Decentralized Finance Part 2: The Behavioral Science Perspective

7 min read

Decentralized Finance

Decentralized Finance (DeFi) is making waves with several of its (crypto-)currencies, platforms and protocols becoming more and more prominent in the news and other forms of mainstream media. I was inspired by an article on “crypto-rebels” published on Bloomberg, that dives deeper into this topic. Within the first article, I laid out what DeFi is, wants and does, to the best of my understanding. In this article, the second part of the mini-series, we are going to look into what we have seen DeFi achieve so far and discuss its not so great reputation, and of course, dive into what Behavioral Science has to say about DeFi. Ultimately, we need to figure out whether the future is decentralized!

Achievements a Plenty, Issues Beyond.

So far, we can’t say that that decentralization has taken over. At least not in the form of cryptocurrencies. It’s not something that everyone has gotten into. And this is mainly driven by 3 reasons:

First Mover Advantage Clear implications to this advantage: you’re either first, or you’re last. The people that invested in crypto first, the first famous one being Bitcoin (and didn’t sell or lose them…) are rich now. Initially, it was a gimmick, a bit of fun on the side, an experiment, then it became serious coin. We all have seen the stories about crypto-millionaires. They moved in before the hype, then came the hype and they cashed in. Good for them.

But not so good for you. Because if you’re only joining now, you’re way too late. Maybe if a new crypto comes out you can still make some profit, but the cat is out of the bag my friend. There is a clear first-mover advantage to crypto.

Now even first movers make mistakes. We all know that story about someone’s friend’s uncle’s brother twice removed, who used to own Bitcoins which they bought cheap and early, to then use 20 of them to buy a pizza. And they felt oh so good about being able to do that, because it wasn’t “real” money. How stupid they must feel now…

Clueless About Crypto?
Another issue with crypto, and its underlying processes such as blockchain, is that they are not easy to understand. For someone who understands money, old school money that is, this remains hard to grasp. Because it’s so out of line with what we already know. Sure, mining money can be compared to a central bank printing more money. And if a crypto-currency is pegged we can also (to some extent) grasp its value. But that is where most people stop, after 3 coffees, a cocktail and a half an hour lecture. But to understand it you need to go so much deeper.

In the first part of this series, I touched on ownership and lending protocols. I kept it short, but you could easily write a book about it. You could write an entire book series about crypto, let alone blockchain. So the tech is hard. But let’s be real, we understand how to operate a computer and a smartphone, but we don’t really know how they work, and we seem fine with that. So it’s not technological understanding that’s holding us back. No, crypto might not be the issue here. It’s the lack of understanding that comes with decentralization that seems to drive the nail into the coffin.

Decentralized Finance

Most people expect an authority (preferably with a face and voice that aren’t generated) to guide processes. To say what can and cannot be done. What is and is not appropriate. Decentralized finance in its purest form doesn’t have someone checking your credit, or issuing loans, but the latter is done through crypto. People lend to other people, in crypto. Crypto in its purest form is build on trust. Well, trust in a financial system might be too much to ask from someone who’s been through the crisis. And to just jump into the deep is pushing a bit too far as well.

What we have seen develop as a result is open finance. A form of finance in which there are credit checks, where there are protocols to keep and meet certain standards. This form of finance wants to integrate with the “normal” finance we know-how. And I think it might actually stand a chance. But more on that later.

You’ve got a Bad Reputation!
Another day another scandal. Well, maybe it’s not that intense, but the news that crypto-currencies were being used in the purchasing of illegal goods and services certainly did DeFi’s reputation no good.

There is a reason crypto is called crypto, it comes from encrypted. Which is what the information related to your transaction is. You hold they key to that information, and only you can unlock it (unless you get hacked). This is one of the biggest advantages to crypto and blockchain, the fact that your information is encrypted. But that’s exactly why it’s being used for illegal activity.

Now if you don’t know much about crypto, blockchain or DeFi and haven’t actively gone out doing research about it, chances are that this is all you know about it. Stories about illegal activity on a mass-scale such as all crypto-users is newsworthy. Crypto got its chance to shine through mass media and blew it like the ammunition that it was used to pay for…

Where does this leave us? Well, it’s a bit of a mess. On one side we’ve got the hopeful extremists (not that kind of extremist…), who want to see the old financial world burn and pay for their mistakes, blatant extortion and create a new world to financial freedom and equality. But this is failing. It’s failing because when it comes to finances people want some type of authority, some type of guard, and despite it all, the old systems (banks and the like) represent that still. We need physical (paper) money. We understand that. We know a bank should be good for it. The rest is just as bit too much to ask. And crypto? Well, it’s just a bit of a gimmick. A dangerous gimmick supporting weapon and drug trade. It’s a coin for criminals! And something a couple of massive nerds got lucky with. That’s not us.

Behavioral Science on Decentralised Finance

Crypto is trying. DeFi is trying. And I appreciate it. But there are some issues here from a behavioral science perspective, based on the three topics I discussed before. Not just issues though, there is also optimism and maybe even some helpful tips. Let’s dive into it.

I should mention that I have written about the behavioral science of cryptocurrencies before: I’m referring to my article on Libra, and feel like I should discuss that before moving on. My article on Libra was very much an angry and (very) overtly critical one. The main reason there being that I am not a fan of Facebook and am more than convinced Zuckerberg has at least 16 alternative agendas, none of them focussing on MY well-being. With other actual decentralized cryptocurrencies (because Libra is not decentralized at all), I’m refraining from judgment so far, but I am cautiously optimistic. I do think the financial system was overdue for a complete overhaul a long time ago, as central authorities (often banks), seem to treat us as the product rather than the client, making money off us rather than helping us manage it. However, here lies my biggest issue: we don’t really understand what’s going on in our current financial system, after decades of research and living in it. Is creating and possibly integrating a whole new system the solution? Or a quick fix leading to the same problem, years down the road?

The fact that it is difficult to understand blockchain and most cryptocurrencies don’t help. Actually, it makes it very difficult to see crypto as actual money. Now, this can lead to a plethora of problems as outlined in the Libra article. It might mean we treat it as play money, don’t take it seriously and overspend it, relative to other methods of payment.

I do think there is a rather easy fix for this: have every vendor accept it as a currency and have it to some extent pegged, so its value becomes clear. As such, we can express products we value in terms of crypto and it becomes a more concrete form of money. But this type of regulated acceptance needs central regulation, which is not what the original idea is behind DeFi. And this seems to be the divide between current DeFi participants: whether to integrate with or terminate the current financial system. This is the difference between decentralized and open finance.

Decentralized Finance

Another issue is the hype currently associated with blockchain and crypto. A small group of people have managed to make money of it, and some have even become millionaires on it. This sounds like the life! But the issue is, as soon as the value of one of these assets drops, so does your millionaire status (very much like the stock market). With limited options of exchange (selling a lot of cryptos would immediately plummet its value and you need to hold quite a bit to be a millionaire), and limited understanding of what crypto is and how it properly functions does lead to some issues. It’s partly the limited understanding that has given rise to the hype. But that isn’t exactly a smart reason to invest… This issue becomes evident as Long Island Iced Tea Corp. recently changed its name to Long Blockchain Corp. and saw its share price rise with 289%, driven by new demand for the stock. That should tell you everything you need to know.

For crypto to work it needs to be properly seen as money. This is something that will be authority driven. From a behavioral science perspective, what we need isn’t DeFi, we aren’t ready yet. We aren’t that revolutionary. We dipped our toes, but it will be a lot of paddling before we take an actual swim. I think DeFi will do well transforming itself into open finance, integrating into current systems and turning them over from the inside.

Is the Future Decentralized?

I feel that, with the previous paragraph, I have sort of answered this question already. So far, what we’re dealing with is clear: new money, which we don’t know how to perceive, with an incredibly bad or gimmicky reputation. Cool, but is that likely to become the future?

We are currently in one of the early stages of decentralization. We have a crisis to thank for that. People have lost their faith in the “normal” system and are kicking against it. Good. Do it! And some clever people have gone further than kicking; they started creating, coding and mining. They created something new to rise from the not-yet-ashes of the old establishments.

When we look at the functions of banks and other financial institutions, their initial roles have long gone. They are not the safekeepers of our money anymore. Often they are the root cause of our monetary problems. Crypto, and DeFi as a whole are grinding away against the foundation of this system, and this I can only applaud. But, this is a system we know. It’s all we know. And as such, I wouldn’t be surprised if the future is open, rather than decentralized.

Another thing to keep in mind is that technology is moving forward in big leaps. Not only do we have computers that are becoming increasingly more powerful (faster trading and mining!) but the same power can be used to become faster at decrypting (annulling the encryption). This is not great news for blockchain, as its main asset is the encryption.

The impact this will have on DeFi remains elusive. It is possible that it will drive out the illegal purchasing activity that has stained crypto’s reputation. Have it all out in the open. The information will be up for grabs, but that is effectively no different from the system we have now. It might put crypto in a brighter light and make it appear more friendly to others.

The decryption might also ruin the entire appeal of crypto, it might give rise to an even more difficult to understand version of crypto. Who knows? The one thing that is a certainty is that as long as technology will evolve, so will blockchain, so will crypto and as a result, so will DeFi. It might be that this is the evolution we were hoping for. Or at least the first version of it.

Another aspect of this technological evolution is that is has been rather sudden and quite fast. People will need some time to get used to it. Every generation under 35 years of age is incredibly tech-savvy. We will become acquainted with newer technologies and learn to understand them. Longer-term exposure will help. Education might even move into this. It’s all about becoming adaptable to the current world after all.

The future is bright, my mind is open. I’m just not sure whether the financial system will be as well.

Merle van den Akker Merle van den Akker is a PhD student in Behavioural Science, at the Warwick Business School. She studies the effect different payment methods, especially contactless and mobile methods, have on how e manage our personal finances. In her "free" time she writes articles on personal finance, behavioural science, behavioural finance and life as a PhD student, these are all published on Money on the Mind. With DDI, she writes on personal and behavioural finance, to ensure that knowledge from academia trickles into the mainsteam, and can help as many people as possible!

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