The DeFi Déjà Vu

There are patterns in the history of finance and economic development, such as 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 the process of 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. Given the central role that finance plays in economic development, such tendencies naturally 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 practices 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 a broader institutional reconfiguration, driven by 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 also highlighted 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 major 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 working capital 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 early interventions included the 1812 and 1821 self-regulatory initiatives by the London Stock Exchange to reduce fraud and improve due diligence on market participants, and the 1816/1821 establishment of the world’s first official gold standard to restrain both the government and the financial sector. But perhaps the most important step was taken with 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 serious 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 economically disruptive 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 fueled 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 rest of 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 financial 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] Even 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 investment strategies, 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 increased 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 financial information and transactions, the growing use of leverage, securitization and quantitative risk models, deterioration of regulatory and underwriting standards (resulting in significantly 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 the financial sector. 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 by the EU which were prompted by the 2010–12 European debt crisis, the actual regulatory response has been rather 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 financial assets/contracts and persistent attempts to simplify and democratize ways to issue, trade and monetize these assets/contracts. DeFi is merely 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 public blockchain 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 amplified 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 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.
• After starting out as informal and marginal, emerging sectors and practices go through a process of institutionalization and professionalization. In the case of DeFi, this involves the emergence of crypto-financial protocols and institutions offering services such as data curation and disclosure, exchange, interest accounts, borrowing/lending, investment management, structured products, insurance, etc. It also includes the emergence of specialized intermediaries such as the emerging ecosystem of delegated staking providers, the creation of industry associations such as MAMA and POSA, and setting up increasingly formalized governance structures such as online discussion forums, ecosystem funds, voting dashboards, protocol rule change procedures, etc.
• New financial systems emerge in areas with underdeveloped market infrastructure and regulatory standards, offering ample room for fraud, price manipulation, and other questionable practices. In the case of DeFi, this is amplified by certain ideological motivations and resulting technical choices that initially launched this industry. As often happens, innovation has created a mismatch between market practice and existing regulations. This has two effects. First, it triggers an ideological debate about the relative benefits of minimal and/or self-regulation versus updating external regulations (see [13], [14], [15] and [16] for examples in the context of crypto assets and DeFi). And second, it drives creative destruction, while introducing new problems and challenges. The latter tend to be misunderstood and underestimated until the experience of shock events such as financial crises. This may also happen in DeFi which is additionally exposed to new types of systemic technical and cyber security threats. The ability to handle these risks and navigate potential situations of crisis will be an important competitive advantage for DeFi networks and applications going forward. Over time, as both market participants and regulators learn, the ground will shift towards increasingly stable, compliant, and consumer-friendly systems. [I’ve discussed systemic risk mitigation in DeFi more extensively here.]
• Financial stability boils down to two objectives. First, prudent regulation of rights and responsibilities in the context of financial contracts, which requires a difficult balance between allowing voluntary agreements and avoiding the excessive buildup of relationships that have the potential to cause undesirable outcomes such as deflationary spirals, extreme inequality, or social conflict. As DeFi grows, finding this balance will become increasingly important. And second, reducing the likelihood of an economy-wide collapse of asset/collateral prices (results in negative equity, i.e. liabilities exceeding assets) and income flows (results in insolvency, i.e. inability to continue making necessary payments). This must be achieved without inhibiting a healthy level of market discipline that helps prevent the expansion of unsustainable economic arrangements. These dynamics should be further considered in light of power relations and wealth inequality — both important determinants of social and political conflict. To give a concrete example, if the financial instrument in question is used to denominate debts and other obligations, and the economy connected to it is growing, a decreasing or fixed supply of it tends to favor asset holders, creditors, and rentiers, whereas a more inflationary supply — preferably targeted at real value creation — tends to favor entrepreneurs, debtors, and workers. [17] Such tendencies will obviously have an impact on how people perceive the fairness of the system, and this applies just as equally to DeFi as it does to traditional finance.
• To summarize, financial innovators have a tendency to under-appreciate the reasoning behind the institutional and regulatory arrangement of existing systems, which represent the outcome of a long process of trial and error under constantly changing economic and political circumstances. In the crypto-financial industry, this is driven mainly by the appreciation of technological and societal change (“the old system is outdated”), but also a relative lack of experience and historical perspective given the youth of the industry. In other words, each generation has to go through their own practical lessons while attempting to make the most out of the unique possibilities of their era.

But in addition to showing how DeFi repeats historical patterns, it is equally important to highlights its more unique aspects, and how these relate to the fundamental drivers of financial development, such as asset prices, income flows (which determine 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:

• By relying on open source software, decentralized permissionless networks, cryptographic verification, and open data, DeFi enables both code and ledger forks, more user-centric 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.
• DeFi is Internet-native, making it both digital and global at birth. Relative to earlier generations of financial technology, it is also more decentralized and thus difficult to censor or regulate. As such, assuming the currently existing digital divide is reduced over time, it has the potential to serve as a great equalizer, providing easy access to financial services to anyone in the world with a desktop/mobile computer connected to the Internet. Access to finance is a key component of economic opportunity, the expansion of which is foundational for an inclusive and prospering society.
• DeFi is built on globally auditable digital ledgers and takes advantage of the trust and contract execution guarantees provided by blockchain networks. In theory, this allows for more automated risk management, as well as more granular regulatory oversight. Ideally, assuming that DeFi scales and breaks into the mainstream, it will make the financial system more efficient, transparent, and resilient. However, by enabling unprecedented levels of global integration and unfamiliar forms of financial complexity, it is also likely to drastically reduce the efficacy of national regulations and create a variety of new systemic risk factors. Understanding and addressing these, especially in situations of crisis, could have far-reaching implications to the future of the financial sector at large.
• Apart from the deployment of physical infrastructure and the employment of the still relatively small number of people who are professionally involved in the industry, DeFi has evolved in relative isolation from the rest of the economy. As such, it is useful to distinguish between two types of systemic risk: internal and external. The first is already relevant, especially in the context of the growing importance of Ethereum (see [18]) and the leading financial applications built on top of it such as MakerDAO or automatic market makers (AMMs), such as Uniswap. [19] The second is less relevant today, but should receive more attention as DeFi becomes increasingly accessible to and integrated with the legacy financial system (see [20] and [21]), or used for coordinating activities in the rest of the economy (see [22]). This includes the growth of crypto asset allocations in traditional investment portfolios (and thus the broadening of the impact of crypto asset price volatility) and the expansion of cryptocurrency-denominated liabilities and incomes. As this new economy grows, understanding interlocking balance sheets with exposure to crypto asset price fluctuations and/or cash flows will become increasingly important in assessing the potential buildup of DeFi-related systemic risk.
• Blockchain networks and the open financial system that is being built on top of them are part of a more general drive to hyper-rationalize and automate the global administrative infrastructure. Blockchain networks help enable bureaucratic systems of unprecedented scale in which human administrators are increasingly replaced with machines. On the one hand, this could bring incredible efficiency gains administering information. On the other hand, these systems may gradually evolve into a silicon cage of sorts — a society in which recordkeeping involves minimal subjective input, instead following a set of abstract, automatically executing rules of “the system” that itself is too extensive and complex for any single group of humans to censor or govern. To a degree, this also applies to society as we know it today. But globally scalable decentralized computing networks that are systemically important but increasingly difficult to unilaterally control will make it much more explicit.

Concluding Takeaways

Financial services delivered using open source protocols and public blockchain 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 is likely to decline.

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.

Related Writings

Systemic Risk Mitigation in DeFi (March 2021)

The Great Automaton (December 2020)

Ten Theses on Decentralized Network Governance (September 2020)

The Bookkeeping View of Money (October 2019)

Cryptonetworks and Governments (August 2019)