DeFi and the Future of Finance
Summary
Harvey, a Duke finance professor, with Ramachandran and Santoro, wrote a short explanation of decentralised finance and an argument for its potential.
The critique of existing finance comes first. The authors identify what they consider the incumbent system's flaws: centralised control by institutions extracting rents, limited access for people outside the banking system, inefficiency in settlement and clearing, opacity in pricing and in counterparty exposure, and lack of interoperability between systems.
The explanatory content covers the mechanisms. Smart contracts execute agreements without an intermediary. Automated market makers replace order books with a pricing formula and a pool of assets supplied by liquidity providers who earn fees, which permits trading without a counterparty being present. Overcollateralised lending protocols allow borrowing against crypto assets with automatic liquidation when collateral falls below a threshold, which removes credit assessment by replacing it with collateral. Stablecoins provide a unit of account. Composability means that protocols can be combined, since each is a public interface any other can call.
The authors are explicit about the risks: smart contract bugs, which have produced very large losses; oracle manipulation, where the price feed a protocol depends on can be attacked; governance attacks; scaling limits; and regulatory uncertainty.
Harvey is a serious academic and the explanation is technically accurate. The book argues a position and its assessment of the opportunity has not been borne out over the following years: activity outside speculation remains limited, overcollateralised lending cannot serve borrowers without existing assets, and the sector's losses to exploits have been substantial. The explanation of the mechanisms is the durable content.
Key takeaways 7
- Smart contracts execute agreements without an intermediary, which removes counterparty risk and also removes discretion.
- Automated market makers price trades from a formula and a pooled asset supply rather than by matching buyers with sellers.
- Overcollateralised lending replaces credit assessment with collateral and automatic liquidation, which limits it to borrowers who already hold assets.
- Composability lets protocols call each other as public interfaces, which allows combinations no single party designed.
- Liquidity providers to automated market makers face impermanent loss when the relative prices of the pooled assets change.
- Protocols depend on external price feeds, and manipulating those feeds is a documented attack route.
- Requiring more collateral than the loan restricts these systems to people who already have capital, which limits the access argument.
Who should read it
Readers who want an accurate technical explanation of how decentralised finance protocols work, discounting the assessment of their prospects.
About Campbell R. Harvey
Professor of Finance, Fuqua School of Business, Duke University; Research Associate, NBER; former editor of The Journal of Finance (2006-2012); Partner and Senior Advisor, Research Affiliates
The multiple-testing work with Liu and Zhu reset the evidentiary bar for the entire factor literature, and the Graham-Harvey CFO survey is a primary source for corporate finance practice.
Fuqua School of Business, Duke University, NBER, Research Affiliates, The Journal of Finance
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