Decentralized Finance (DEFI): Toward a Digital Barter Economy

This text has been adapted from a chapter of the book Token Economy.

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Cryptographic tokens represent a new heterogenous asset class that can fulfil a diverse range of economic functions. They can represent money (payment tokens), securities (security tokens) or any other real or digital asset (asset tokens) but also a series of non-fungible and non-transferable credential tokens that are tied to one’s identity. As for transferable, and thus tradeable, token types, tokenisation can create more market depth and liquidy, especially in the case of fractional tokens of real assets with generally little market dept.

The emergence of a series of plug and play DEFI products has further contributed to an increase in liquidity for existing digital assets, and can do the same thing for real assets once they become tokenized. Their frictionless issuance and settlement process could potentially convert many assets or access rights of the real world into bankable funds.

“Non-bankable funds” are assets that are not accepted as a method of payment in a bank. “Bankable funds” are forms of payment that are accepted at financial institutions and easily liquidated into local currencies such as checks and money orders. They can be converted into cash with short notice and are generally accepted by merchants as a method of payment. In light of potential widespread tokenization, any tokenized asset could — in the future — receive the status of a “bankable fund.” Such developments could make any tokenized asset a potential medium of exchange — aka money.

However, as of today, most tokens do not fulfil some important properties of money: stability, and to some extent, also fungibility. Furthermore, usability and scalability are also entry barriers to potential mass adoption of tokenization.

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Source: Shermin Voshmgir, https://token.kitchen

The speed at which tokens are currently being issued is an indicator that a new tokenized economic system is emerging (see the number of Ethereum Token Contracts issued). Such tokenization of the real economy could gradually lead to the merging of the monetary system, with the financial system and the real economy.

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Source: Shermin Voshmgir, https://token.kitchen

Tokenizing economic activities, from real assets to digital assets and all types of access rights, could impact the role of central bank money as a geographical monopolist providing a medium of exchange, once mass adoption of the Web3 manifests and necessary network effects kick in.

DEFI

A range of easy-to-use decentralized financial (DeFi) applications have emerged — beyond simple payments networks — that facilitate frictional and P2P asset issuance, trading, lending and hedging. The term “DeFi” encompasses any decentralized and permissionless financial application that builds on top of distributed ledgers, including:

  • privacy-preserving payment systems (privacy tokens),
  • stability preserving payment systems (stable tokens),
  • P2P exchanges (token exchanges),
  • P2P fundraising (token sales),
  • P2P credit and lending,
  • P2P insurance, and
  • a growing list of P2P derivatives.

These Web3-based DeFi applications could, potentially, open traditional financial services to the general public, mitigating current inefficiencies of financial markets.

Challenges of the Current Financial System

The current financial system, even in its electronic form, requires a range of intermediary services for (i) mitigating counterparty risk, (ii) market making, and (iii) securing funds from being stolen. This is a result of the server-centric nature of the current Internet. In a tokenized economy, however, distributed ledgers and user-centric identity solutions could increase ecosystem transparency, accountability, and market efficiency:

  • Due to the public nature of distributed ledgers, DeFi applications are designed to be globally accessible by anyone around the world with an Internet connection and a Web3 wallet. Once the smart contract is deployed, DeFi applications self-execute with little institutional intervention except for code upgrades, bug fixes, and dispute resolution.
  • If users choose “non-custodial” wallet solutions, they remain in possession of the private keys and in full control of the funds, potentially disintermediating many financial services that currently provide services to mitigate counterparty risk, act as market makers, or secure funds from being stolen.
  • Any smart contract code can be audited by anyone and is subject to collective loophole fixing, which is the basis for the rapidly evolving DeFi ecosystem.
  • All token transactions are publicly verifiable, reducing market friction and increasing the interoperability of financial services. As a result of such interoperability, DeFi applications can be built in a modular way, which is why many refer to them as “money legos.”

Combining various DeFi solutions, such as “stable tokens,” “decentralized exchanges,” and “decentralized lending,” can produce completely new products available to retail investors and the general public. Any private person could, in such a setup, tokenize their real assets and use them as collateral for P2P lending solutions without bureaucracy by using a combination of simple DeFi applications. Such new services could, in the long run, change the dynamics of our economic system and contribute to the merging of the real economy and the financial system, making their distinction increasingly impossible.

Money Legos: The End of Money as we know it?

While such “money legos” are quickly emerging, they are still nascent and often prone to exploits and attacks as a result of unintended programming mistakes and malicious hacks. The governance/business logic of the underlying smart contracts needs extensive auditing and bug fixing, especially in light of a growing and complex network of interoperable DeFi applications. Furthermore, most DeFi applications today are built for developers, not for users. Their current lack of usability undermines decentralization efforts. However, once the user experience improves, and user-centric identities become mainstream, any non-bankable funds could be managed by a public infrastructure and converted into a financial product that can be easily used as collateral or traded with a simple mobile wallet where you are in full control of all your assets and all your data (read more: Part 1 — User-Centric Identities).

Many economists remain skeptical that cryptographic tokens can permanently replace conventional currencies since: (i) There are strong network externalities that favor existing conventional currencies; (ii) The lack of sophisticated token supply rules leading to socially desirable stability and liquidity of tokenized economies. Furthermore, (iii) from a classic economic perspective, it seems impossible to pre-specify socially optimal “lender-of-last resort” rules in a smart contract. Lender-of-last resort refers to a safety-net institution, usually provided by central banks, to reduce the risk of a lack of liquidity of financial systems as a result of financial panics and bank runs. It represents government-guaranteed liquidity to financial institutions. The lack of such a lender-of-last resort makes financial systems susceptible to financial crises and systemic panics.

I would like to argue that we are still in the very early stages of a tokenized economy. I am confident that economic methods and practices will find their way into the smart contracts and token governance rules of future token systems. We can already see this happening in the cases of algorithmic stable tokens. Furthermore, many central banks are currently looking into or have already started to tokenize central bank currencies (Central Bank Digital Currencies) and make them distributed ledger compatible. New legal frameworks will be needed as these new structures transition from an early innovation phase to a more mature infrastructure phase.

Bottleneck: Multi-token capability

One important bottleneck will be the emergence of better multi-token capability of wallets and better key recovery solutions. Another bottleneck will be overcoming the challenge of token trading through the inefficiency of centralized exchanges.

Once P2P swapping of tokens matures and is adopted by wallet software, anyone will be able to exchange any token P2P, wallet to wallet, without any intermediary. In such a future scenario, powered by AI and DeFi applications, atomic swaps could potentially introduce a tokenized barter economy powered by global trading platforms, without the coincidence-of-wants problem we face today.

This text has been adapted from a chapter of the book Token Economy.

About Token EconomyWhile it has become easy to create a token, which is collectively managed by a public infrastructure like a blockchain, the understanding of how to apply these tokens is still vague. Tokens can represent anything from an asset to an access right, like gold, diamonds, a fraction of a Picasso painting or an entry ticket to a concert. Tokens could also be used to reward social media contributions, incentivize the reduction of CO2 emissions, or even ones attention for watching an ad. The book refers to tokens, instead of cryptocurrencies, and explains why the term “token” is the more accurate term, as many of the tokens have never been designed with the purpose to represent a currency. This book gives an overview of the mechanisms and state of blockchain, the socio-economic implications of tokens, and deep dives into selected tokens use cases: Basic Attention Token, Steemit, Token Curated Registries (TCRs), purpose-driven tokens, stable tokens, asset tokens, fractional ownership tokens, Libra & Calibra (Facebook), and many more. The second edition of the book Token Economy (June 2020) which was originally published in June 2019 comes with updated content of existing chapters and four additional chapters: “User-Centric Identities,” “Privacy Tokens,” “Lending Tokens,” and How to Design a Token System and more focus on the Web3.