. Fallon then tells Hilton that he has himself bought a bored ape, but his has a captain’s hat, a striped shirt and red, heart-shaped glasses. And then Paris tells the audience that she is launching her own NFTs and everyone in the audience is getting one.
If you aren’t quite following what happened here, you aren’t alone: A
The NFTs Jimmy and Paris were comparing are perhaps the best-known NFTs out there, from the Bored Ape Yacht Club, a collection of 10,000 unique images that sell for upward of $200,000 apiece. When you buy one, you own that image, much like when you buy a Picasso or a Rembrandt you own that image. The difference is that these NFTs exist on the blockchain — the same technology that enables cryptocurrencies and is fueling a movement known as decentralized finance, or DeFi.
Defining DeFi is difficult — it doesn’t have a leader or a stated list of goals, but it can perhaps be best understood by understanding what it’s not. The existing financial system is one whereby money is issued by governments and managed by central banks; depository institutions take money and use it to make loans and serve as gatekeepers and intermediaries between people and their money.
DeFi is about undercutting that entire top-down structure, and envisions a viable alternative monetary system in which value is stored and goods and services exchanged based on mutual agreement of the counterparties rather than by governments and banks.
If that sounds like an existential threat to the existing financial system, it is. If you can live, work, eat, play, buy, sell and invest without ever using a dollar or peso or yen, then it doesn’t matter to you what the Federal Reserve does on interest rates. It doesn’t matter if your bank charges overdraft fees. It doesn’t matter if markets are up or down. What you do with your money is between you and whoever you’re transacting with, and the secret ingredient that makes all of this possible is the blockchain.
Trusting a trustless medium
Aaron Lammer, a DeFi specialist at the proprietary trading firm Radkl, said the concept of DeFi is intertwined with the birth of cryptocurrencies.
“It’s very difficult to talk about crypto without, like, zooming very, very far backwards,” Lammer said. The concept of bitcoin was laid out in a
“Commerce on the internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments,” it said. “While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust based model.”
In other words, the existing framework for processing payments online — which is to say, most payments — requires someone in the middle of any transaction that is trusted to validate and to some extent guarantee the transaction. If, instead, all transactions were perfectly transparent and final, then what do you need an intermediary for? And with a blockchain, all transactions are perfectly transparent to all users.
But Lammer says that structure really only took one bottleneck of financial intermediation and replaced it with another: bitcoin exchanges.
“At its core, bitcoin is a permissionless system that allows people to transfer bitcoin around the world,” Lammer said. “But if you, a normal person, wishes to purchase or sell these bitcoin, you have to go to a centralized exchange — which is not decentralized, as you might guess, and has a lot of problems that the system which bitcoin seeks to replace also have.”
There are plenty of examples of how crypto exchanges can endanger customers. Perhaps the best-known example of crypto exchanges’ risk was the
In 2018, Gerald Cotten, the chief executive of QuadrigaCX — the largest crypto exchange in Canada — died while on his honeymoon in India. He left no passwords to the exchange, and
In 2015, ethereum — a rival blockchain system to bitcoin — was created. Ethereum was different because users could tell their cryptocurrency to do specific things. People could tell their money to go into someone’s wallet on a certain date or under certain conditions; users soon found they could build protocols that performed increasingly sophisticated functions on the ethereum rails, functions that to that point had only been done by banks and other financial companies for a fee. In 2018,some programmers were kicking around ideas for what to call this movement, and Inje Yeo suggested decentralized finance, or DeFi. The name stuck.
“What DeFi as a whole is, it’s trying to rebuild many of the parts of the financial system, but replacing centralized intermediaries with smart contracts,” Lammer said. “And smart contracts aren’t just a different take on this — they have some very different properties. People can’t go around and monkey with them and change them, and they’re not subject to some of the same risks because there isn’t a person sitting there who has control over them. They’re dictated by code.”
And companies are being formed to build out the ever-expanding universe of DeFi applications, many of them formed as distributed autonomous organizations, or DAOs. The exact structure of a DAO varies, but the gist of it is that the group is made up of buyers of a governance token that serves like a share, and with that share you can work directly on the protocol that the DAO is working on.
One famous example was a DAO called ConstitutionDAO that collected over $20 million to bid on one of only 13 remaining original copies of the U.S. Constitution —
Victor Lee, chief executive of DAOVentures, which develops DeFi index funds, said smart contracts actually change the fundamental structure of how an investment works because there’s no change in custody. If you want to invest in a mutual fund, you have to actually give them your money and they invest it while it’s in their possession — and a great deal of auditing and compliance costs goes along with ensuring that they have your money. With a DeFi fund, the money never leaves your hands.
“For the first time ever, you don’t even need to trust that company, because the money that you send is actually on the blockchain itself,” Lee said. “We just created a smart contract that automatically invests the money.”
And NFTs have also created the means for either physical or digital objects to be broken down into a finite number of pieces that likewise live on the blockchain — which wallet it lives in is known to everyone at any given time. There are, and will only ever be, 10,000 bored apes, which is a big part of what makes them valuable. You could also own one ten-thousandth of a physical thing — one of only 13 existing copies of the Constitution, for example — and that value would also be derived from the finite quantity of the item in question. But NFTs have other applications as well.
“A one-of-one minted NFT could also represent a financial position — it could represent a bond that pays you over time,” Lammer said. “You could create some sort of a financial contract and encapsulate that contract into the NFT format. And then if you were to say, ‘Hey, I kind of want to get out of this relationship,’ instead of us tearing up the contract and writing a new one, you would transfer that NFT, which would represent that obligation to someone else.”
The fundamental magic trick in banking, going back hundreds, possibly thousands of years, is this: Bank has some money. Borrower needs money to do something. Bank lends to borrower. Borrower pays interest. And that is how banks turn money into more money.
Imagine instead a system where much of that process is more or less automated — if the $5 in your wallet was slowly but steadily getting closer to $6 all the time. Your money gets thrown into this magic wheel and more money comes out. And that’s just what is known as liquidity pooling — lending your crypto out for defined periods and subject to specific terms. That is just one of the ways that frictions in the financial system can be reduced, cheapened or eliminated by DeFi.
And this is just the beginning — new protocols are getting made all the time that do for free the very things that the financial system relies on for revenue. But this isn’t a revolution, Lee says — it’s an evolution.
“When the internet started, people thought it is a fad,” Lee said. “Same thing as bitcoin — like 10 years ago it’s like a fad, right? But if you look at how the internet has changed the way we communicate, which is something that I don’t think anybody even thought of 10 years ago. Now I can talk to anybody at any time, anywhere, for free. The medium has changed, and then after that the business model has changed.”
Where it’s at
The places in the world where these DeFi concepts are gaining the most traction are kind of like the inverse of the places around the world where the existing financial system is most beneficial. The Finder survey that concluded that only 2.8% of Americans owned an NFT also found that 32% of Filipinos owned NFTs. The next largest adopters are Thailand, Malaysia, the United Arab Emirates, Vietnam, Nigeria, Brazil, Hong Kong, Venezuela and Peru.
At the bottom of that list are the wealthiest countries — Japan, the United Kingdom, the U.S., Germany, Australia, Canada and Singapore. There’s a reason for that.
“In a lot of the world, you go into a bank and the first thing they want to know is who is your father,” said John Edmunds, professor of finance at Babson College. “And if you have the wrong answer, then they’d say, ‘We only deal with country club people and that’s not you, so get out of here.’ ”
The places where DeFi technologies are most competitive at the moment are places where the existing financial infrastructure is serving ordinary people the least well. In the United States,
So if the DeFi movement has so much potential to provide services more cheaply than the establishment and is already beating the competition in lower-income countries, does it have the potential to threaten the U.S. banking system? It’s possible, but at the moment the scale of DeFi versus the establishment make that hostile takeover seem unlikely.
If you took the nominal values of every DeFi token and added them up together, that would
“It certainly is not ready for prime time yet, because it’s very hard even to explain to people what it is,” Edmunds said.
Even though the mechanism of DeFi and blockchain is new, the movement is still fundamentally about finding quicker and less expensive ways to do financial tasks that have been happening without blockchain for centuries.
Alex Lemberg, CEO of the DeFi firm Nimbus, said NFTs are the same as equities — shares in a company or thing. Cryptocurrency markets and exchanges are the same as foreign exchange markets and exchanges. A DAO is a limited liability corporation. None of these concepts are fundamentally new.
“If you don’t look at the news and the hype, you look past it, these are all exactly the same instruments we’ve always used,” Lemberg said. “I challenge you to find a single new use case by a blockchain that I can’t instantly marry to an actual instrument that we’ve [used] ... be it an equity, a bond, FX, a derivative or an option-based product. They’re all identical.”
And as with the financial establishment, there are malevolent interests abusing people’s trust for financial gain. One popular crypto scam is called the “rug pull,” where a group will get a bunch of investors to buy the group’s token, thus driving up the price, and then abscond with all the investors’ money and the price drops to zero — basically pump and dump for crypto. Other types of scams are basically variations on catfishing, Nigerian Prince chain letters and old-fashioned hacking. But while those older versions of fraud and double-dealing are prohibited by financial laws and regulations, there aren’t many analogous rules for crypto.
But that is changing. In early March, President Biden signed an
We won’t know with any specificity what those rules will look like for months or years, but there is some indication of where the administration plans to start.
Stablecoins — the mechanism through which actual dollars are exchanged for cryptocurrency — are one crypto asset that both the administration and
Gary Gensler, the chairman of the Securities and Exchange Commission, has likewise said that exchanges should offer the same market regulatory structure that has existed in the securities and commodities markets for decades.
“These crypto platforms play roles similar to those of traditional regulated exchanges,”
Karen Petrou, managing partner at Federal Financial Analytics, said that the core functional innovation of DeFi and crypto is a technology that could make for more efficient markets. But efficient markets are not inherently stable markets, and the U.S. financial system is as robust as it is because it offers relative safety and resilience, not because it is perfectly efficient.
“DeFi, for all its rapid growth, is still a very small segment of the financial system in which an array of stresses are just beginning to build,” Petrou said. “If you wipe away all the various internal incentives, potential governance weakness, the role of influencers and the pay-for-play built-in structure — which I think is a lot to take away — you’re left with the brilliance of DeFi, which is that it’s incredibly efficient. But I think we’ve seen a tremendous amount of very sad market history ... from adherence to efficient markets.”
‘Not everyone has the same ambitions’
If finance is ever going to be decentralized, it will have to happen while also preserving something like the regulatory structure that exists today for banks, broker-dealers and exchanges. But that’s a paradox — the whole point of DeFi is to eliminate the need for intermediaries.
The conception of DeFi as oppositional to the financial system may be accurate, but it is not, and has never been, entirely separate from it. The key to the growing popularity of DeFi tokens, NFTs and crypto is their ability to turn dollars into more dollars, not its promise to build a brave new world.
And as the tethers between the regulated financial system and DeFi become more apparent, the ways that risks in the crypto markets can spill over into the broader economy will become better known.
The International Organization of Securities Commissions, or IOSCO,
“DeFi internal chains have all sorts of cross-chain linkages and off-chain linkages into traditional financial services providers and other technologies, like cloud services,” Petrou said. “There is a tremendous amount of centralization.”
But if DeFi is a concept that is only just beginning to realize its potential, its ultimate contribution to the history of finance may be more mundane than crypto bros will have you believe. New markets might be created, and new efficiencies discovered — perhaps people will be scanning NFTs to get into baseball games in a few years. But a decentralized financial universe, a trustless algocratic global economy can’t take hold by being just a bit more efficient than the economy it wants to replace.
“Something is disruptive successfully if it is something like 10 times more efficient than the system you have now,” said Paul Clark, senior counsel at Seward & Kissel. “If you’re going to do that, you have to identify something where the efficiencies are multiples greater.”
Lammer hesitates to assign value to the grandest statements and visions for what DeFi means for the world. That’s because DeFi, at its core, doesn’t really have universally accepted objectives. It’s moving in many different directions all at once, and some of those directions are contradictory. It is experimentation with how money works on a scale that has never been tried before, and everyone is watching the results.
“If it becomes extremely integrated into the existing financial systems, it will have succeeded in getting mainstream adoption and huge amounts of locked value, but maybe it will have failed at revolutionizing some of these elements,” Lammer said. “If it stays smaller and truly outside and almost opposed to the system, it will have achieved some of those objectives of decentralization, but you could say, ‘Well, it’s failed to truly penetrate.’
“These are all dialectics where it depends which thing you think is more important and more valuable,” Lammer continued. “As someone who is on the inside of these fights within crypto — not everyone thinks the same thing. Not everyone has the same ambitions. And therefore, it’s up to people to write code and create products and execute on these visions to drive it one way or another. My experience of crypto usually is that it’s not one vision that wins out, but a variety of visions. And those are sometimes hard to predict.”
