Guest User

July 29, 2022

Understanding Crypto

Understanding Crypto 9: Prof. Campbell R. Harvey: DeFi and the Future of Finance (Rebroadcast)

Guest User

July 29, 2022

Understanding Crypto

Campbell R. Harvey is a Professor of Finance at the Fuqua School of Business, Duke University and a Research Associate of the National Bureau of Economic Research in Cambridge, Massachusetts. He served as President of the American Finance Association in 2016. He has also published over 150 scholarly articles on topics spanning investment finance, emerging markets, corporate finance, behavioral finance, financial econometrics and computer science.

For this week’s episode, we are revisiting a portion of our conversation with the legendary Professor Campbell R. Harvey and his more optimistic viewpoint on the crypto space. Campbell is the Professor of International Business at Duke University and is also a Research Associate at the National Bureau of Economic Research. In 2016 he served as the President of the American Finance Association, and from 2006 to 2012 he occupied the incredibly demanding role of Editor for the Journal of Finance. We hear about Campbell’s latest book DeFi and the Future of Finance along with his most recent research. Discover how Campbell first became interested in the topic several years ago and decided to put together a course for his students. We also delve into the rise of decentralized finance (DeFi) and how we can expect it to shape global finance, trading, and the future of the internet.

Key Points From This Episode:

How Campbell became interested in DeFi, cryptocurrency, and blockchain technology.

How digitized finance cuts out the inefficiency of having a middle person and fosters inclusion and financial democracy.
Dr. Harvey’s thoughts on how cryptocurrencies facilitate criminal and fraudulent activity.
How DeFi could disrupt traditional asset management and how to prepare for those changes.
How to invest in DeFi even though it’s decentralized.
How companies can increase their revenue by using cryptocurrencies in their transactions.
Why the current wave of FinTech will be replaced by DeFi.
Why it’s important to have a very diverse portfolio when investing in DeFi.
How DeFi will allow people to monetize their content and disrupt the money that Google and Facebook make from their users’ data.
Some of the risks of DeFi and investing in cryptocurrencies.

Read the Transcript:

Cameron Passmore: Today we're going back to a conversation that I think Ben, it's safe to say started the whole conversation around crypto and DeFi. So we're going back to the episode with Cam Harvey, which was number 171, which aired October of last year. And Cam was truly one of the top scholars in traditional finance, and in the second half of that conversation we had back in October, he gave us his views on how DeFi could change so much.

Ben Felix: He says in the conversation that his book that he wrote on DeFi, which is what prompted us to reach out to him, is about not a renovation of the financial system, but a rebuild from the bottom up. That's a pretty bold statement from someone who's deeply involved in the world of traditional finance. Cam's a professor of finance at Duke. He's also a research associate at NBER, National Bureau of Economic Research. He served as the president of the American Finance Association in 2016, and edited the Journal of Finance from 2006 to 2012, which sounds like it was quite an experience. He talks about that in the first half of that episode, so just to be clear, we're rebroadcasting the second half of that episode with Cam, because that was the half that we talked to him about crypto.

Cameron Passmore: The whole interview is worth going back and re-listening to, but we wanted to have the crypto part as part of this series in a package.

Ben Felix: It fits. As we've said many times, we've gotten very mixed comments on the crypto series, but one of the things that we've heard on the critical side is where are the pro crypto voices? But it's important to remember that it was those pro crypto voices that prompted us to investigate crypto. We had Marco DiMaggio and Cam Harvey on the normal Rational Reminder Podcast, and they were so excited about it that we were like, "Okay, these guys are pretty credible. Maybe we need to give this a more serious look," which is what led to this series, as you mentioned earlier, Cameron. Cam Harvey has published over 150 scholarly articles on investment finance, emerging markets, corporate finance, behavioral finance, financial econometrics, and computer science. As he says in the interview, he, has published in computer science journals, which is pretty interesting.

He's also a partner and senior advisor at Research Affiliates. We've had Rob Arnott, who leads that firm on The Rational Reminder Podcast as well. He's also an investment strategy advisor to The Mann Group, which is the world's largest publicly-listed global hedge fund provider, and relevant to this conversation, Cam coauthored, the 2021 book DeFi and the Future of Finance, and as you'll very clearly hear in this conversation, he is very excited about the possibilities of DeFi. Now, when we talk to Cam, and you'll hear it in some of the questions, honestly, when I went back and listened to it, I'm a little bit embarrassed at the level of knowledge that I had in terms of the questions that we were able to ask, and the follow up questions we were able to ask at that time. We've learned a tremendous amount since then, which was our mission. After we talked to Cam Harvey, we were like, "Okay, we got to go learn."

Cameron Passmore: I was going to say, that's kind of the point, right?

Ben Felix: Yeah, it is the point. And it just makes me think, my current level of knowledge on this topic maybe a year from now, I'll look back and think wow, how little did I know, which is how I feel about my level of knowledge during this conversation. But anyway, our level of knowledge at the time of this conversation was much lower. Going back and listening to it, which I did before we decided to rebroadcast it, going back and listening to it with fresh ears, and with the knowledge that we now have after going through creating all of the previous episodes in this series, it's a whole different experience. The ability to think through what Cam is saying critically, and I'm not taking a position on whether I agree or disagree, but I'm just saying.

It's very different hearing what Cam has to say after hearing Igor Makarov and Daniel Mescheder, and Esward Prasad, all the people we've talked to in the series that have given us all of these other tools to think about the crypto ecosystem, what the technology could do, how it relates to traditional banking, what the role of intermediaries are, all that kind of stuff. And you go back and hear what Cam has to say, it's just a whole different experience. So without question, this is a pro crypto guest, as many people have requested. Cam's very excited about it.

But again, the difference between listening to this back then, for me anyway, and I think for lots of the Rational Reminder listeners as well, I know that two episodes we did on crypto, this is why we launched a separate series, a lot of people pushed back and said, "I don't really care about this. I don't want to learn about crypto." Okay, fine. Well, we do, so we're going to do a separate series. Anyway, whole different experience. Even if this is your second time listening, I think it's well worth it. It was for me to go back and hear what Cam had to say with all of the context that we've gained in the last eight episodes in this series.

Cameron Passmore: Awesome. All right. Well, let's go listen to or conversation with Cam Harvey. Professor Cam Harvey, welcome to The Rational Reminder Podcast.

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We have an incredible sense of your breadth of research that you've done over the years in what I think we can call traditional finance, but you also have an incredible interest in DeFi and crypto, including your recently released book. What got you interested in this? I'm so curious.

It happened after my stint as editor of the Journal of Finance. So I was basically not teaching for seven years. When you edit a journal like that, it's a full-time job because it's 1,500 papers a year. That's more than a full-time job. These are not easy reading. These are difficult to do, and all the stuff that I talked about, trying to detect if there's data mining, is really challenging. So I went back to my advanced asset management course and decided to redo it. Hadn't taught it in seven years, and I wanted a fresh start. I didn't want to be one of these professors that go in with slides that are 10 years old. Everybody's seen that, experienced that, and I was never impressed, so fresh syllabus. I have a module on foreign exchange, so I'm thinking, "Well, I do the dollar, euro, yen... What about this new thing, Bitcoin?

So I decided I would add that as something that was leading edge. I thought it was just another currency. So I read the paper by Satoshi Nakamoto. This is a paper that's not published in a top journal, it's just on the internet, but I'm reading this paper thinking this is a big paper. This is a big paper. This is in the category of the Markowitz paper, the Sharpe paper. This is a big paper. And then I started trying to understand the mechanics in much greater detail. I don't have a degree in computer science. I've actually published in a top computer science journal, but not in this particular area, so this was a lot of work for me in terms of preparing a lecture on cryptocurrency.

My course has 12 two-hour lectures, and one of them was going to be on cryptocurrency, and I found that this single lecture was taking me more time than the sum of the other 11, and I didn't mind it. So it was the more I read, the more interesting the material got, and the more interested I was. So I reached out for help, and it was hard to find help because it was so new, this area, and I relied upon some local resources to help me, but I was very, very nervous. Indeed, in asset management, given I've published a number of papers and top journals, that I'm pretty comfortable with almost any question that my students would ask, and I can answer most of them quickly. If I can't, then I say, "I'm not really sure, but I can find out," I can rely upon my network of experts in the actual field of asset management to help me out.

For this lecture in crypto, I didn't have that network, and I thought with substantial probability, there could be some students in the class that know much more than I do. So it was probably I was more nervous over this single lecture than any other lecture in my career. So going to the classroom, and there were actually extra seats at the back that were filled because people had heard that I was doing this, even though they weren't in the course. I do the lecture, and we've all been through this before, and this is typical at Duke, that as soon as it comes to the hour where the lecture is over, everybody just gets up and leaves. And if you try to tell people you're going to be late or need two more minutes, then they're just not receptive to that whatsoever, so I really tried to finish on the hour, and immediately people get up and leave.

So I finished the lecture and nobody gets up. They're just sitting there, and I'm thinking, "Oh, made a mistake. Maybe I finished five minutes earlier or 10 minutes early or an hour." I was just so nervous. I'm looking around. No, it is time, and people just sitting there. And I'm thinking I must have really bombed, that this must have been a disaster of a massive scale because people are just sitting there and staring. And then people came to the front and said this was a transformational experience for them, that this was a lecture they will remember the rest of their lives. Some said it was the best one they ever a had in not just their master's program, but undergrad also. And then they said, "This should be more than a lecture. It should be a course," and that's how I started in this space.

It's a difficult space to deal in because it's just transforming so rapidly, so that lecture of seven years ago, there's almost nothing in it that I do today. Indeed, the course I taught this year in 2021 was 85% different than the course that I taught in 2020, so you need to be really interested in this space to do that. The course this year was based upon the framework of my book, DeFi and the Future of Finance, and we look at infrastructure, we look at some of the primitives. We do a deep dive on the leading companies in the space, and then we look at all the risks that this technology faces. But it was a journey to get here, and I see something different. I see something really transformational to finance. The problems that are solved are remarkable.

Actually, in my course I show a photo of one of the first Western Union wire transfers from 1873. It's for $300, and then the fee to do it is $9, 3%. 150 years later, 3%, so little has changed over the past 100 or 150 years. You've got digitization, but the same level of inefficiency exists. I transferred some money in euros to Europe the other week, and my bank said, "You're such a good customer, we're going to waive the fee." I said, "Fine," and then they quoted me a rate. I said, "Oh, okay. Well, that's 2.5% off the market, so it's like a credit card," and the person doing the mechanics had no idea what I was talking about. She said, "No, this is the rate." So inefficiency is obviously a big deal, but decentralized finance is about trading with your peers, so there's no middle person.

You're trading with an algorithm, so an algorithm matches you with your peers. So you send money, example, you send by the algorithm to your peer. There's no spread, there's no middle person. So if you're doing exchange, if you're buying one thing for another, you send some token to the algorithm, and the algorithm sends you the other token that you want to buy. Everything is wide open. You can see the code, you can see the liquidity, and again, the cost is really low. And importantly, it is available 24/7, the algorithm doesn't care if you're buying or selling, and it's open to anybody. So it is really about a financial democracy, so everybody is just a peer. It's not like the banker and the retail client, so there's no labels like that. It's about peers. And the issue of opacity in our current system, that you deal with the financial institution, you don't know their health. Maybe the regulator's got an idea.

You just delegate to the regulator, and the regulator has got a dubious history of actually carefully monitoring, in the US at least, these institutions, so it's completely open. So again, these algorithms are open source if you can do better, so the speed of change is remarkable because the algorithm is available. You might have an idea to improve upon it. You just take the code that already exists and then bolt on your idea, and you're in business. You'd be in business in one day, so you get rid of this thick layer of middle people. You basically make this much more inclusive, and I believe it's important. This inclusion is really important. I mentioned in my book that 1.7 billion people in the world are unbanked, and probably more are underbanked.

And the way that I describe the underbanking is the following. You're a small entrepreneur, you've got a great idea. It's got a 24% projected return on investment. You go to your bank, so you're banked, and you want to loan. And the bank says, "Well, you're too small. We don't want to deal with it, but what we'll do is increase the amount you can borrow on your credit card." And it's remarkable how much entrepreneurial financing happens on a credit card. You know the story, right? You got 24% projected rate of return, 24% interest rate on your credit card, and the project is never pursued. And these are exactly the types of projects that need to be pursued. The US is stuck in this 2% growth zone, Europe is worse, maybe 1%, Japan is at zero, and I think one major factor here is the financial friction, that the projects that should be financed are not being financed.

So the larger firms are financed, and they actually don't have the growth opportunities that these smaller firms have. So if you want to see 5% or 6% or 7% growth, then you need to change the financial system. You need to make it more democratic, that you get the financing if you've got a good idea, and you do it directly from your peers, and basically cutting out this middle layer. So it means that borrowing rates go down and savings rates go up, and it makes sense because you're not paying for the brick and mortar, the middle layer and all this stuff. So the book is about not a renovation of the financial system, but it's about a rebuild from the bottom up. And we are so early into this, it's less than 1%. And it's exciting to me, and it's consistent with my teaching philosophy that I want to give my students a glimpse of the future. It might not be accurate, but it gets them to think about the future so they can make better decisions. I tell my students that I want them to be disruptors, not disruptees.

How much should we worry about sketchy activity or fraud with respect to crypto?

Let me answer this in two ways. Number one, if you want to do criminal activity, then Bitcoin or Ethereum is probably your last stop, and the reason is that every single transaction is posted to a ledger that's available to anybody to see, and is there forever. It's immutable. So while you can set up an address that appears to be anonymous to receive some ransom from a ransomware attack, you got to move it at some point, and when you move it to basically cash out, you can be caught. And when you're caught, the justice is swift. Exhibit a is here's your address in this ledger that's immutable. Guilty. So you want to do something anonymous, you use the most anonymous technology, cash, and most criminal activity is done with cash, so on the criminal side, this is a bad technology. There are some anonymous coins, but most of the press mentions the ransomware and Bitcoin and things like that.

The second aspect is people basically just taking advantage of this technology, and people wanting to get in. So given this is a young technology, there will be multiple situations where people try to take advantage of potential investors, and as many schemes that are possible, many have been documented. I get asked all the time to be advisors to some token, and I'll ask questions, and almost always decline. There was one that was interesting for me, in that they called me, wanted me to be academic advisor, set up a meeting with the CEO, and I went along with it. And the meeting started out, the CEO wasn't there. They went through their pitch, didn't make any sense to me. The CEO shows up, and basically what they were doing was they were going to issue a token and you would buy it, and then you could use it later to pay for digital advertising.

And I'm thinking well, why would you do that? That's like prepaying. And who knows if the token's even going to be around, so why not just pay when you have to pay? Why would you prepay? So I tried to figure out their business model. Why are you doing this? Why are you wishing this token? And finally, they admitted that well, because this is a way to raise money. So it is not like this is a way to raise money to fund this great idea that we've got, this is a way to raise money. So obviously, I just brushed them off, but one of my students did a little research on the CEO, and it turned out that he had been found guilty of domestic abuse on 100 different counts, and he was awaiting sentencing. So now it makes more sense to me that there's zero chance if he went to a bank to get a loan, that this venture would be funded. The only chance of getting it funded is to go into this new space and take advantage of all the buzz about all these tokens.

So again, you need to be careful here. This is, again, not without risk, and maybe it's obvious to you that if something's without risk, there's no upside to it. You might as well just invest treasury bills. So there is risk here, and this is a complicated space. And a lot of the motivation for the book is to access the millions of people that are interested in finance or work in finance, don't really understand this space. So one of the motivations for my book is that there are millions of people that work in finance or are just interested in finance, and they might not realize what's happening in terms of the structural disruption. Maybe they know a little bit about crypto. They read about Bitcoin going up and down, they read about Elon Musk tweeting about Dogecoin. And my book isn't about Bitcoin or Dogecoin, it's about a potential future, and this helps people, I think, with what they're doing.

I've got a big picture question that relates DeFi back to asset management. A lot of the people listening to our conversation right now are invested in maybe index funds, cap weighted. Maybe they got some overvalued companies in there, but maybe they got a bit of a factor tilt, but either way, they're diversified stock market investors. For those types of people listening, if there's a DeFi revolution coming that's going to disrupt traditional finance, do they need to be buying crypto or investing in DeFi? You can't invest in DeFi companies, it's all decentralized, so what do you do? Is the total stock market going to benefit from the DeFi revolution, or do we have to be doing something special to take advantage of it?

Just last week, I had a conversation with a major pension fund, and they were thinking of putting on some DeFi exposure. It's not just DeFi, within this disruption it's generally linked to blockchain technology, so there's other applications of blockchain. So they said to me, "Well, we don't really have any exposure to DeFi right now," and I said, "That is false." They said, "Well, what do you mean? We not invested in any of these tokens or companies."

I said, "You've got exposure because the traditional companies that you're invested in had this negative exposure to DeFi, that DeFi actually potentially can put them out of business. So you are totally exposed to this risk, and you need to look at it that way. What is the risk of potentially disrupting many of the stocks in your portfolio right now with this technology? And then you need to realize that risk exists." And then the other part of this is do I invest in some of these companies directly to diversify my portfolio? So right now, given that they're not invested in DeFi, they're undiversified on the downside.

I've got a question that's maybe going to sound naive. I said as part of my previous question how would you invest in DeFi if it's decentralized, but you were just talking about companies that exist that you could potentially invest in. How does that work? If total stock market's undiversified with respect to DeFi and somebody wants to add more, what is a company that you could invest in that's in the DeFi space?

How to invest in DeFi. That's the question, and there's basically a number of different ways to do this. So number one, and often institutional investors do this, they invest in a venture capital fund that specializes in DeFi, so leading funds might be a16z crypto or Paradigm, funds like that, and they actually do the work of actually doing the individual investments. So if you're at a scale where you're going to do this on your own, there's other possibilities. One is directly investing in the equity of a company that is developing product to be deployed in the DeFi space, so that's a possibility. The second possibility is to invest in a governance token that is linked to a particular protocol, so I mentioned a system, for example, where there's an algorithm that you can send some token to and get another token back.

There is a governance mechanism for that algorithm that fine tunes the parameters, so you can get exposure investing in a token like that, and it gives you voting rights. There is another way of doing it where you actually invest in the platform token, and the platform token doesn't give you a voting right, but if the platform is successful, it will go up in value. That's a possibility. Also, there's also this idea of yield farming, where remember I mentioned that given that there's no fixed cost, brick and mortar stuff, that the savings rates can be higher. Another possibility is just to invest as an alternative to investing in bonds or certificates of deposit to get a rate of return that's much more reasonable, like 4 or 5%, compared to close to zero today. So there's many different ways to actually do this.

And the last way, when I said platform token, it could be that could be Ether or Bitcoin, so some people just buy directly. So there's various different ways to do this, and it is a little difficult to get your head around because when you think of a regular equity, you buy that and get some rights to the residual cash flows, dividends, but you also get the voting right, whereas in decentralized finance, that is separated usually. So it is different, but there's many different ways to get exposure. And again, if you're an institutional investor, often you're using a VC to do this, but just the average retail investor, that's really easy to do. You set up a wallet, and you can have a small portfolio where you experiment in investing in some of the coins, in some of these DeFi protocols.

So you might have $500 ,and maybe you put that to work, and in doing that, you learn about this space. And in my course, I put up a word cloud, that's got about 80 different words on it, and the students have no idea how these words apply to this space. So some of the words are understandable, like minting. We know what minting means, but what does that mean in DeFi? Or slashing. Slashing is the opposite of minting, so you're actually decreasing a supply. So it is, I think, a good exercise, you can read about this stuff, you can read my book, but it's much different to actually play in the space. And in my course I do the lectures, but my students also run portfolios where they actually do it and invest in these protocols in a small way, just to get the experience with that. It's way different. Once you actually go through those steps, you really understand it.

And this is a subtle point also, it is a complicated space, and if you invest some time, it means that you've got a huge advantage over other investors, so it's a really good investment of your time. And then the second point is equally as important. I mentioned that we're 1% in, so this is exactly the time you want to get in. You don't want to get in when we're 98% of the way.

Could all this technology not benefit public companies in a broadly diversified site portfolio?

Yes. Many companies, basically this will be really important for them because if you think just in general, you think of the retailer that accepts the credit card, they lose the 3%. Even a company like Amazon, I have my students do the math, and just suppose half of their revenue comes from credit card, and probably more does, and then just do the calculation. So 3% times 50% of Amazon's revenue, and then take the present value of that, that's just one year. And can this technology benefit these firms? Oh yeah, just in the most basic ways. And even the banks realize that their days are numbered and they need to embrace some of this stuff, so JP Morgan has got a stablecoin, and they realize that they need to reduce the costs for their customers, or their customers are going to leave.

So think about what's happening in the banking sphere. You've got FinTech knocking on their door, neobanks and things like that, that are just much easier to use, better user experience all around. So they're being attacked by the FinTech, and they're trying to embrace some of this, they're trying to reduce a cost, but a lot of the FinTech is basically using the same structure. So think of Apple Pay. It's great. I use it all the time. It's way more secure than a credit card, but the credit card company is more than willing to give 0.5% to Apple, and they take 2.5. It's a great trade-off, because it's much more secure to use the Apple Pay, but it's using the same structure. It's the same 3%. And some of the other FinTech is just using the basic infrastructure.

So you need to be careful, again, thinking about the future. One of my guest speakers, very prominent person in the DeFi space, described the current wave of FinTech putting lipstick on a pig. And effectively, what he was saying is, "Yeah, it's great, it reduces costs, but is fleeting, and the current wave of FinTech will be replaced by decentralized finance," and I think it's a credible story. The banks are very powerful, they will resist, but I think they know the writing is on the wall. Various different countries, the US banking system is very concentrated, other countries much more concentrated, like Canada. Again, if you think about it, the cost is really clear. You're giving up growth, so the growth opportunities that I described that these small projects not being financed, or the borrowing rate, if it is too high, then a lot of stuff just isn't pursued.

So what we need to do is to reduce those frictions and to do it in a way that's efficient. And indeed this is all peer-to-peer. I remember when my grandfather passed away, going through his will we discovered that he actually held a mortgage. He actually funded a mortgage, so he held the note. So that was a peer-to-peer transaction that somebody, basically he lent money to them for a house., so that was pretty undiversified, and it was a major part of his portfolio, but think of the possibility of something like that, but there could be thousands of people that are participating in that. And again, you're diversified across mortgages all around the world, potentially, and it's all peer-to-peer.

And it's interesting to me that market exchange started out with a barter method thousands of years ago, and that was the first peer-to-peer, and there's a possibility that we actually move to a more efficient barter in the future. So my vision is that there are billions of different tokens. Your wallet has got whatever you want to hold, so I might have some US dollar token, I might have some gold. I might have some token that's based upon equities, like a token that is linked to the price of IBM stock. And then I go to pay for something and I'm at my grocery store, I want to pay in gold, but they don't want gold, but they'll take something else. No problem.

Totally seamless that I basically go to an algorithm and trade out of the gold into what the grocery store actually wants. And indeed, this is an existential threat to central banks also, so their reason to exist becomes marginalized. We see this already. A country like Venezuela, where it's in hyperinflation, just gross mismanagement of their fiscal and monetary policies, if you're rich in Venezuela, then it's no big deal. You got a bank account in Miami. You're protected. You're in US dollars. Who cares if there's 700% inflation in Venezuela? But the vast majority of the population really gets hammered by this inflation.

So what's happening is the vast majority can't afford to have a bank account in Miami, but they have a smartphone, and that smartphone becomes their bank because they hold US dollar token like USDC, and effectively, they have disintermediated the banks, number one, and the central bank, because who wants to even use the local currency when you can just use these tokens? So again, the central banks will try to issue their central bank digital currencies. They'll do that. I think people will resist because you want the government to see every single transaction that you do? But I really believe that they're too late to the game. The horse has left the barn.

You mentioned USDC, so it's a stablecoin linked to the value of the US dollar. Does the importance of a currency like that, like the USD, does that persist if DeFi takes over?

I guess what I'm saying is it doesn't have to. So my hypothetical wallet had USDC in it, but also had gold, it also had stocks, so it doesn't have to have USDC.

I understand.

Right? So it's just one of the possibilities. Look, the US dollar will stick around for a long time, as other central currencies will, I just believe that the money supply's out of control already. So they have no control over the real supply of money, because money is not just the US dollar, it's a much broader concept now. If I can pay for things with my IBM shares or my gold, then it's just a different world.

Okay. I've got another big picture question. In 1990, if someone could have told you, and then I think there were analysts that were telling people that e-commerce and the internet was going to be the future, and there was going to be a big revolution, and they were right 30 years later. But ex ante, if you're there at the time in 1990, the chances of getting it right in terms of investing in the right companies were pretty low. Talk about skewness. Is it going to be similar with DeFi or with crypto?

Yes, except it happens a lot faster, so you can be successful, and then immediately unsuccessful. We call it forking in DeFi. So the pace is much more rapid. It's important to have a diversified portfolio, so you just can't bet on one name. DeFi actually, you mentioned the internet, and when the worldwide web was created in the late 1980s, it was assumed that there would be digital currency. And actually, the Mosaic and the browsers afterward actually incorporated features to allow for that, but it never happened. There was a huge amount of research in the 1980s about digital currency, and it went nowhere, and went nowhere for a very simple reason, that just like a movie or a book or an image, you can make a perfect copy. So it went nowhere until the Satoshi Nakamoto paper in 2008.

And basically, the way I view DeFi is that it completes the internet, so we can have an internet of value. So what I mean by that, if you're paying for something on the internet, you have to load in your credit card, and it's really unlikely you can pay for something really small, like 5 cents, with your credit card. It's really clunky, even worse to put your bank account in, and it's difficult to be paid also. So this is going to allow value, so it'd be very easy to sell stuff or to buy stuff on the internet. The internet changes so that it's really easy, so if you're a blogger or you have a podcast, you can actually have a small fee for it, and maybe the one that's live is more expensive than the one that was done a few weeks ago, so you can monetize your content. This fundamentally disrupts companies like Google and Facebook. Google and Facebook, basically, they take your information and sell it.

I tell my students that Google probably makes $10,000 a year of each of them. Google claim, "Well, we only make $100 a year per user," but my students are exactly the market that advertisers want to pay for. So think of a different world where you're actually paid directly. So somebody wants to get it to you, then you're paid in a seamless way. Somebody wants to send an email to get to the top of your inbox, there's a price for that, and you harvest that directly. So indeed, and this is a speculation on my part, I think part of the reason that Facebook is so interested in developing its own crypto is to solve this problem where they can actually pay their users directly for the content that they produce in a very simple way. Amazon, it's simply to save the money from the credit card swipe, but Facebook understands that this model is not sustainable, and the same thing for Google.

If Facebook's users are able to monetize their own content, and Facebook's being disintermediated in that they're no longer the central hub, where does that leave Facebook?

Well, it's kind of obvious. And again, this trend of decentralization is a broader thing than just finance. So there are many ideas in terms of decentralized internet, decentralized social media. This is just the tip of the iceberg. Decentralized finance is just the low hanging fruit.

Okay. I've got one more question. We just talked about a lot of the benefits and potential for decentralized finance and cryptocurrencies. What are the risks? How could this go wrong?

It's a huge amount of risk. The last chapter of my book goes through various different risk factors, and my view on whether they'll be mitigated. For example, these algorithms that I've described are called smart contracts. I've also mentioned totally open source, so anybody can see it. So think of a hacker trying to get into Target. That's hard to do, so you need to break through, and then you need to figure out millions of lines of code to get what you want. Well, this is just wide open, and it's like a new attack vector, so that's a risk, that these algorithms could be flawed. It could be a logic error, there could be economic exploit. That's a type of risk. A major risk is scaling. Right now, for example, Ethereum maybe can do 15 to 20 transactions per second, where Visa can do 75,000.

And there's a lot of stuff going in the space to bring the transaction per second to something equivalent to visa, and then it must go higher. So in my world, you potentially can do billions of transactions per second in the future, so that will likely be mitigated. Talk about environmental risk. So Bitcoin uses as much energy as the country of Argentina, and much of it from coal, so you can argue that's environmentally reckless. Ethereum, which is the backbone of DeFi, they're switching next year to a different algorithm. They use the same one as Bitcoin right now that's very energy intensive, but they're switching, so I'm not too worried about the environmental risk. Here's the issues in terms of custody, that the user experience is not as friendly as it should be. Many institutional investors have avoided the space because they don't know what to do with their private keys, but now we've got custodians like Fidelity or Coinbase Pro, so that'll be mitigated.

And of course, there's the regulatory issue, and the regulators, I think they realize that the story that I told they embrace, that if we reduce financial frictions, that's a good thing, and that's good for economic growth. And they also realize if they're too harsh on the regulation, then the innovation either doesn't occur or goes offshore, so it's a balancing act because you also want to protect the users from being exploited, so the regulators need to do this really difficult balancing. And what is important is that this technology, given that it's deployed to a blockchain, which means that the same algorithm is running on tens of thousands of computers all over the world, that even if you block out the US, the algorithm still runs. And so regulatory risk definitely exists, but it is a new world.

It is how do you use an algorithm? That's all it is. It's just there, and it could be there forever. And there's no CEO, there's no board of directors, no head office, it's just an algorithm that people are using. And maybe you can block it in one country, but then people get their VPN going, it's really difficult to control. So again, we need to be careful. I think that some level of regulation is a good thing, in terms of the exploitation of uninformed users, but too much regulation will kill this innovation. It's the last thing that we want, because it is a path to economic growth, and I think that that needs to be paramount.

You think about our situation in the US, that we've racked up so much debt, and that debt has to be paid off, and there's three ways to pay it off. Number one is to raise taxes and that's toxic for growth, so you're shooting yourself in the foot doing that. Number two is to inflate, so just print the money to pay off all the debt. Pretty simple, but a disaster in terms of inflation, and inflation's just like a tax, and it's bad for economic growth. The third way is just to grow. The more you grow, the more tax revenue comes in, and you paid on the debt. And right, now we're not growing because of these financial frictions and other factors, but if we can reduce the frictions, we have a path.

Well, this has been a truly amazing conversation. I mentioned earlier, I finished your book this weekend. It blew me out of the water and I have to go back and learn a lot, but this has been a great time together. Thank you.