Imagine a financial framework that spreads financial democracy, increases inclusion, reduces consumer pain points and increases economic growth. DeFi has arrived.
Andreas Park: You believe the scaffolding is emerging for “a historic disruption to our financial infrastructure.” Please explain.
Campbell Harvey: The key characteristics of traditional centralized finance are familiar to all of us: central banks control the money supply; financial trading is largely done by intermediaries; and borrowing and lending are conducted through traditional banking institutions. Decentralized finance, or ‘DeFi,’ seeks to build and combine open-source financial building blocks into products that maximize value for users.
DeFi will cover everything from exchange to savings and lending. It’s also about ‘tokenization’ — which I am very excited about. Say you drop into your local Loblaws to grab some items for dinner. When the time comes to pay, you will have choices to make: Your eWallet might include Canadian dollars as well as tokens that are collateralized with, for example, gold or IBM stock. Maybe you want to pay with your gold token, but the store doesn’t accept those. Seamlessly (and without any intervention from you), your e-wallet finds a decentralized exchange and the best possible rate is determined to exchange your gold token for whatever the store prefers.
One thing that is getting a lot of media attention is ‘non fungible tokens’ (NFTs), which are already transforming the world of art. Art is a space that has historically been plagued by very powerful middlepeople who have made it difficult for artists to make any money. With NFTs, artists can go directly to the people who enjoy the art. This will be transformational for many industries, I believe, including gaming, ticketing, legal documents, domain names and even fashion.
We have come full circle, because market exchanges started out with barter, and what I just described is also barter. We won’t actually need to carry ‘money’ in the traditional sense; value will be represented by a variety of tokens that people will be able to barter with.
Two key elements of the DeFi infrastructure are blockchains and cryptocurrency. Can you provide readers with a ‘Coles Notes’ definition of each?
Traditional finance contains layers of inefficiency that have removed value from the average consumer. DeFi brings this value back.
The most popular application of blockchain technology is cryptocurrency — a token (usually scarce) that is cryptographically secure and transferred. Typically, digital objects are easily copied, but the scarcity of the token is what ensures its value. A single account can’t ‘double spend’ its tokens because the ledger keeps an audit of the balance at any given time, so the faulty transaction would not pass the verification process. The initial cryptocurrency model is the Bitcoin blockchain, which functions almost exclusively as a payment network, with the ability to store and transact bitcoins across the globe in real time.
Talk a bit about the role of ‘smart contracts.’
Currently, the biggest blockchain with smart contract capability is Ethereum, which you can think of as one giant computer with many applications (the smart contracts). Users are charged a ‘gas fee’ for each transaction — similar to the way driving a car requires gas, which costs money. Simple computations such as sending Ethereum’s native cryptocurrency, an ether (ETH), require minimal work to update a couple of account balances and thus have a small gas fee, while complex computations that require checking conditions across several contracts require more ‘gas’ and thus have a higher fee.
In terms of transparency, smart contracts provide an immediate benefit compared to centralized financial systems: All parties involved are aware of the capitalization of their counterparties and, to the extent required, can see how funds will be deployed. They can all read the contract and agree on the terms, eliminating any ambiguity. This transparency substantially eases the threat of legal burdens and brings peace of mind to smaller players who, in the current environment, can be abused by powerful counterparties through delaying or even withholding their end of a financial agreement.
Realistically, average consumers won’t understand the contract code — but they can feel secure due to the open-source nature of the platform and the ‘wisdom of the crowd.’ Over time, many of the clauses of traditional business agreements could be shifted to smart contracts.
In addition to greater transparency, you believe DeFi addresses several other inefficiencies of centralized finance. How so?’
Users can largely self-serve within the parameters of the smart contract and of the blockchain the application lives on. In the case of Ethereum-based DeFi, the contracts can be used by anyone who pays the flat gas fee — currently around $3 for a transfer and $12 for a dApp feature such as leveraging against collateral. Once deployed, these contracts continually provide their service with near-zero organizational overhead.
The fact is, traditional finance contains layers of inefficiency that have removed value from the average consumer. The efficiency of DeFi brings this value back.
Who should be paying close attention to all of this over the next few years?
DeFi will reduce transaction costs and make transactions more efficient. Economists don’t agree on much, but one thing they do agree on is that reducing transaction costs is good for economic growth.
Do you think big financial institutions will embrace DeFi tools so they can offer these services at a lower cost than smaller start-ups?
Today, as indicated, it can take days to settle a trade and get a stock in your name. That makes no sense and it’s because of all the middlepeople involved who are making money off these transactions. Decentralized financiers know there’s no need for a time lapse between the execution of a trade and the settlement of that trade: It should happen simultaneously. It is also the case in DeFi that if you have an asset to sell, you’ll be able to put it on NASDAQ, NYSE and the Toronto Stock Exchange. This will lead to healthy competition between the exchanges.
Coinbase already has a higher profit margin by an order of magnitude than the NYSE or NASDAQ. I imagine that must already be eating into brokerage revenue from retail investors. How do you see this playing out?
With DeFi, everyone is equal. It is a democracy where no one is called ‘client,’ ‘banker’ or ‘broker.’ Everyone is a peer, and it doesn’t matter if you are big or small. Coinbase is the most successful firm in the crypto space, but I should emphasize that it is a centralized exchange/broker — and as such, it will likely come under intense competition from decentralized exchanges.
It’s a bit like the Wild West out there right now. How do you see regulation evolving?
Just think of all the possibilities in this space: We’re talking about financial democracy, increasing inclusion, reducing frictions and increasing economic growth—all of which are highly relevant today. Stifling innovation with overly strict regulations would be a big mistake.
What are some of the key risks posed by DeFi?
Smart contract risk can take two main forms: an error in the code or an attack focusing on a vulnerability in the code. Over the past decade, crypto-focused products, primarily centralized exchanges, have repeatedly been hacked. To be fair, many of these situations happened because of the poor security practices of these centralized companies. The fact is, DeFi is built on open-source code, and that gives attackers a much bigger playing field than what traditional financial institutions provide. Attackers don’t need to break into any system because everything is open and transparent.
Those with doomsday concerns should know that it would be extremely difficult for any actor or country to amass the network power required to derail the most widely used blockchains, such as Bitcoin and Ethereum. But as indicated, public block chains are open systems: After the code is deployed, anyone can view and interact with it. The recent hacks of dForce and bZx demonstrate the fragility of smart contract programming; but auditing firms like Quantstamp, Trail of Bits and PeckShield are emerging to fill this gap.
Beyond democratizing finance, you believe DeFi is “a technology of inclusion.” How so?
Currently, 1.7 billion people in the world are ‘unbanked,’ which makes it extremely challenging for them to obtain loans or operate in the realm of e-commerce. And many more are ‘under-banked.’ Here’s an example of what that looks like: An entrepreneur in Toronto is seeking financing for a new small business, so she goes to her bank to pitch it. The loan officer cover this financing.’ A remarkable amount of entrepreneurs are financed with credit cards — but because the interest rates can soar up to 24 percent, many choose not to proceed with their business.
DeFi gives large, underserved groups direct access to financial services, regardless of their wealth or geographic location.
These types of scenarios are very costly for our economies in the long term. We sorely need many more small businesses that return 20 percent, because our economy is stuck in two per cent growth mode. In my opinion, this and some of the other financial frictions we’ve discussed are big contributors to this lethargic growth.
The fact is, DeFi gives large, underserved groups like the global unbanked population and small businesses that employ substantial portions of the workforce (nearly 50 per cent in the U.S.) direct access to financial services, regardless of their wealth or geographic location. Access to these new products is of critical importance in preventing widening wealth gaps and the resulting impact on the global economy should also be very positive.
If you were to advise young professionals, what should they do: Learn about DeFi and find a way to integrate it into an existing institution or jump in and join (or form) a start-up?
Most of my students don’t go to start-ups right away because they’ve got heavy debt to pay down. They often start off at a big bank or insurance company. But I always tell them: From the very first day you start your job, you need to be thinking about a strategy to jump. It’s just a question of when. Maybe you’ll stay 18 months, maybe two years. Once they start working at these institutions, they see firsthand how difficult change is.
With start-ups, change is very natural because they must continually pivot. People might think, ‘But if I go to a start-up, there is a much higher probability that the company will fail and I’ll lose my job.’ Obviously, there is a higher probability of failure with start-ups, but the people you’re interacting with are really innovative, energetic, high-quality people, and those connections can enable you to quickly transition to your next opportunity.
Remember, failure is a very important experience for busi nesspeople — if we learn from it. Having a résumé with a few failed companies on it often increases the probability that the next one is going to be really great — maybe even a unicorn. Basically, my message to young professionals is very simple: Be a disruptor, not a disruptee. 
Campbell Harvey is the J. Paul Sticht Professor of International Business and Professor of Finance at Duke University’s Fuqua School of Business , a Research Associate of the National Bureau of Economic Research and a Research Fellow at FinHub, the Rotman School’s Financial Innovation lab. He is the co-author of DeFi and the Future of Finance (Wiley, 2021). Andreas Park is a Professor of Finance at the University of Toronto, appointed to the Rotman School and the Department of Management at U of T Mississauga and Research Director at the FinHub.
This article was published for the Rotman Management Magazine.
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