DeFi - a Sovereign Financial System
MARCH 12TH, 2021
Thomas Hobbes’ doctrine of sovereignty dictates complete monopoly of power within a given territory, and also insists on the fundamental equality of human beings. He maintains that the state is a contract between individuals; that the sovereign state owes authority to the will of those it governs and is obliged to protect the interests of the governed by assuring civil peace and security.
A nation state is sovereign when it is neither dependent on nor subjected to any other power or state. Similarly, a financial system is sovereign when it runs in a way that resists outside influence. DeFi represents just such a system. Instead of sovereignty relative to managing the laws of a geographic region, DeFi uses protocols to govern the exchange of value, information and services in a natively digital environment. DeFi’s sovereignty is necessary to fulfill crypto’s ultimate promise of digital systems that distribute value more broadly across its participants, instead of concentrating it in a particular company or jurisdiction.
In many ways, DeFi does to Big Finance what the Internet did to centralized industries such as telecoms and retail: it introduces open source code and standards, thereby collapsing entry barriers and increasing competition. But unlike the Internet, DeFi uses a community consensus governance model. The rules of each DeFi protocol are tightly specified and rigid, activity is coordinated via community consensus which is driven by economic incentives, and system rules are enforced by smart contracts.
In a nation state sense, sovereignty is a matter of trust and scale. Sovereignty thrives in jurisdictions where there is a high degree of trust in the rules of the state, and in the state’s sovereign ability to enforce, defend and uphold those rules. The state’s ability to do so is largely dependent upon its economic scale relative to outside threats. The same principles apply to financial systems: DeFi will thrive when there is a high degree of trust in the system due to minimizing the risk of threat from outside parties. In order to build that trust, DeFi must achieve two things, 1.) decentralization and 2.) scale.
Decentralization is a prerequisite to sovereignty because it makes the system resistant to outside influence. To illustrate this fact, we can compare Facebook’s Libra to Bitcoin. Facebook promised a ‘decentralized’ stablecoin, but its development was financed and promoted almost entirely by corporate America. This gave the U.S. Congress the power to call hearings and eventually halt the project. That the U.S. Congress can do this disqualified Libra as a sovereign network. By contrast, it would be practically impossible for the U.S. Congress to stop the development and operation of the Bitcoin network world-wide. There exists no centralized attack vector to call in for hearings and impose regulation or penalties upon. In this manner, decentralization is a prerequisite to sovereignty because it gives network participants trust that the system is structurally resistant to outside influences. In the DeFi context, centralized attack vectors that are vulnerable to outside influence include: mining, governance, infrastructure and user base. Each of these components must be decentralized over the widest possible number of participants. Participants must be decentralized over the widest possible geographic spectrum.
Scale can only be achieved once the system is structurally resistant to outside threats via decentralization, as described above. Once this foundation is built, the network is ready to scale. With scale comes economic power, further enforcing sovereignty. Economic power is primarily driven by economic incentives of participants. A growing number of institutions adopting crypto, and things like the sector’s growing cultural importance via NFTs will ultimately make it virtually impossible for regulators to squash the sector once it reaches a certain scale. Whereas decentralization is primarily a defensive mechanism to protect sovereignty, scale can be used to facilitate offensive protection, as institutions and cultural influencers are financially incentivized to use offensive tools (lobbying, activism, etc.) to protect the system.
The reality is that, today, most DeFi protocols are nowhere close to being sovereign. This is both expected and acceptable during this early phase of the system implementation. However, there are green-shoots, and I think projects like REN provide a plausible roadmap towards bridging the gap to sovereignty.
In practice, 100% nation state sovereignty does not exist in the physical world and I think it is unlikely that 100% sovereignty will exist in the digital world. However, I also believe that DeFi’s largest and most successful protocols will be those that are the most sovereign, because, for the reasons stated above, they will have the easiest time convincing miners, users and investors to commit their time, work and capital by mitigating outside attack vectors. While not 100% purely sovereign, these protocols will operate with functional sovereignty nearly indistinguishable from the real thing.
