Origins of money
Money is a feature of increasingly sophisticated human networks. When we lived as bands of hunter-gatherers there was little need for it. One could keep an informal tally of favors owed.
With the greater complexity of settled communities, in which people specialized in activities matching their skills and preferences, the barter system became the norm.
But barter required a double coincidence of wants. Someone who had excess food and wanted help building a home had to find a hungry builder. They then needed to haggle over how many hours labor was a fair exchange for a meal.
So ‘money’ was invented.
Money could be shells or some useful storable good. It could be a tally of debts safely recorded somewhere (the earliest forms of writing, dating from 3000 BC, were cuneiform financial records). Then came human-made tokens, which led to coins of rare metals.
So-called ‘spade money’, a hybrid between weeding tools used for bartering and stylized objects used as money, emerged in ancient China about 3,000 years ago.
Money meant people could save the rewards of their labor, and lend it to others. But bringing together lenders with borrowers, and ensuring the lenders the borrowers would repay, was a challenge. This is why banks developed.
Banks didn’t just issue a convenient form of money in the form of coins and notes. They also provided four basic banking services:
bundling: by gathering a lot of small deposits, they could make large loans
diversification: by lending to a range of borrowers, one default mattered much less
risk assessment: specialized skills in assessing trustworthiness reduced defaults
maturity transformation: they could offer loans for longer periods than most depositors wanted to keep their money in the bank.
The oldest bank still operating today is Italy’s Monte dei Paschi di Siena, founded in 1472.
Addressing problems with banks
But private banks with their own currencies was not a stable system. So-called ‘bank runs’ occurred when depositors lost confidence in a bank and sought to withdraw their funds. When a bank was unable to redeem all the banknotes or deposits demanded, panic ensued.
Bank runs were often contagious. People found it hard to distinguish whether a bank had an idiosyncratic problem (such as a fraudulent manager) or was suffering from a general problem (such as an economic downturn leading to bad debts).
A run on one bank would often trigger runs on others.
In the 20th century most countries resolved these problems by having a government-owned central bank issue currency and regulating private banks to assure depositors of their solvency.
These regulations included requiring banks to keep a minimum proportion of their assets available for withdrawals and to take out deposit insurance.
The movement for decentralized finance
This process of bank centralization has not been universally applauded, however. Libertarians are suspicious of the system’s reliance on government-issued monopolies and licensed banks. They dislike banks almost as much as they do governments. They regard centralized finance as both inefficient and coercive.
Their dream: decentralized (or disintermediated) finance, enabling transactions directly, without the need for banking intermediaries. By cutting out the ‘middle man’, their pitch has been, transaction costs will be lower and the power of the state over individuals curbed.
With the internet and block-chain technology, these dreams have launched more than 20,000 cryptocurrencies, with the first, and still largest, being Bitcoin.
The ‘decentralization illusion’
But as the massive losses within the cryptocurrency markets in recent months demonstrate, DeFi has yet to prove it’s a viable alternative to the centralized banking system. It remains unclear how the four banking services discussed above can be delivered without trusted financial intermediaries.
Indeed, according to economists with the Bank of International Settlements (the central bank of central banks): “While the main vision of DeFi’s proposals is intermediation without centralized entities, we argue that some form of centralization is inevitable. As such, there is a ‘decentralization illusion’.”
Few uses other than speculation
As the BIS economists note, decentralized finance still has few real-economy uses. Mostly it has facilitated speculation. But what attracts speculators – wildly fluctuating prices – makes for a bad currency.
A salutary lesson comes from the experience of two (former) top ten cryptocurrencies, TerraUSD and its stablemate Luna. TerraUSD was supposed to a ‘stablecoin’, with its value pegged at US$1.
That was true up to the beginning of May. By the end of May it was trading at less than 3 US cents. Over the same period Luna’s price dropped from $82 to 0.02 US cents.
These examples illustrate how cryptocurrencies such as Bitcoin, lacking any fundamental value, are speculative gambles.