Updated: May 12, 2021
Modern Money Theory (MMT) says that governments can print as much money as they want as long as inflation stays in check. The theory states that keeping inflation in check should be done by raising taxes and not raising interest rates. MMT prioritizes full employment, more significant equity in wealth distribution, and social safety nets over achieving a balanced budget. As we wade through the devastation of the global pandemic, this view is gaining popularity for its justification of large stimulus spending by governments.
This wave of spending falls on the back of a pivotal decision made in March 2020 by the U.S. Federal Reserve, which ended fractional reserve requirements, joining the ranks of other developed nations such as Canada, the U.K., New Zealand and several others. Private U.S. banks can now lend without reserve restrictions. Mass money injection paired with no reserve requirement means that the market is now awash in liquidity. This liquidity is driving down the value of fiat currency as a store of value.
The great money printing experiment
Since the beginning of February last year, central banks around the world have dramatically increased the money supply; Australia, Brazil, Canada, China, India, Japan, Mexico, Russia, South Korea, Turkey, U.K., U.S. and Europe have printed a total of over USD 33 trillion worth of their local currencies. This sample represents over half the globe's population and is the equivalent of nearly USD 6000 printed per person over the last year. Have a look at these approximated charts that I put together.
(Note: Authors' calculations using a variety of national sources. Happy to discuss upon request.)
All of this money has been injected into the monetary and financial system, some with conditional spending and some just landing in the pockets of the everyday person. As a result, millions of savers have been pushed into the stock market, many of which sought to buy big names in tech, such as Tesla. Tesla subsequently saw an explosion in its market cap to $830B billion at the beginning of 2021. In turn, Tesla chose to store over a billion dollars in Bitcoin instead of cash, as they understood money in the bank is vulnerable to devaluation and is not a good store of value. People and companies are being pushed away from holding cash and pulled into speculative ventures, like Bitcoin and a host of fringe stores of value items such as rare collectables, fine wines, and even sneakers.
One way people are choosing to park and grow their money is through "Decentralized Finance" (DeFi). The term DeFi covers financial services carried out on a distributed ledger, also known as blockchain technology with smart contacts. DeFi services can provide traditional financial services without a central authority. It involves taking traditional elements of the financial system and replacing the middleman with smart contracts.
Another way to understand DeFi is through "tokenization." Security tokens are essentially digital, liquid contracts for an entire asset, or any fraction of it, that already has perceived value, like real estate, a car, or paintings. In the case of NFT art, the process of tokenization has given the art perceived tradable value.
An interesting feature of DeFi is that it is now possible for people to store their savings in fractions of real value assets, rather than having to afford the entire asset (think part of a house, car, property, or stocks or bonds issued directly from businesses). Our value stores can now be divided and distributed, making it much more accessible to the everyday saver to diversify, shifting from wage earner to asset owner.
With their ability to distribute store of value, security tokens, in particular, will roil traditional financial markets as we move to this more efficient, blockchain-based financial system. This will inevitably require new levels of regulation, but the role that DeFi is playing in addressing how we effectively store and trade value is exciting.
The current state of DeFi
There has been explosive growth in DeFi. According to DeFiPulse, the total value (USD) locked in DeFi has risen from $928 million to $76.68 billion over the last year. The expanse of Defi use cases includes asset management, compliance and know-your-transaction, decentralized autonomous organizations, data and analytics, derivatives, developer and infrastructure tooling, decentralized exchanges, gaming, identity, insurance, lending and borrowing, margin trading, marketplaces, payments, prediction markets, savings, stablecoins, staking, synthetic assets, tokenization, and trading (for an in-depth description of each of these, visit this page by Consensys.
Most DeFi projects are built on Ethereum because of its smart contract capability. However, the ethereum network is getting congested, and gas fees are going up mainly due to DeFi. The author does not see this as sustainable and expects DeFi to expand onto other networks if Ethereum cannot upgrade soon. Many other blockchains with smart contract capabilities and several DeFi projects are being developed on other networks. It is to see which one will become dominant in the future.
As discussed, a key component to DeFi is smart contacts, which are an application, or computer program with relevant rules written in code rather than a written document. It is up to code developers and lawyers to ensure the contract functions as expected and according to applicable laws. Since the execution of a smart contract does not necessarily involve decisions or actions by humans, they can be faster and with less risk of human error. Both increased speed and reduction in errors are driving the growth of DeFi.
Other benefits of combining smart contracts with blockchain for DeFi are that they can be immutable, verifiable and remove the need for a trusted central coordinator. Blockchains provide an additional layer of security over traditional finance, referred to as incentive security. Blockchains can be designed to be too expensive to hack; the financial rewards of good behaviour for individuals and the collective are greater than those of misbehaving.
The value of smart contracts on a decentralized blockchain sets DeFi apart from other technologies when it comes to where and how best to store value. The next question isn't whether DeFi will become a major factor in the global economy, but how creatively it will be developed and its extent as a force for broad benefit.
I believe bonds and futures are two distinct areas where DeFi will take hold in the coming years as more people look for new ways to store value.
DeFi allows companies to float bonds in a cheaper, faster, more transparent, and open to new (smaller) investors than traditional bonds typically allow. The current way companies issue bonds is to approach a bank that charges high fees to do an analysis of their business and develop a bond financing plan. This financial synopsis gets reviewed and rated by a rating agency. Then the bond gets marketed and sold. The first step with the bank and high fees can be replaced with a DeFi smart contract – reducing time and money. The targeted number of investors can increase, as the minimum buy-in can decrease. For the first time, retail investors may be able to purchase small portions of large bond issuances. For an interesting and expanded discussion on blockchain bonds, see this article.
Cryptocurrencies have had futures and options for some time, but only recently have they started developing their versions of the more sophisticated structures in the traditional financial world.
DeFi and tokenization of rare stores of value will expand futures markets. The real test of whether something functions as a store of value is if it has a futures market and significant liquidity.
Where does DeFi go from here?
Presently DeFi technology is in a transition state and still has all the same problems associated with traditional digital financial systems:
operating system upgrades, new versions of software, and contract changes mean that the architecture of the tech is in motion, complicating developer work;
network security is still open to vulnerability; and,
hardware and power stability still experience problems that may undermine the network.
DeFi is the killer app for blockchain. It is still in its infancy but will expand exponentially, particularly in this context of mass liquidity and declining use of cash as a store of value. A lot of technical skills and innovation will need to be brought together to grow this new technology. We need to be able to imagine what an economy connected to a CBDC with smart contracts looks like. We need to consider what fractionalized asset holding and trading will mean for our governance of those assets. However it happens, we can be sure that people are increasingly less likely to hand over their money to a bank without earning anything (or worse yet – being charged to do so), allowing the bank to use this money in any way they see fit. People will want to have greater jurisdiction in how their money is being used and benefited from accordingly.
*Curious about integrating DeFi in your organization and offerings, please get in contact.
There are currently many companies with Security Token offerings. https://blog.stomarket.com/complete-list-of-security-token-exchanges-marketplaces-1615fde71645