There are important patterns in the historical development of finance, most notably systemic crises associated with the collapse of asset prices or income flows and the recurring interplay between financial innovation and regulation. Understanding these patterns can help the architects of open and automated crypto-financial services, known as DeFi, to assess potential risks and prepare for different economic and regulatory scenarios. This article highlights some relevant historical precedents and considers the potential long-term implications of this latest wave of financial innovation.

Finance and Creative Destruction

The Austrian-born American economist Joseph A. Schumpeter famously popularized [1] the idea that at the heart of capitalism lies creative destruction — the recurring and often painful reorganization of economic structure as old ways of doing things get displaced by innovative alternatives.

There are two main ways in which finance relates to this phenomenon. First, coming up with new inventions and successfully bringing them to the market requires funding. And second, the financial sector itself is constantly innovating, enabling increasingly varied and complex forms of financial relations. Innovation is generally beneficial, but may also introduce new and initially poorly understood forms of risk, in addition to the normal cyclical instability that monetary economies are prone to. And because of the central role that finance plays in economic development, such tendencies raise the question of how the financial sector should be appropriately regulated without thwarting its ability to encourage social progress.

There are several instances in modern Western history in which changes in financial practice have contributed to economic transformation and made existing regulatory frameworks obsolete. Conversely, whenever innovation has enabled new forms of participation in financial markets, it has also triggered institutional reconfiguration, including new regulations to address concerns over consumer protection, market integrity, and perhaps most importantly — social and economic stability. Below are a few examples (less interested readers may skip this historical overview as its main takeaways in relation to DeFi are re-emphasized in the next section).

(1) The combination of limited liability with transferable joint stock in the late 18th and 19th century Britain. Although both had been invented earlier, combining the two in the context of British industrialization played a key role in the formation of modern financial markets and business regulation.

Used mostly in industries that required large upfront capital expenditures such as shipping, mining, railroads, public utilities and insurance, joint stock financing contributed directly to the growth of the British securities industry, and the professionalization of various legal, media and administrative functions connected to it. Putting a cap on the personal liability of investors for the debts of the entities they funded encouraged risk-taking. And by enabling easier access to and transfers of ownership, public markets attracted a broader set of investors, providing an important complement to other sources of funding such as wealthy individuals (central to the launch of new and unproven industrial ventures) and banks (source of credit for more established firms).

The expanding securities industry enabled new capital formation, but it also resulted in a more complex financial system where formal rules, standards and risk management practices had not yet been developed or were simply ignored. In an environment of speculative excitement, this naturally led to some excess and malpractice which, combined with the lack of institutional frameworks for dealing with systemic shocks such as the Panic of 1825 in England (sometimes described as the first modern financial crisis), resulted in a number of important reforms.

Significant interventions included the 1812 and 1821 self-regulatory initiatives by the London Stock Exchange to reduce fraud and improve due diligence on market participants, the 1816/1821 establishment of the world’s first gold standard to restrain both the government and the financial sector, and the 1826 Country Bankers Act which — by allowing the formation of note-issuing joint stock banks outside of London — aimed at making the English banking system more competitive and resilient, and thus better positioned to serve the growing industrial economy.

Naturally, all such regulations were mired in ideological controversy and established the setting for new kinds of challenges later down the road. Subsequent regulatory milestones included the 1844 Joint-Stock Companies Registration, Incorporation and Regulation Act to simplify incorporation and increase public confidence in business, the 1855 Limited Liability Act that formalized and radically expanded access to limited liability, and the 1844 Bank Charter Act aimed at reducing the destabilizing effects of excessive bank note issuance. As could be expected in the context of a rapidly expanding economy, the latter became a hindrance and was effectively suspended whenever there was a full-blown liquidity crisis, with the Bank of England establishing itself as the go-to monetary problem solver. [2] [3]

(2) Developments surrounding the financial crises of the late 19th and early 20th century United States. This was a particularly eventful period in the historical evolution of U.S. financial markets and corporate governance, with a variety of innovative practices first pioneered in the context of large railroad companies and industrial trusts such as Standard Oil and U.S. Steel.

As often happens in financially active times, more questionable methods such as stock watering and anti-competitive business practices proliferated alongside productive enterprise. Combined with growing concerns over the excessive accumulation of wealth and power in the hands of a small group of financiers and industrialists, this triggered considerable hostility against big business and contributed to various regulations aimed at reducing economic concentration and improving corporate disclosure. Most prominent examples are the 1890 Sherman Antitrust Act, the 1914 Clayton Antitrust Act, and the 1914 Federal Trade Commission Act.

Importantly, the period also experienced a series of boom-bust cycles with notable crises in 1884, 1893, 1896, 1901 (the first stock market crash on the New York Stock Exchange), and 1907. The specific origins of each event are varied and beyond the scope of this article. But in addition to causing much havoc in financial markets and throughout the economy, these crises fueled a number of controversial debates about the gold-centered institutional foundations of the U.S. financial system, leading eventually to the establishment of the Federal Reserve in 1913.

It is worth noting that even though the 1913 Federal Reserve Act represented a significant shift towards federal legislation, much of the regulatory authority remained with the states and private industry bodies, including local clearing houses, banking associations, financial conglomerates, professional service providers such as rating agencies, and of course securities exchanges. [4] [5] [6] [7] [8] Today, state legislators and industry associations remain influential actors in U.S. financial regulation.

(3) The 1920s stock market boom, the 1929 crash, and their regulatory aftermath in the United States. The boom leading up to the crisis — and eventually the Great Depression — saw an unprecedented popularization of common stock ownership. A highly competitive securities industry proved to be a fertile ground for all sorts of unsound practices as widespread expectations of quick profits on the stock market found a dangerous match in the proliferation of options for purchasing securities on credit or by paying in installments. This is when investment houses began employing swarms of securities salesmen whose primary task was to find eager purchasers among the investing public who inevitably were at an informational disadvantage relative to stock issuers and their representatives.

An important development of this period was the emergence of investment trusts which became a convenient dumping ground for securities that could not find a home elsewhere. Although some had existed before, their number ballooned during the late 1920s. Contrary to their counterparts in Britain who tended to prefer diversification and long-term investing, many U.S. investment trusts of the era did not shy away from speculative attempts to time the market and were actively involved in creating increasingly complex capital structures.

All of the above was taking place in an environment of still relatively underdeveloped regulatory and disclosure standards which contributed to the scale of the damage caused by the crash in 1929, the aftermath of which saw a series of emergency interventions to stabilize the banking system and stop deflation. In addition to various updates to state-level regulations, landmark federal legislation was introduced to improve investor protection and market integrity. Most notable examples are the 1933 Securities Act which introduced more stringent securities registration requirements, the 1933 Banking Act which established the Federal Deposit Insurance Corporation (FDIC), and the 1934 Securities Exchange Act which created the Securities and Exchange Commission (SEC). [7] [8] [9]

(4) Deregulatory and technological developments after the collapse of the Bretton Woods system in 1971, particularly in the United States but increasingly all around the world, leading up to the Global Financial Crisis (GFC) in 2007–08. The term that is often used to describe this period is financialization, i.e. the growing importance of financial institutions and instruments relative to the rest of the economy. [10] Recently, much of this growth has taken place within and through the so-called shadow banking system operating outside of conventional banking regulations.

The flood of financial innovations since the early 1970s has been truly remarkable and generating a complete list of them would be a sizeable research task on its own. But some of the more notable trends included the digitization of finance, the growing use of leverage, securitization and quantitative risk models, deterioration of regulatory and underwriting standards (resulting in higher levels of debt), and the proliferation of increasingly complex and esoteric financial products, some of which played a key role in the U.S. subprime mortgage crisis that triggered the GFC and the Great Recession. [11]

Similar to the three examples above, the post-crisis period reignited the discussion on the need for appropriate regulation of finance. However, apart from the 2010 Dodd-Frank Act and the 2011 Consumer Financial Protection Act in the U.S., and a series of emergency interventions prompted by the 2010–12 European debt crisis, the actual regulatory response has been somewhat limited. Meanwhile, unconventional forms of monetary policy such as quantitative easing and zero or even negative interest rates have become the new normal. Combined with recent trends in distributed computer systems, cryptography, and automation, this then provides the backdrop for the emergence of crypto-assets and DeFi.

What’s (Not) Special About DeFi

Possibly the most infamous phrase in all of finance is: “This time is different.” It is certainly true that each period unfolds in the context of unique historical circumstances and it would be an oversimplification to claim that the underlying processes remain fundamentally unchanged over time. But there are also important historical regularities that should not be ignored. Before considering how these relate to some of the more unique features of cryptonetworks and DeFi, here’s a list of reasons why observing the evolution of this still nascent industry should generate some strong feelings of déjà vu:

  • There are three basic elements to financial innovation and development that are crucial for understanding DeFi within a broader context of finance. The first is the continually growing variety of possible financial assets/contracts and persistent attempts to simplify and democratize ways to issue, trade and monetize these assets/contracts. DeFi is only the latest example of this. The second is the use of technology to operate financial markets. From railroads to telegraph to Consolidated Tape System to computers, the Internet, and high frequency trading bots — the financial sector has often been at the forefront of adopting new technology. Today, DeFi is leading the way in developing use cases for decentralized networks and smart contracts. The third concerns the evolution from broker/agent (acts on behalf of others, earns commission) to dealer/principal (trades on own account, takes on risk). The shift from one to overlapping with the other has historically occurred in many financial markets, from commodities to foreign exchange to stocks to interest rate swaps to subprime mortgages, and has always introduced new risk because it results in systemically important market participants taking on liabilities they may not be able to meet. [12] A similar lens can be applied to the analysis of DeFi by regularly assessing the degree to which crypto-financial service providers such as exchange operators and prime brokerages engage in (potentially leveraged) position-taking on their own accounts.

But our analysis would remain partial if it settled on describing DeFi as merely the latest instance of known historical recurrences. It is equally important to also highlight the more unique and potentially world-changing aspects of DeFi and relate these to the fundamental drivers of financial economies such as asset prices, maintaining income flows (and thus the ability to continue making payments), the ethical and business integrity of market participants, the buildup of systemic risk, and the evolving role of regulation:

  • The principles of open source, decentralized permissionless networks, cryptographic verification, and self-sovereign data provide DeFi with some interesting features. These include the possibility of both code and ledger forks, improved control over personal information, enhanced privacy, and the ease of combining multiple protocols or applications into a single interface (composability). As the user experience of DeFi improves over time, the true potential and value of these features will become increasingly apparent.

Concluding Takeaways

Financial services delivered using open source protocols and decentralized networks are here to stay. In the past, concerns over consumer protection, market integrity, and economic stability have played a decisive role in determining the regulatory and institutional foundations of finance — one crisis at a time. Crypto-financial technology offers unique opportunities for democratizing access to finance and making the economic system more efficient and transparent. However, it is also likely to create new forms of systemic risk, especially as the role of crypto-assets and DeFi applications grows in coordinating real economic activity. As the emergent complexity of the system increases, the ability of humans to understand and directly control or govern it may decline. Time will tell whether that’s a feature to be desired, at least as long as finance serves its underlying purpose of sustainably enabling the activities necessary for the health and well-being of life.

Footnotes

[1] Schumpeter, J. A. (2003). Capitalism, Socialism and Democracy (pp. 81–86). Taylor & Francis e-Library. Available here. (Originally published in 1942.)

[2] Harris, R. (2000). Industrializing English Law: Entrepreneurship and Business Organization, 1720–1844. Cambridge University Press. Available here.

[3] Both Larry Neal (see here, here and here) and Philip Cottrell (see here and here) have written extensively on the relationship between finance, industry and regulation in the late 18th and 19th century Britain. The linked materials in particular were used as source material for this section.

[4] Noyes, D. A. (1909). Forty Years of American Finance. A Short History of the Government and People of the United States Since the Civil War, 1865–1907. G. P. Putnam’s Sons. Available here.

[5] Neal, L. (1971). Trust Companies and Financial Innovation, 1897–1914. The Business History Review, Vol. 45, No. 1, pp. 35–51.

[6] Baskin, J. B. & Miranti, P. J. Jr. (1999). A History of Corporate Finance. Cambridge University Press.

[7] Mitchell, L. E. (2008). The Speculation Economy: How Finance Triumphed Over Industry. Berrett-Koehler Publishers.

[8] Komai, A. & Richardson, G. (2011). A Brief History of Regulations Regarding Financial Markets in the United States: 1789 to 2009. NBER Working Paper No. 17443. Available here.

[9] Rutterford, J. (2009). Learning from one another’s mistakes: investment trusts in the UK and the US, 1868–1940. Financial History Review, Vol. 16, No. 2, pp. 157–181.

[10] A critical pre-GFC overview of various dimensions of financilization can be found in Epstein, G. A. (Ed.). (2005). Financialization and the World Economy. Edward Elgar Publishing.

[11] Tymoigne, E. (2009). Securitization, Deregulation, Economic Stability, and Financial Crisis (Parts 1 and 2). Levy Economics Institute Working Paper No. 573.1–2. Available here and here.

[12] Kregel, J. (2010). Money, Credit and Keynes’s “Banking Principle”. Unpublished manuscript.

[13] Avan-Nomayo, O. (2019). Pushing for Crypto Self-Regulation Amid Tightening Government Scrutiny. Cointelegraph. Available here.

[14] FRBB. (2019). A New Use Case: A Supervisory Node. Federal Reserve Bank of Boston. Available here.

[15] Massad, T. G. (2019). It’s Time to Strengthen the Regulation of Crypto-Assets. Brookings Economic Studies. Available here.

[16] Sharma, R. (2019). Winklevoss Twins Unveil Proposal for Self-Regulation of Crypto Markets. Investopedia. Available here.

[17] Cipolla, C. (1956). Money, Prices, and Civilization in the Mediterranean World: Fifth to Seventeenth Century (p. 50). Princeton University Press. Cited in Wray, L. R. (2012). Introduction to an Alternative History of Money. Levy Economics Institute Working Paper No. 717 (p. 35). Available here.

[18] Lee, L. & Qureshi, H. (2019). Ethereum is now unforkable, thanks to DeFi. Medium. Available here.

[19] Disclosure: The author’s work is funded by Placeholder, an investor in ETH, MKR, and BAL.

[20] White, A. (2018). Announcing the Coinbase Suite of Institutional Products. Medium. Available here.

[21] Palmer, D. (2019). New Law May Encourage German Banks to Offer Crypto Services From 2020. Coindesk. Available here.

[22] Schmitt, L. (2019). Centrifuge Tinlake: Adding real-world assets to MCD. Medium. Available here.