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In Code We Trust: Decentralized Finance and The Emergence of the Trustless Society

Trust is an essential lubricant for social interaction. We go our entire lives trusting people. Children for the most part trust their parents to have their best interest at heart. Students trust their teacher and employees trust that their employers will pay them at the end of the month. And while there are always some bad apples among us, for the most part we consider people to be trustworthy.

Modern society has exist thanks to the development of trust in centralised institutions. Historically, as state power became more centralised it became possible to “outsource” trust from individuals to institutions. Today, for society to keep running, we need to trust in the institutions that enforce the rule of law. And when things go wrong, there needs to be a legal path that can enforce the re-establishment of that trust.

But how does this relate to finance and banking. After all we hear relentlessly, that Banks have their customers trust, so let’s put this into context. Let’s say that you want to buy a house, so you go in search of your dream home and you find a house on sale that you fall in love with. You could just go to the person selling the house with a whole bunch of cash ask for the keys and sign the papers. But you also want to make sure that the other person doesn’t run away with your money and the property titles and conversely they want to make sure that you are not paying with funny money.

For this to happen you have to enlist the help of a third party that acts as a guarantor, so you ask your bank to sit in the middle of the transaction to keep everyone honest.

The bank does this through a process called an escrow. Through it the bank receives your money and holds the property titles. Once the transaction is completed and all the paperwork has been signed, it realeases the money to the seller and you are the official owner of your new property. This mechanism ensures that neither party is tempted to run away with their part of the sale. However its a slow process, and of course it generates fees that the bank is only too happy to charge both parties.

Since the credit crunch in 2008, western democracies have experienced a crisis of trust in their institutions. The system has been abused by the whims of people with power in Government, Central Banks and the Financial Sector at large.

Veracity Index 2020 Source IPSOS MORI, November 2020

In 2020 the British Market Research Company Ipsos Mori, did a Survey where they asked respondents if they thought people in different professions would tell the truth.

The results showed that the most trusted profression is Nursing with 93% of people trusting in nurses to tell the truth. In second place came Doctors, with 91% of people considering them to be trustworthy.

The picture becomes very bleak as we look further down the index, where we see that only 44% of people trust in bankers to tell the truth. And even more shockingly, a mere 16 and 15% trust in government officials and politicians respectively.

Unfortunately it gets worse. Another poll done by the same company, asked nearly 20,000 people globally how they felt about their banks trustworthiness. 32% or respondents strongly disagree with the statement that banks keep their promises. 39% disagree with the statement that banks are open and transparent, and a whooping 52% of respondents believe that their bank would take advantage of them if it could.

Trust Dimensions for Banking. Source IPSOS MORI

This combination of declining trust in instututions and the rise of trust enabling technology is driving momentum towards a paradigm shift.

In its seminal paper of 2009: Bitcoin: A Peer-to-Peer Electronic Cash System, Satoshi Nakamoto wrote: “What is needed is an electronic system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.” This has brought a new way of thinking about money into the mainstream, whereby trust enabling technology is slowly replacing centralized trust in institutions In this “trustless society” transactions will depend less on contractual agreements and more on self verifying, and self executing code.

This means that in the next 5 to 10 years, we’re going to see the locus of trust shift dramatically: from centralised institutions, to individuals, and from elites to “people like you and me.” But how will this happen? you may ask. Well this will be achieved thanks to bits of code known as Smart Contracts. Smart contracts are essentially a set of instructions designed to follow an IF – Then Logic. IF event A happens, then action B should follow.

Smart contracts are essentially secure in the sense that they use cryptography to stop people altering records. They are also transparent as through blockchains, everyone can see what the smart contract is and what it’s being used for. They are third-party free as they don’t need a middleman like a bank or a government to verify its execution, autonomous as they self execute and accurate, since they don’t rely on the grey areas of a language and the meaning of words.

Smart contracts are enabling a new type of financial service called Decentralized Finance, or DEFI which lets people lend and borrow money without the need for a bank.

Instead, smart contracts use the blockchain as the registry for the transaction, and code to execute it. There are examples of organisations that are already experimenting with these types of services. For example the Dutch bank ING has co-created Fnality, a blockchain-based trade-settlement system using smart contracts. And the Swedish government tested a smart contract based land registry for proving the ownership of land

So how could DeFi services and smart contracts impact you? Think about your travel insurance policy. One “rule” of the policy may be that a policyholder receives compensation if a flight is delayed or cancelled. This rule can be installed into a smart contract, which means that the policyholder doesn’t have to rely on the insurer to hold up their end of the bargain.

If your flight gets cancelled, that information gets added to the blockchain which triggers the rule in the smart contract. You receive compensation automatically and avoid the entire claims process and any potential friction.

Sounds Exciting? Well perhaps, but consider the fact that the benefits of smart contracts rely on a big assumption. To benefit from this new technology, increasingly more and more aspects of your life would need to be recorded digitally.

For a smart contract to work, there needs to be a digital record of your purchases, your travel plans, your day to day activities and other events that relate to you.

Leaving aside the obvious privacy concerns associated with this, code errors in smart contracts are one of the biggest challenges for wider adoption.

A November 2020 report by CipherTrace found that around  $10 million USD a month is drained from DeFi contracts alone. To help minimize the risk of this, third-party firms are offering code auditing services for smart contracts.

This suggests that perhaps trust is not being removed, but instead it’s just being transferred, from the individual to the code and therefore to the coders? Technology is always exciting but there are always things to consider before we run to indiscriminately adopt innovation.

For example, could distributed trust lead back to centralized power? Take Amazon, Alibaba or Facebook. They might have begun as ways to democratize commerce and information, but conversely have become centralized behemoths in control of our data.’

It is also true that most of us don’t understand legal terminology, will this get worse as we try to grapple with code?

And perhaps the most fundamental question of all is, do we know what we are doing when we allow technological developments to lead us to a place whereby the magic dust that enables us to relate to each other is replaced by cynicism distrust and lines of code?

Chris Crespo
Chris Crespo
Chris is a Co-founder and Chief Editor at Nordic Fintech Magazine, where he simplifies complex financial concepts through jargon-free content, making it easy for anyone to understand. With extensive experience in financial services, including working with some of Europe's largest banks, he brings a wealth of knowledge and insight into the industry. As the former Chief Futurist of the largest bank in the Nordics, Chris has a deep understanding of the Future of Financial Services, the Future of Money, Disruption, and Ethical AI in Finance. He is also a guest lecturer at Stanford University, where he shares his expertise on these topics. As a Behavioural Economist, Chris is passionate about exploring the connections between human behaviour and decision-making under risk, as well as uncovering and communicating the links between psychology, leadership, and technology in financial services.

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