Luohan Academy

DeFi and the Future of Finance

Event materials

  • Campbell Harvey's transcript

Campbell R. Harvey is Professor of Finance at the Fuqua School of Business, Duke University and a Research Associate of the National Bureau of Economic Research in Cambridge, Massachusetts. He served as President of the American Finance Association in 2016. He talks about DeFi and the Future of Finance at the 4th Luohan Academy Frontier Dialogue.


Campbell Harvey:

Thanks, Steve, for the introduction. And it's great to kick this off. We've got some really interesting research papers and discussions, and I'd like to kind of set the scene. And the first thing I'd like to say is – (lost audio)

Okay. So, let me share again. So, obviously things are different today. Jamie Dimon said that any employee at JP Morgan that was found trading Bitcoin would be fired. JP Morgan is trading Bitcoin. So, it is a completely different story today, and I think that too much attention is being paid to Bitcoin. So, many are familiar with Bitcoin. It's difficult to understand, but there's other stuff going on that's way more relevant for what we do in finance. And this is the world of decentralized finance or DeFi.

So, basically, what I'd like to do in the next 10 minutes is to talk about some of the problems that DeFi solves and some of the risks that exist. These are five problems that DeFi attempts to solve. Inefficiency. It's kind of amazing that, in this day and age, it takes two days to settle a stock transaction, that we routinely pay 300 basis points for a credit card swipe. And in the world of DeFi, the smart contracts are available to anyone. There's very little organizational overhead because the contracts are reused. And, basically, if there's any improvements, it's really easy to improve by forking the protocol.

So, limited access. The second problem. We know that 1.7 billion people are unbanked. Probably more than that are underbanked. And many entrepreneurs with very good ideas are forced to resort to credit card borrowing because banks are not interested in dealing with them. Savings rates are low and loan rates are too high. So, in DeFi, we've got yield farming, we've got flash loans, we've got initial DeFi offerings, and essentially it's just a little more democratic compared to traditional finance.

Transparency is important. It's difficult in traditional finance to determine how the health of the bank is doing. We know that there's regulators that are involved in that, but with decentralized finance, everything is in the open. And staking is a very important mechanism whereby we can enforce basically good behavior on the part of the participants. Tokenization is transparent ownership, and essentially everybody knows where the tokens are. And people know when they're transacting if the other person actually has the tokens.

Centralized control. Basically, that's the system that we're in right now, where we've got central banks, we've got large financial institutions, and basically it's difficult for the smaller players to actually exercise any control. So, this is much different in decentralized finance, where even if it's the case that the admins have control over some parameters, if the community doesn't like it, it's easy to fork the protocol and to basically make it more decentralized. So, this is something that is definitely new.

And the last thing is the lack of interoperability. So, to go from, in centralized finance, I need to do a wire transfer to my broker. Very slow, very inefficient. And this is definitely not the case in decentralized finance, where even if you use a broker, you don't need to transfer any money there. The broker can literally plug into your own fault or wallet. So, there's lots of possibilities here. There's the possibility of basically using one protocol to build upon another. There's the possibility of bundling tokens and trading like ETFs.

So, let me talk about some of the risks, and these are very important, especially given that this is fairly young in terms of this space. So, we're very early on. So, number one, smart contract risk. Given that the code is public, it creates a new attack vector. So, usually by hacking you get into a system that's not transparent...[lost audio] damage. But given smart contracts are fully visible, it creates additional opportunities. So, there's new businesses that focus on auditing, and those audits are mainly concerned with logic errors, but there's also the possibility of economic exploits. And this is just an amazing exploit from February 3rd, 2021, where it's 161 transactions, some of them quite amazing in terms of the size. So, this involves flash loans. Basically somebody with no collateral, zero collateral, took out a loan of $200 million to start this off. And you can do this because with a flash loan, the loan is paid back at the end of the transaction. So, the 161 different components, and this was a very substantial exploit.

Governance risk is an interesting risk that really hadn't been realized until literally a few weeks ago. Basically, what happened was somebody started to hoard a governance token for TSD(True Seigniorage Dollar), and they got enough of the governance token to change some parameters. They drained the TSD and then basically use Uniswap to translate it into something that they could dump. So, this is an ongoing issue.

DNS attack is nothing special to decentralized finance, but there have been some DNS attacks where essentially a fake website is set up, and you put your information in, and then they exploit that information. And, obviously, it's a mistake to give away your private key if anybody asks for it, but some people will do that.

So, number four is Oracle risk, and this is a big deal. So, oracles are necessary because without an oracle to the outside world, blockchain is completely self-contained. So, you need, for smart contracts, some sort of information. You need a price feed, for example. And this is a significant problem as to how to do this. Do you do it in a centralized way? Do you do it in a decentralized way? There's many companies that are working on this. There's front running issues. Probably the leading protocol right now is Chainlink.

Number five is scaling risk. So, Ethereum right now is 15 transactions per second. Visa can do up to 75,000. So, most of the DeFi protocols, if they're not there already are basically using a proof of work or proof of stake. Ethereum is currently proof of work, which limits its transactions per second. There are many things going on to improve the number of transactions per second that can be done. So, Ethereum two is a proof of stake consensus mechanism. It will also implement a sharding mechanism. There's many firms working on layer two solutions, where some business is done off-chain. And, actually, one of the more promising ideas is the optimistic rollup, which is basically an off-chain aggregation of transactions that employs a staking mechanism. So, I think that the scaling issue is a temporary issue, but it is a significant issue right now, especially given the size of the gas fees in Ethereum.

So, decentralized exchange risk. Basically, you're trading with an algorithm, with an Automated Market Maker, and there's a liquidity pool, but there are issues in terms of illiquidity and slippage. Impermanent loss, on the people that fund the liquidity pool. And importantly, for us in finance, the price discovery is happening outside of the DEX. So, the DEX is just an algorithm. It doesn't matter if you're buying or selling. But the discovery is happening outside. So, I'm wondering what the world looks like in the future if these DEXs become more and more prominent. How will price discovery actually happen?

Number seven is custodial risk. So, this is something that people worry about today. Many institutions didn't want to deal with cryptos because they had no idea how to custody their private keys. And I'm sure you saw this story in the New York times where somebody's got 220 million Bitcoins locked in a vault, and they've forgotten the password, and they get 10 tries, and then the hardware is destroyed, and they've tried eight, and two more tries or that 220 million in Bitcoin's gone.

And, finally, regulatory risk. It's very difficult for the regulators. They know that too much regulation, the innovation is driven off shore. Too little, then consumers get exploited. So, it's really a challenge for the regulator to invest the time to understand the technology. And then, even if they do that, even if they invest the time to understand the technology, after a year, that knowledge is stale. So, you have to continually keep up with this, and certainly this is the price I've paid in teaching, over the last seven years, a blockchain course. And it's also difficult for the regulators to recruit talent that is knowledgeable in this space because they've got other options.

So, in conclusion, and to kind of start things off, I would argue that we've essentially been living in the same kind of technological world in terms of finance for the last hundred years. With commercial banks, central banks, stock exchanges, brokers, insurance, the business model is very, very similar over the past a hundred years. But I see something different. I see the scaffolding of a new city that essentially reinvents finance. And it is, in my opinion, just a matter of time. Indeed, I was invited to give a talk to the senior management of a unnamed major world stock exchange group, and they also brought in their board of directors. And I said, "Sounds great. What's the topic?" And the topic was, "How long do we have?" So, I think that they understand what's happening, and it is very dramatic, and I think it offers a lot of opportunities.

So, I do have a book on decentralized finance, and it kind of starts off with this idea that we've come full circle. That the earliest method of exchange was peer to peer, the barter system. And in the future, I believe that we'll actually circle back. That everything will be tokenized, whether physical or digital, and essentially we'll be able to do something akin to efficient barter. So, that's pretty dramatic in terms of what might happen in the future. It is a great time to be a finance researcher because there are just so many opportunities here in terms of reinventing the way that we do finance. So, I will leave it at that and stop the share.

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