Traditional Banking vs. Decentralized Finance

We’ve received such rave reviews of this article, we have decided to republish it here — not only for the benefit of all those who may have missed it, but also to underscore how important we believe these developments are for the future of Distributed Ledger Technology (DLT) and Decentralized Finance (DeFi).


Imagine a country that replaces culture with computer code.

Instead of laws and police, it has smart contracts.

Instead of a president, legislature or supreme court, it simply has another layer of computer code called “governance.”

Instead of money, it has digital tokens uncontrolled by any government or central bank.

There are no states, counties, towns or territorial boundaries. Everyone is online.

Citizenship is not defined by where you were born or your ancestry. All you need is to do is own its tokens. Tokens are your ticket to entry and participation.

There are no governments, politicians or leaders of any kind. Every decision is made by the public. Every issue is voted on.

It’s not really a country. Nor is it a corporation, partnership, society or NGO.

It’s a DAO, a Decentralized Autonomous Organization.

The ancient Chinese Daoists, who always sought to live in harmony with Dào (), “the Way,” would be proud …

… provided, that is, there are no bugs in the code; no bad actors who hack the system.

Because when hackers can find a bug and hack the code, they can overturn the governance, wipe away the laws, break down the pillars of society, siphon off all the money, and destroy the virtual country.

It ceases to exist. Almost instantly.

Can’t the citizens see the bad actors hacking the system? Yes.

Can’t they see how the bad actors bring it all down like Samson at the Temple of Dagon? Yes.

But all they can do is stand by and watch. Helplessly.

Because, by design, there is no authority, no police, no one who can stop the destruction.

Therein lies the deficiency of “perfection”; it can never be truly perfect.

That’s why hackers nearly destroyed Ethereum (ETH) a few years ago.

And it’s also why no one has built a successful DAO ever since.

Until, that is, the emergence of ...

The Maker DAO (MKR)

What makes Maker different?

Maybe it’s because its creators are smarter. More likely it’s because they’re less ambitious.

You see, Maker does not seek to recreate a multi-faceted country, culture or community. Nor does it seem to have ambitions to perform a whole grab-bag of functions.

Its functionality is strictly in the realm of Decentralized Finance (DeFi), which we’ve written about extensively here, here and here.

Right now, it has one limited, but very important, goal: to someday become a Federal Reserve-type institution like none other in existence today: A DECENTRALIZED Federal Reserve. (No, please don’t say “Decentralized Central Bank.” That’s a moronic oxymoron.)

And right now, Maker’s primary project is to manage DAI (DAI), the special kind of stablecoin I told you about in this post.

DAI is the equivalent of money. And Maker is the equivalent of the Federal Reserve that manages that money.

Maker makes the rules. Maker applies the rules. And Maker enforces the rules. It is the decentralized regulator of DAI.

Plus, it’s more than that. Because DAI is not just money. It’s also the basis for things people do with money, especially borrowing money.

And it goes far beyond that, too: When a bank or central bank lends people money, it expands the money supply. And when it gets repayment of those loans, it contracts the money supply.

It creates money; it destroys money. That’s what happens in the DAI network, too.

Unlike other stablecoins in existence today, DAI does not rely on a central authority to hold collateral. And its code ensures that it always has more than enough of that collateral on hand.

To acquire DAI, you deposit Ether in a smart contract. Then you receive a certain amount of DAI tokens in return — like a loan with no fixed term.

As long as the value of your ETH deposit is at least 50% greater than the value of your loan, you can keep the loan indefinitely. But as soon as the value of your deposit falls below that threshold, the smart contract liquidates your loan. Then, it uses your ETH to recover the amount owed.

The Market (Not Maker) Automatically Balances Supply and Demand

When you first make such a loan, the supply of DAI expands. When you pay it back, the supply contracts.

This market-driven expansion and contraction in the money supply balances supply and demand to achieve monetary stability.

DAI issuers pay interest on the loans they take. This is at the heart of how DAI maintains parity with the U.S. dollar.

If DAI trades at US$1.01 or higher, the smart contract tweaks interest rates lower. This encourages more loans, increasing the supply of DAI. The extra supply then depresses the price, bringing it back down to $1.00.

If DAI trades at US$0.99 or lower, the smart contract does the opposite. It tweaks interest rates higher. That increases the cost of making new loans and encourages paying off existing ones. The resulting contraction in supply puts upward pressure on price of DAI, nudging it back up to $1.00.

So far so good. But now comes the $64 trillion question:

Who Sets These Rules?

Who decides how much the minimum collateral should be for new loans?

Who decides what the starting level should be for the interest rate? And …

Who determines how fast they adjust?

As you might have guessed, the answer to all the above is Maker. Or more specifically, token-holders in the Maker Decentralized Autonomous Organization, the Maker DAO.

This is effectively the “government” (governance mechanism) that sits atop the DAI smart contract.

The Maker DAO is Akin to the Federal Reserve.
MKR Token-holders are Like the Fed’s Board of Governors.

The key difference from the real Federal Reserve, of course, is that anyone who holds MKR tokens can participate in the governance process. It's completely open to everyone who wants — and can afford — to get involved.

The most common thing that Maker token-holders vote on, naturally, is the interest rate on new DAI. But they can vote on longer term issues as well.

For example, one of the key issues with DAI is its over-reliance on ETH to collateralize creation of new DAI. This had the unwelcome side-effect of making the stability of DAI too dependent on the price of Ether, itself a highly volatile asset. Realizing this, Maker token-holders recently voted to allow other crypto assets to also be accepted as collateral for new DAI.

And once the vote is passed, the new rules go into effect automatically, on the date specified. There’s no need to designate a special task force or waste human resources on enforcement.

On top of that, rules can be changed on the spot, and voting can be done on a real-time basis, on demand, on any issue.

It’s like democracy in real time.

On the surface, this may not seem so special. Maker DAO is just an organization, tasked with guaranteeing the price stability of DAI, the currency it oversees. But the way it's set up is truly unlike anything the world has ever seen.

The Radical Idea of Coercion-free Enforcement

As I explained at the outset, a DAO like Maker does not rely on laws and contracts enforced by a government. Nor does it have a court system, police force or army to control the populace or punish violators.

Never forget: As painful as it may sound, it’s the threat of state-sanctioned violence that ultimately makes traditional human laws enforceable.

If you don’t pay your taxes, you could go to jail. If you rape and murder, the sentence could be life … or even death.

Distributed Ledger Technology (such as blockchain) and Decentralized Autonomous Organizations (DAOs like Maker) turn this paradigm upside down.

Coercion is not possible. And assuming the DAO is never hacked, nor would it ever be required.

Instead, a distributed network of willing participants replaces coercion. Its laws and contracts are written into a distributed ledger, an immutable record of human activity. And this ledger automatically enforces the rules.

Think about it: Yes, Maker DAO may resemble a traditional governing body. But its members are completely anonymous. They can enter and leave the organization as they please. Yet none of this prevents Maker from executing its tasks — seamlessly and flawlessly (so far).

If All This Seems a Bit Abstract, I Suggest You Get Physical.

Pick up some DAI tokens. Tuck them away in your laptop wallet. Then observe how remarkably stable the price is, always hovering around US$1. But as you do, bear this in mind: The stability of the currency is maintained without coercion or the threat of coercion.

There is no Federal Reserve, no Board of Governors, no Federal Open Market Committee (FOMC).

There is no irrational exuberance or political interference.

Nor is there the lunacy of cutting official interest rates three times in a row with unemployment at record lows.

Stability is maintained by the Yin-Yang of the market and the way of the DAO.



About the Editor

When econometrician and pro trader Juan M. Villaverde first applied his algorithms to Bitcoin years ago, he discovered a regular cyclical pattern. And he has since used it to build the world’s first crypto timing model based on cycles. Thanks to his analysis, the Weiss Ratings team has accurately picked the top and bottom of major crypto booms and busts.

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