How Algorand can handle DeFi? Fully decentralized DeFi won't scale!

The article assess viability of a fully Decentralized Finance solutions in the world wide economy and how we can use Algorand for adapting new financial solutions.


DeFi (Decentralized Finance) in it's visionary form (fully open, inclusive, custody-less, decentralized) won't work in the real world unless our civilization will restart. Here is why.

defiprime defines DeFi as:

Decentralized Finance (DeFi) is the movement that leverages decentralized networks to transform old financial products into trustless and transparent protocols that run without intermediaries.

Most of us would like to add there one more word: autonomous (decentralized autonomous networks).

This article was motivated by my observations in the community, talks with maximalists and the state of DeFi at Q1 2020.

Let's start with simple observations:

  • Ideologically, a system is as decentralized and as autonomous as it's most centralized component.
  • From an outside view, a permissionless blockchain usually brings composability and disintermediation.
  • Changing rules, law and potential security reasons are hooking central components to the systems.

Traditional finance?

Traditional finance is grounded around investment, money transmission and money deposits. It's good to have a look at that from the "banking" perspective.

A bank is a financial institution that accepts deposits from the public and creates credit. Lending activities can be performed either directly or indirectly through capital markets. Due to their importance in the financial stability of a country, banks are highly regulated in most countries. [Wikipedia]

A financial intermediary is an entity that acts as the middleman between two parties in a financial transaction, such as a commercial bank, investment banks, mutual funds and pension funds. Financial intermediaries offer a number of benefits to the average consumer, including safety, liquidity, and economies of scale involved in commercial banking, investment banking and asset management. [Investopedia]

Note: the safety could be well questioned by our crypto space, as it heavily relays on the trust in the middleman.

There are two categories of financial intermediaries:

  • monetary financial institutions (MFIs), and
  • other financial intermediaries (OFIs).

Why traditional finance is regulated?

Regulations and compliance is there because we don't trust each other. We inherently want a layer of governance and because there are always a group of smart hackers who will try to crack the system and take some benefit (personal, ideological, anarchist like).

This is what the regulations are for:

  • Limit the freedom of the network in order to control any behavior which potential leads to bad / illegal things (terrorism, money laundering, cheating).
  • Limit the criminal activates. Again there will be always a group which will try to hack the system, so most of the people want to have some kind of protection.
  • Apply monetary policy - this is very important form economical perspective. Without monetary policy we can be a victims of our own system build on capitalism and allowing lions rule the jungle.
  • Monetary policy also acts as a stabilization mechanism, which is designed to provide a protected ecosystem and healthy grow. Contractionary monetary policy can lead to increased unemployment and depressed borrowing and spending by consumers and businesses, which can eventually result in an economic recession if implemented too vigorously.

The state of the DeFi

Today

It's worth to note that today DeFi is not very decentralized

  • Smart-contract has central admin features.
  • There is a single entity controlling many of the smart-contracts.
  • We relay on a somehow concentrated source of truth. We don't have fully decentralized network of oracles with a fair market split - either we have centrally managed data source, or Chainlink (so we don't have a fair market split).

DeFi today is controlled. There has to be a shutdown mechanism and a form of upgrade ability (which potentially involves migration).

Future

The future of DeFi is even more centralized.

By definition most of DeFi projects are falling into the banking and financial intermediary category. Hence, they will need to either work with a bank or become a bank. Working with a bank doesn't make things easier - because DeFi will still need to get into the same restrictions as bank, otherwise the partner bank will loose it's license and none of them will be able to legally operate.

The regulatory framework will apply to the DeFi. Legal authorities will force the legal entities (companies and individuals) behind the projects to obey the regulations and hook to the regulated environment (which is evolving and getting stricter year by year).

Once DeFi will reach a scale where people will go out of the regulatory environment, it will either move to a form of a dark net where no legal entities will be identified to a DeFi projects. Otherwise it will be shut down.

Can Ethereum retain it's position the center of blockchain based finance?

Today, Ethereum regimes the DeFi world. Thanks to it's proven security (consensus) and wide adoption, it's a default platform of choice for shipping DeFi products. However we can already see a resistance in the industry, and some big players are withholding their fully dependency on Ethereum (Dapper Labs, Polymath, Synthetix...).

People like to have their own vision, control or be different. Especially on a bigger, commune / country level. Moreover we don't share a common culture. We don't even agree to make it easier to communicate - most of the world don't want to speak the same, universal language! So the assumption that we will agree to use the same "ledger", the same base currency or the same mechanism is wrong. For many reasons: culture, leadership, innovation, politics. This is our nature, and we have to understand it in the DeFi / DLT world. Hence an assumption that only a single DLT will be at a center of finance is wrong.

What's in it to Algorand?

Interestingly enough, Algorand is taking a bit different approach. Instead of growing the ecosystem with a general use smart-contract platform, Algorand is limiting the functionality, providing necessary tools to do useful financial instruments:

+ Algorand Standard Asset (ASA) provides very limited functionality for managing fungible tokens.
+ Algorand Smart Contract (ASC1) it's an execution environment interpreting scripts written in Transaction Execution Approval Language. Provides enough functionality to express any mathematical operation which doesn't require recursion. ASC1 doesn't have any knowledge about other smart-contract, so it's not possible to compose ASC1. You can learn more about TEAL at https://medium.com/algorand/understanding-algorand-smart-contracts-b9fc743e7a0f.

With that it's impossible to build fully autonomous DeFi lego. But it's perfectly enough to make a regular, compliant assets. This reduces the area of Decentralized Finance, but provides enough space to innovate and interact with the regular market.

Conclusion

This is a fact - the world is complicated. We, people, don't agree on a political or a social paradigms (left-center-right, liberalism, conservatism). We have different motives and different goals. At the end of the day we need to exchange and trade so we constantly agree on some regulations for a "common good". Why? Again - because we don't trust each other. Are smart-contracts going to change this?

Yes! Smart-contracts will make the whole process more efficient and more transparent. But we will still not trust each other. We won't event trust smart-contracts hooks required by the regulations. What's more, we will always extend a regulatory environment because there will be always a group of hackers who will like to take a bigger benefit of the system and hack it.

If your assumption is that nobody will try to outsmart the system then you are utterly wrong.

DeFi to improve the current systems

The current financial systems is inherently complicated because of the differences among systems / jurisdictions and regulations we have. Many of that inherited complications, causing massive inefficiency could be done better. Some of them are probably not needed. Blockchain is a great technology which makes many things more efficient. Even though the core of it is slow, we can leverage the great value of immutability, decentralization, disintermediation, audit-ability... Thanks to thees features we will be able to build better financial solutions. However at scale, the system will keep centralized hooks for compliance and governance rules.

Algorand is well positioned to empower current and new businesses to exchange values without intermediaries. Algorand's innovative economic model paves the way for widespread blockchain adoption and realizing the potential of the borderless economy: an easy, inclusive, secure and transparent system, where everyone has the opportunity to build prosperity, no matter where they are.


This article was originally posted on author's blog.