Crypto Was Born Because Institutions Failed
Why the emergence of crypto is a result of the friction between institutions and society's need for change?
by Juan Aranovich
"The first step towards getting somewhere is to decide that you are not going to stay where you are." - J.P. Morgan
It's quite ironic that I’m using a quote by J.P. Morgan, a titan of traditional finance, to set the stage for an article exploring the revolutionary impact of cryptocurrencies and decentralized finance on our troubled financial world.
Introduction
While some may argue that the emergence of cryptocurrencies was simply a result of technological advancement, it is difficult to ignore the role played by institutional failures in creating the need for such disruptive innovation.
The centralized intermediaries and inherent power imbalances of the traditional financial system have long been criticized for their inefficiencies, lack of transparency, and vulnerability to crises.
The rise of cryptocurrencies and decentralized finance (DeFi) challenges the status quo, offering innovative solutions that address many of these shortcomings and provide a more equitable financial infrastructure.
This article examines the emergence of crypto and DeFi in the context of institutional economics, highlighting the friction between existing institutions and society's evolving needs.
Institutional Economics and the Importance of Change:
Douglass North's theory of new institutional economics offers a unique perspective on the role of institutions in shaping economic outcomes. According to North, institutions represent the rules of the game in a society or economy. They are the formal and informal constraints that shape human interaction, such as laws, customs, norms, and conventions. Institutions are crucial for economic development because they provide the framework for economic activity.
The effectiveness of institutions in facilitating transactions determines the ease with which economic activity can occur. However, institutions are not fixed and can change or evolve over time in response to changes in technology, culture, and politics. This adaptability is essential for maintaining a healthy economy. For example, the shift from agrarian to industrial societies necessitated significant changes in property rights and labor laws, enabling the efficient allocation of resources in the new economic landscape.
The Rise of Blockchain and DeFi
After the 2008 financial crisis exposed the vulnerabilities of the traditional financial system, Bitcoin emerged as an alternative currency that promised greater decentralization, security, and control over transactions. The subsequent rise of DeFi platforms and other cryptocurrencies has continued this trend, offering innovative solutions that circumvent the limitations of traditional financial institutions.
For instance, blockchain technology increases transparency by maintaining a public, tamper-proof ledger of transactions, reducing the likelihood of fraud and corruption. Additionally, DeFi platforms enable users to access financial services without the need for traditional intermediaries, fostering financial inclusion and empowering individuals to take control of their financial lives.
Applying Economic Theories to Crypto and DeFi
Ronald Coase:
Coase's theory of transaction costs emphasizes the importance of institutions in reducing the costs of economic transactions. In situations where the existing institutional framework no longer serves the needs of society, new institutions can emerge to fill the gap. Blockchain technology addresses this issue by eliminating the need for intermediaries, significantly reducing transaction costs, and increasing efficiency.
Oliver Williamson:
Williamson, awarded the Nobel Prize in Economics in 2009, focuses on the analysis of governance structures and the transaction costs associated with different types of transactions. He argues that different types of transactions require different governance structures, and that transaction costs can be reduced by choosing the appropriate structure. Blockchain and DeFi platforms exemplify this concept, as they establish new governance structures that facilitate transactions more efficiently than traditional financial systems.
Elinor Ostrom:
Ostrom's work on the management of common-pool resources provides a valuable framework for understanding the potential benefits of decentralized governance structures, such as those employed by blockchain networks. Decentralized systems can foster cooperation and trust among users, leading to more effective management of shared resources and increased resilience to shocks and crises.
Daron Acemoglu:
Acemoglu argues that inclusive institutions that provide equal opportunities for all citizens are necessary for sustained growth. However, institutions can also be extractive, benefiting a select few at the expense of the broader society. In situations where extractive institutions dominate, innovation and economic growth may be stifled, leading to a need for new institutions to emerge.
The rise of blockchain and DeFi can be seen as a response to these institutional frictions, as individuals seek greater autonomy and control over financial transactions. Thus, Acemoglu's work offers an important lens through which to understand the role of institutions in shaping economic outcomes and the emergence of new technologies like crypto.
Why Has the Government Pushed Back?
While there is a growing consensus that some form of regulation is necessary to ensure responsible and transparent use, regulators struggle to keep up with these technologies' rapidly evolving nature.
The recent crackdown by US regulators demonstrates their resistance to change. DeFi platforms offer viable alternatives to traditional financial services, promoting financial inclusion and innovation, and enabling real-time asset transfers and settlements on a unified ledger, reducing errors and compliance costs, and improving resilience and decentralization, as stated in SGC's response to a recent US Government RFI.
Governments may push back against crypto because it represents a potential challenge to the existing financial system, particularly the power and influence of central banks in controlling the money supply and managing inflation. The decentralized nature of crypto and its potential to operate outside of traditional banking systems could undermine the regulatory power of central banks and disrupt the financial system - one that has failed over and over, but benefits the status quo.
Additionally, the potential widespread adoption of crypto could lead to reduced demand for traditional currencies like the US dollar, potentially threatening the US's status as the reserve currency of the world. The US dollar's reserve currency status allows the US to borrow money at lower interest rates than other countries and gives it significant influence over global financial markets.
The government's pushback against cryptocurrencies can be seen as a strategic move to maintain its control over the financial system and prevent the destabilizing effects of decentralized currencies.
Conclusion
The emergence of cryptocurrencies and DeFi can be seen as a response to the frictions that arise between the existing institutional framework and the evolving needs of society. While the desire for greater autonomy and control over financial transactions is unlikely to go away, it is important to recognize the role that effective regulation can play in shaping the evolution of these emerging technologies.
It is crucial that governments and regulators strike a balance between encouraging innovation and ensuring that these emerging technologies are used in a responsible and transparent manner. By doing so, they can fully leverage the potential of cryptocurrencies and DeFi to reshape the world of finance and foster a more inclusive, efficient, and resilient financial system.