How would you like to be your own banker? How would you like to have the equivalent of credit card function without the exorbitant interest rates that range from 14% to 24%? How would you like to have the payment for the sale of any expensive item placed in escrow before you deliver that item? Think: selling a car, furniture, tools, etc.
The possibilities for the financial functions mentioned above, and many more, are carried in the "genome" of blockchain technology. A description of how this all works is contained in DeFi and the Future of Finance (Wiley), a 2021 book by Campbell R Harvey, Ashwin Ramachandran, and Joey Santoro. Having self-studied over the last 12 years money and banking in the traditional central bank system used widely today and having only superficial knowledge of cryptocurrencies and blockchain, I was attracted by the title. I immediately accepted the opportunity to review the book when offered by the publisher.
The lead author is Professor of Finance at the Fuqua School of Business at Duke University, as well as a research associate at National Bureau of Economic Research, Cambridge, Mass. He has taught a course at Duke for the last six years, "Innovation and Cryptoventures," focused on blockchain technology and decentralized finance.
Ashwin Ramachandran and Joey Santoro are both Duke graduates with degrees in Computer Science. Ramachandran is General partner in Dragonfly Capital, San Francisco, a venture capital firm seeking to support promising ventures in the cryptoasset class. He formerly worked at Duke in 2017 and 2018 as researcher and lead teaching assistant for the "Innovation and Cryptoventures" course. Santoro is founder of Fei Protocol, a stablecoin cryptocurrency headquartered in the San Francisco Bay area. From June 2018 to May 2019 he was president of the Duke Blockchain Lab.
The first impression of the book for me was intimidation. The language of blockchain finance is an entirely new vocabulary to someone like me, whose prior knowledge is limited to knowing how to spell cryptocurrency and is aware that there are such beasts as Bitcoin (BTC-USD) and Ethereum (ETH-USD) among that menagerie. My trepidation diminished, though, once I found the extensive glossary near the end of the book. I printed a copy and kept the pages alongside the text as I read.
The book is organized to lead the reader from a general understanding of the current centralized banking system to the genesis of the idea of a decentralized digital system over 20 years ago, and then to the status of a fledgling DeFi system today. "Fledgling" is the operative word, well implied by Fred Ehrsam, co-founder and managing partner of Paradigm and co-founder of Coinbase in the foreword:
The internet showed the power of a universal, open network for information. In 40 years the idea of a similarly open, global network for value transfer will seem obvious, which makes this a truth hiding in plain sight today. (page ix)
The book uses the smart contract platform of Ethereum blockchain to describe the protocol (operational rules) of DeFi infrastructure as it has developed so far. This is covered very early in the book (Chapter III), and immediately the description of the terminology is interlaced with some of the problems yet to be resolved. These problems are developed further in Chapter VII, titled "Risks."
The smart contract is the key feature of DeFi as described in this book. Smart Contracts can be written by the user, negotiated between users, and/or selected by the user from existing smart contracts.
Why all the fuss about DeFi to a produce a completely peer-to-peer financial system? The answer deserves (and gets) its own Chapter V. Once operational, the authors say that blockchain system(s) will provide an improvement over the centralized system of today. Some of these features are:
The heart of the book is Chapter VI, titled "Deep Dive," 60 pages of operational detail for a variety of finance functions with numerous tables and graphic illustrations. This is where a person can get an excellent functional understanding of what DeFi is and what it can become. The dilettante can indulge in the many graphics with a gainful outcome. I found reviewing the graphics before reading the accompanying text to be very helpful. Perhaps this advanced me beyond the stage of being a dilettante.
There are many interesting applications in Chapter VI. One example (pages 121-122) is a new type of derivative such as those developed by Synthetix. The example shows how a derivative formed from equal dollar amounts of three assets, Bitcoin, Ethereum, and the U.S. dollar, each staked (put up) by a different individual, would be formed and how the individuals would profit or lose from subsequent market moves.
My view of this derivative is that it is something like a "3-D" futures contract, compared to the traditional binary ("2-D") futures contract.
When I accepted the opportunity to review this book, I had hoped to get a more detailed understanding than the book offered of how DeFi addressed the shortcomings of traditional money and banking. Some examples of comparisons to DeFi I had thought would be worthwhile:
I now realize my expectations were beyond the scope of the authors' intentions for the book. These are all interesting questions, but DeFi is in such early stages that attempted answers now might not be all that informative in the long run.
Before ending this review, I strongly recommend that you carefully read Chapter VII, "Risks." If you have read it in advance of reading the rest of the book, read it again. In trying to digest all the nuances of this chapter, I came to understand why Fred Ehrsam in the Foreword suggested that up to 40 years might be needed to bring DeFi to full maturity. In Chapter VII you learn of successful attacks by hackers for some current protocols. Also emphasized are risks in governance. It is an attractive feature that users gain some ownership functions. But it is also a point of vulnerability in that bad actors can gain governance and sabotage a protocol for their own financial advantage. There are eight areas of risk described and analyzed. The summary for the first risk, Smart Contract Risk, captures the essence of each of the risks. The authors write:
Smart contract programming still has a long way to go before best practices are developed and complex smart contracts have the resilience necessary to handle high-value transactions. As long as smart contract risk threatens the DeFi landscape, application adoption and trust will suffer as users hesitate to trust the contracts they interact with and that custody their funds. (page 135)
There is one risk area that is different from the rest in that it becomes greater as the other risks are reduced: Regulatory Risk. The more successful digital currency becomes the greater the likelihood of regulation, as has been pointed out by Ray Dalio.
Also, on Friday, Sept. 18, 2021, Barry Ritholtz interviewed the lead author of this book - listen here.
This book not only gives a good introduction to DeFi as it exists today, but also provides a thoughtful assessment of where it has yet to go to become widely used. I recommend this book to anyone who wants a good introduction to DeFi in a book that should also remain valuable as a reference for several years. And the price is right: 208 pages, hardcover, for $18.88 on Amazon Prime, $24.95 otherwise.
There is one (out of nine, at the time this was written) very critical review of this book on Amazon. The reviewer represented that the book contained material already available in PDF form from the authors and contained no new content. Not being aware of the PDF documents, this criticism is completely not applicable to me, and I suspect not to most (if not all) of those reading this review.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: A review copy of the book was provided by the publisher.