Decentralized finance feels like the future. This category of financial services is built on blockchain technology and transacted solely in crypto. It’s executed by automated programs called “smart contracts,” which helps reduce costs. And advocates say DeFi is more democratic: Everyone involved is just an anonymous node on the blockchain, making favoritism impossible.

But how will it really play out? Some tell the Boston Fed’s podcast, Six Hundred Atlantic, that it requires too much tech savvy to be truly inclusive. Others worry about the safety of a “trustless system,” where the lack of an intermediary could make DeFi vulnerable to people with bad intent. And skeptics doubt decentralized finance can remain decentralized at all.

View the presentations New York University professor Hanna Halaburda and UC-Berkeley professor Christine Parlour submitted for the Boston Fed’s 68th Economic Conference. Watch the panel they participated in, titled “Decentralized Finance (DeFi), Blockchain/Distributed Ledger Technology (DLT), and Smart Contracts: Hope or Hype?”

Jay Lindsay:

There’s an emerging category of financial services called decentralized finance, or DeFi for short. And a lot of people are excited about it.

Why? Because in DeFi, the word “decentralized” means exactly what it says. Financial services are delivered without a central authority or intermediary making rules or charging fees for those services.

Anyone with an Internet connection can trade cryptocurrencies, or purchase insurance, or invest in anything from real estate to art.

Plus, to its fans, DeFi feels like the future.

It’s built on blockchain technology. It’s transacted solely in cryptocurrencies. It’s executed by automated programs called “smart contracts.” And proponents say that leads to numerous benefits.

They say it’s cheaper, because it’s automated. They also say it’s more democratic: Everyone who uses it is just another anonymous node on a blockchain. No favoritism is possible.

So, DeFi sounds good. And it may be good. But Boston Fed research director Egon Zakrajsek cautions that gains from innovation are never free.

Egon Zakrajšek:

“Like with anything, innovation will have fits and starts, there is no smooth path that can ensure that we'll get to a good outcome without any costs.”

Jay Lindsay:

In fact, there are significant questions about decentralized finance.

For instance, will DeFi really extend financial services to more people? New York University professor Hanna Halaburda doubts it. She compares trading DeFi digital assets to games of chance.

Hanna Halaburda:

“People who are underbanked or unbanked are typically lower income, and they do not really engage in casino games. They want to guard their money, and they want to save their money.”

Jay Lindsay:

What about safety?

Here’s Ken Anadu, a vice president in the Boston Fed’s Supervision, Regulation & Credit department:

Kenechukwu Anadu:

“There’s no intermediary. So, essentially blockchains and DeFi operate in a trustless environment. So, if there's a bad actor that is able to invade that, that could cause problems.”

Jay Lindsay:

Another question is whether decentralized finance can really exist as advertised. Because the economic pull toward re-centralization is so strong.

Boston Fed principal economist Christina Wang – who helped organize the conference – says a good example of this is the most famous technology enabled by blockchain, the Bitcoin cryptocurrency.

Christina Wang:

“They kind of trumpet themselves as decentralized. But actually, if you look at the number of people involved in, say, designing the algorithm or maintaining the rules that govern how a network runs, it's actually a very small group of people. I mean, there are economic research papers showing that by some measure, these networks or systems are actually very concentrated. And so that, at least, it's not really true to its name.”

Jay Lindsay:

I’m Jay Lindsay, and welcome to Six Hundred Atlantic, a podcast produced by the Boston Fed.

Our seventh season of Six Hundred Atlantic is called “The Future of Finance,” and it’s based on materials and talks presented at the Boston Fed’s 68th Economic Conference. That includes discussion on DeFi.

And the question they asked at the conference is one we’ve started answering here: Is DeFi “Hope or Hype”?

Either way, DeFi is going to make an impact, according to Berkeley professor and finance expert Christine Parlour:

Christine Parlour:

“I don't know if I'm optimistic or pessimistic, but this is coming. Just get out of the way, it's coming.

“You know, finance has been ... stale is the wrong word. But there hasn't been a huge amount of innovation in any of the kind of models or the financial structure that we've seen for quite a long time. And decentralized finance is offering a way for the traditional finance sector to automate a huge number of their processes. And the minute you automate things, things get cheaper. And so that potentially is going to be a huge benefit.”

Jay Lindsay:

Before we go deeper on DeFi, let’s better define its components, starting with blockchain. The cryptocurrencies that are exchanged in DeFi don’t exist without blockchain. So, what is it?

Anadu says it’s helpful to think of blockchain as a database, an Excel spreadsheet that everyone can see.

Kenechukwu Anadu:

“If we go back and use that Excel analogy, you can imagine that everyone has that same spreadsheet open, and as somebody makes one change, everyone that has that spreadsheet open sees that change. So, yes, it is transparent. And, again, once you make that change, it can't be altered. That also gives the blockchain that immutable characteristic.”

Jay Lindsay:

That immutability is critical. It prevents the cryptocurrencies built on a blockchain from being duplicated and double-spent, for example.

These cryptocurrencies are then sent around the world on blockchain networks, typically one block at a time, person-to-person. Here’s Parlour:

Christine Parlour:

“Within each block is a set of instructions that says, ‘Hey, I want to send one piece of this cryptocurrency from person A to person B.’ And that's kind of the foundation or the basis of all the stuff that's grown up around it.”

Jay Lindsay:

Blockchain networks also host the “smart contracts” that make DeFi transactions happen.

Smart contracts are computer programs. And they’re coded to automatically execute tasks relevant to the financial service being provided after certain conditions are met.

It’s not just the cost savings from this automation that are said to make DeFi more accessible. It’s also because none of this is happening through the established financial system. Here’s Parlour:

Christine Parlour:

“What potentially is interesting to people is that the way this stuff is set up is that you can send, essentially, or do financial transactions or things that look like financial transactions. But do them through, not through a traditional bank or through any of the traditional channels, but in a new way. And so, what people are hoping is that these new ways will end up being cheaper, more resilient, and just much, much easier for everyone to use.”

Jay Lindsay:

But do easier and cheaper necessarily mean more accessible? Parlour notes that a fairly high level of technical sophistication is needed to operate with confidence in the DeFi realm.

Christine Parlour:

“In order to use cryptocurrencies or to sort of plug into this space, you need to know a little bit about how it works. So, it's not really completely user-friendly yet.”

Jay Lindsay:

Halaburda adds that many DeFi assets have limited appeal. She points to DeFi “tokens” as an example.

Tokenization in DeFi allows investors to digitally own and trade pieces of real-world assets, like a building, or painting, or even baseball cards.

Here’s how it works: Legal ownership of that asset sits in a line of code that can easily be broken up and traded, digital wallet to digital wallet.

But Halaburda says these fast-moving tokenized assets are “highly volatile.” She adds that unpredictability is unattractive to underbanked or unbanked people.

Ultimately, she says, claims that DeFi is increasing financial inclusion are overblown.

Hanna Halaburda:

“They may be marginally true. When it comes to inclusion, what we see is that mostly young, male, highly educated people play with those assets. I do emphasize that they ‘play,’ because it's more like a casino, it's more like games of chance, it's more like video games with some lottery built in into it. It's not exactly the financial inclusion that we typically have in mind when we are thinking about unbanked and underbanked people getting access to financial services.”

Jay Lindsay:

The size of the DeFi market indicates that, right now, it's a niche sector.

The data on the DeFi market are limited, with estimates on its size ranging from about 20 billion dollars to more than 110 billion dollars. By comparison, the size of the U.S. equity market is about 64 trillion dollars.

So, DeFi is not huge yet. And that impacts how regulators currently view it.

Kenechukwu Anadu:

“By my estimation, large disruptions will likely pose limited risk to financial stability. Now, of course, that will change as it continues to grow and get more interconnected with the traditional financial system. But right now, it's relatively small.”

Jay Lindsay:

Anadu is quick to point out that “limited financial risk” doesn’t mean “no risk.” There have been some big problems in the DeFi space and in adjacent sectors.

For instance, there’s a type of cryptocurrency called “stablecoins,” which are supposed to hold a steady value because they’re linked to a traditional fiat currency, often the U.S. dollar.

Stablecoins are heavily used in the DeFi market for the same reason they’re used everywhere. They’re seen as a refuge from the wild swings of other types of crypto.

But certain stablecoins have collapsed. And so have cryptocurrency exchanges – the FTX implosion in 2022 is probably the most infamous.

That impacts investor confidence in crypto in general – and in dependent markets like DeFi. And that could have ripple effects through DeFi and downstream.

But keeping an eye on DeFi is tough. Here’s Wang:

Christina Wang:

“And a lot of the regulatory system is designed basically to oversee the intermediary. With the DeFi system which entity do you regulate? Because in theory, nobody's in charge.”

Jay Lindsay:

Parlour hopes the U.S. can soon devise some kind of regulatory framework for cryptocurrencies.

She says countries like Singapore and Luxembourg are examples of two countries who have done it, and the EU is starting to do it.

Parlour says the U.S. could do the same and eliminate uncertainties for people devising new cybercurrency products and designs.

Christine Parlour:

“If you think about any of the sort of rules and restrictions we have in the financial system today, it's based on a series of principles. And then every time there's some weird thing happening, people go, ‘Uh oh, that was a hole, we should have plugged that.’ And then they plug it. So, that's sort of how regulation evolves. But what we don't have for crypto yet is just a sort of conceptual framework that sort of tells people, ‘Okay, this is sort of how you can behave.’ And I think that would be really useful for innovation.”

Jay Lindsay:

One question as regulators work to figure out how to monitor an evolving DeFi market is whether decentralized finance can truly remain “decentralized” at all.

Halaburda acknowledges the appeal of decentralization: It’s the powerful story of individuals free to seek out each other, to trade and exchange goods without oversight or levies from some intermediary with potentially competing interests.

But she adds re-centralization is a proven and strong economic force.

“Network effects” are gained when people practice commerce in the same places, like shopping malls and stock exchanges. And they undeniably improve efficiency. Both providers and participants have incentives to grow and maintain centralized networks.

Hanna Halaburda:

“Complete decentralization is also not good. This is why we live in cities, and we have states, and police. The whole financial system as it was created, it was in the response to something that was before, which was completely decentralized.”

Jay Lindsay:

So, what’s ahead for DeFi? Will it make financial services more available, safer, and more democratic? Or will it make no difference? Will it even be decentralized?

Predictions are tough, and even experts shy away from them. Parlour says the potential benefits of DeFi and the automation it brings to financial services are clear. The risks aren’t as fully revealed yet:

Christine Parlour:

“One of the problems with automation is that sometimes things go out of human controls, they might be a little bit less safe. But that's something that we'll find out about, won't we?”

Jay Lindsay:

Another advance in financial services that raises plenty of questions is the increased use of artificial intelligence.

AI has already shown it can make lending more profitable, and that it might enable lenders to offer more products in more places.

But there are reasons to be nervous.

AI will lie unless you tell it not to. It can collude on pricing in ways that distort markets. And it also poses a threat to community banks.

Berkeley finance professor Adair Morse says AI’s tremendous potential to expand and improve financial services can’t be ignored. But neither can its risks.

Adair Morse:

“And so we need to understand how to operate in this moment of time, where I think I characterize as we're on a racetrack and there's a yellow flag.

“You need to proceed with caution and to understand what are the hazards ahead.”

Jay Lindsay:

That’s next time, on Season 7 of Six Hundred Atlantic.

Jay Lindsay:

Thanks for listening to Season 7 of Six Hundred Atlantic. You can find interviews and our first six seasons and subscribe to our mailing list at bostonfed.org/six-hundred-atlantic. And please: rate, review, share, and subscribe to Six Hundred Atlantic on your favorite podcast app.

The producers would like to thank our contributors for their insights and time. They are Kenechukwu Anadu, Hanna Hallaburda, Adair Morse, Christine Parlour, Christina Wang, and Egon Zakrajšek.

This has been “The Future of Finance,” the seventh season of the Boston Fed’s Six Hundred Atlantic podcast.