What Should Crypto Do With Traditional Finance?

By Derek Sorensen, Research Mathematician at Pyrofex

Before it’s reasonable to even consider the possibility of crypto replacing fiat, we need to acknowledge a few elephants in the room. I’ve written already about a couple of topics I consider to be urgent, including transaction speeds and international regulations. The next topic that jumps out at me is this: what do we do with the long-standing, well-established investment banks and financial institutions?

Decimating Economic Foundations Isn’t Wise

On the one hand, these institutions embody the exact values that cryptocurrency subverts (AKA: centralized, top-down control). Cryptocurrency has the power to democratize finance, something that I believe, in the long run, will completely transform the structure of our economy and the distribution of wealth. On the other hand, these institutions have a major hand in shaping industries and gluing the economy together. We felt all too poignantly the 2008 financial catastrophe which resulted from unwise and risky practices within these banking and investment empires.

The world of finance is extremely complex. We have a history, thousands of years old, of banks and financial institutions entrenching themselves into the economic fabric of society. Every day, a massive amount of money pumps through the economy in the form of stocks, bonds, contracts, futures, options—the list goes on. Over the course of centuries, these financial firms have developed their own specialized contracts that make money move faster and stretch further. To say that they play an influential role in the workings of our economy is a gross understatement.

Crypto Can Improve Upon Existing Financial Systems

But their influence doesn’t make them virtuous or desirable. I think most cryptocurrency advocates agree that financial institutions need to change. The financial world has such daunting barriers to entry that the rich stay rich while would-be financial innovators find it impossible to enter the space. Because of this, there isn’t much room for productive innovation.

This is where the genius of smart contracts comes in. If a cryptocurrency has smart contracting capabilities, anyone who likes can write contracts, derivatives, and other financial tools. That means anyone can innovate and contribute to finance. On the Ethereum blockchain, for example, contracts and derivatives already exist. In addition to making room for innovation, smart contracts divorce finance on a cryptocurrency from the structure and regulation that the finance industry has built up over time.

To be clear, I think that it is good to break down these barriers to entry and democratize finance. The existing structure needs to change, but it would be unwise to believe that we can just get rid of it without considering the consequences. Hate it as we might, financial institutions provide our economy with stability. They are heavily regulated and fine-tuned. Putting the financial industry into the hands of the people, while exciting, may destabilize our economy if we aren’t intentional about the way we do it.

First Step to Changing the System: Smart Contracts

I think it’s pretty clear that the more popular cryptocurrency gets, the more the government will notice, and the more regulations we’ll see. I will leave those complications to economists and legal experts. What interests me are the kinds of contracts that will continue to spring up with smart-contract-enabled blockchains—especially those like Ethereum which can, in principle, be used as a currency.

Financial mathematics—the techniques used to model, understand, and reason about financial markets—do a good job of describing the markets as they are currently structured. They model markets with the common financial tools already in place. These financial tools rely on specific kinds of contracts. Since contracts underpin finance, a change in the nature of contracts could change the nature of the markets in a mathematically nontrivial way.

In my estimation, the more that everyday people can conceptualize, innovate, and write financial contracts, the more radically our markets will change and innovate. Along with that change, we will almost certainly need to innovate the tools and mathematical models that we use to understand and reason about markets and the economy. This means that we need strong, active research teams to develop new financial models in tandem with financial innovations on the blockchain.

We should take this fact seriously. The less we understand about our markets, the harder it will be to mitigate things like recessions, market crashes, monopolies, oligarchies, and undesirable financial phenomena that happen because of a lack of regulation. If we democratize finance, it could evolve so fast that we can’t properly manage our economy. We should take care to not innovate so quickly that we fall on our faces. Lest we forget, financial instability is a nasty thing.

Derek Sorensen, Pyrofex Research Mathematician, has an MSc in Mathematics and Computer Science from the University of Oxford and is set to start his PhD this fall at the University of Cambridge, where he will study logic and topology. His work at Pyrofex is in formal verification, which includes research on the theory of consensus and setting up mathematical frameworks to prove theorems about code.