How can we discover what defi is good for?

Originally a post at Cryptoeconomics.

The blockchain world is currently obsessed with defi. In the past few months, billions in digital value have been staked, swapped and farmed in radical experiments using liquidity pools, automatic market makers and decentralised exchanges.

Defi is easily belittled as a collection of scam-riddled projects powered by magic internet money. Perhaps. But more optimistically defi is a spectacle of entrepreneurial discovery.

These wildly fresh experiments are the infrastructure of a distributed digital economy. This infrastructure is being built right now, from scratch, by a bunch of internet entrepreneurs buying, selling and farming digital vegetables.

Defi as a discovery process

In the past decade institutional technologies such as blockchain have helped us coordinate our economic and social activities in new ways. We can now protect, enforce and coordinate property rights, contracts and organization through decentralised networks. Blockchains are being deployed in supply chains, digital identity and asset registries.

Defi is the financial infrastructure that underpins this decentralised digital economy. The once-radical concepts of credit, loans, options, futures and exchanges that support the traditional economy are now familiar.

It’s easy to forget that these financial institutions (and the concepts that underpin them) were developed over the order of centuries. By stark contrast, defi is being developed in a matter of months. Projects are born and die within a matter of hours.

The pace of defi development makes it look messy and uncoordinated. This messiness is a feature, not a bug. Messiness reveals information. Experiments tell us what consumers want, how they behave in a distributed environment, and how secure protocols are.

We have very little idea what defi infrastructure we need, let alone how each of those systems will interact with all of the other infrastructure.

It was inconceivable that in 2020 we would use yield farming, liquidity pools and decentralised organizations to make stablecoins stable. Those complementarities needed to be discovered.

Any new institutional infrastructure needs to be conceived, built, and adopted. New tools need to be bolted on. Others need to be thrown away.

For instance, what happens when things go wrong? How can we embed dispute resolution mechanisms into smart contracts? How should governance rights over a protocol be structured between different stakeholders? These are hard decisions in the centralised world, let alone in the decentralised digital economy.

Innovation requires experiments and failures. Defi experiments reveal how people act in a socio-technical distributed environment and necessary complementary infrastructure. The process reveals institutional innovations that people want to use. That’s how innovation works as a process of bottom-up trial-and-error discovery.

Bottom-up institutional change

Defi is a rapid process of change in institutional rules. But we don’t usually think about institutional change from the bottom up. We normally think institutional change with the government. Top-down planners direct how institutions change.

We even see top-down institutional change in the developing world, where governments are told to become less corrupt, or to adopt new democratic voting systems, or to control monetary and fiscal policy around particular rules.

Defi is also a process of economic development and institutional change, but there is no central direction. There is no planner directing reform of the courts, or enforcement of the property rights, or changes in the money supply. It is a decentralised network of wacky sometimes-pseudonymous blockchain entrepreneurs writing code.

That is not to say that the entrepreneurial development of the defi ecosystem isn’t being planned. There are plans. They just aren’t central plans.

Coordination is happening in innovation commons, where entrepreneurs pool and share ideas about valuable defi uses. These innovation commons are governing the entrepreneurial discovery of defi.

Twitter and Telegram groups share information between developers and users. They foster a culture of participation and contribution to projects.

What some see as a bubble is alternatively understood as a rapid coordinated stress-test of a new institutional idea. Memes like YAMS and concepts like yield framing help to coordinate that stress testing, encouraging bootstrapping.

Defi as exit

The culture and ecosystem emerging around defi doesn’t just aid coordination. It defensively protects defi experiments from outside interests that might seek to quash it.

Defi entrepreneurs are making a clear choice to develop this decentralised ecosystem far from the reach of the government (and its tight grip on the traditional financial ecosystem). In this way defi is a prime example of entrepreneurial exit.

On one hand, exiting from existing systems avoids the various enemies of innovation. Even if defi isn’t a long-term substitute for the existing financial system, we can be sure that incumbents will think that it is. Defi has avoided (or at least delayed) this regulatory threat. The farmers of digital vegetables haven’t (yet) been hauled before congressional inquiries.

But exit comes with costs. Entrepreneurial costs. This new institutional world needs to be discovered and developed from scratch.

These are not marginal changes to the existing financial system — defi starts from scratch. There is no legal jurisdiction looming in the background to protect consumers.

Defi entrepreneurs must embed private governance mechanisms into the ecosystem they are building. Security and liquidity doesn’t just need to be developed in isolation, but fit together into some coherent web of decentralised financial infrastructure.

The desire to solve these incredibly difficult entrepreneurial questions is propelling the unbelievable pace of defi discovery and development.

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