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Written by Henrik Cronqvist, The George L. Argyros School of Business and Economics, Chapman University, US and Desiree-Jessica Pely, Institute for Capital Markets and Corporate Finance, Ludwig-Maximilians-Universität München, Germany.
For as long as wealth has existed, humans have pursued a higher standard of living, both personally and socially. From land hoarding in ancient Egypt to capital allocation during the Industrial Revolution (Allen, 2009), and the stock market boom of the Roaring Twenties (White, 1990), the concept of wealth has always been closely tied to centralized forms of ownership. Governments have played a crucial role in reinforcing this ownership, and without state backing, capital would lose much of its value (Hardin, 1968). Traditionally, an individual’s wealth is held by institutions like banks, which facilitate the movement of funds between parties.
However, this paradigm shifted dramatically in January 2009 with the creation of Bitcoin (BTC), the world’s first cryptocurrency, by the pseudonymous Satoshi Nakamoto (Chohan, 2017). Unlike traditional assets, Bitcoin has no physical form and is tracked using a digital ledger known as a blockchain. Although its initial adoption was slow, with the first real-world transaction being the purchase of two pizzas for 10,000 BTC in 2010 (Yermack, 2015), Bitcoin’s value has grown significantly over the years. It reached parity with the US dollar in April 2011 and soared to $1,242 by November 2013. Despite a period of recession, Bitcoin hit new heights in 2017 and peaked at over $60,000 in 2021, making cryptocurrencies some of the most relevant financial instruments on the market.
Cryptocurrencies and the advent of decentralized finance (DeFi) have introduced a fundamental shift from centralized to decentralized financial systems. DeFi eliminates the need for banks and other financial institutions by using blockchain technology and similar online ledgers. This allows anyone with an internet connection to hold funds in online wallets and transfer assets quickly and privately without government or institutional intervention (Schar, 2020). However, is this shift entirely rational?
When considering economic behavior, we often assume that all agents act “rationally,” making choices to maximize their utility after carefully considering all available information. However, decision-makers rarely have perfect information, and human decisions are subject to various biases that make choices easier. The study of these biases and other psychological determinants of choices falls under the domain of behavioral economics. As suggested by Cronqvist and Pely (2019), we distinguish between behavioral states, traits, and actions.
Behavioral Biases in Economic Decision-Making
One significant bias influencing behavior is rooted in our traits, shaped by upbringing, environment, historical events, and life experiences. For example, individuals who grew up during the Great Depression tend to be more risk-averse compared to those who experienced economic prosperity (Malmendier & Nagel, 2011; Schoar & Zuo, 2016).
Moreover, our moods and emotions significantly impact our decisions, representing behavioral states where impulses drive temporary choices. People may indulge in short-sighted purchases following positive news or avoid strategic risks when feeling anxious about the future (Mannor et al., 2016). Past decisions also affect future choices, leading us to seek shortcuts by replicating previous actions.
Social and cultural norms also play a crucial role in decision-making, known as behavioral actions. Herding effects, where positive sentiment or topical relevance surrounding an asset influences others to invest, are particularly prevalent in crypto markets, especially during times of uncertainty (Bouri et al., 2019). These influences have a heightened impact on decisions related to assets in DeFi, where assessing the value of cryptocurrencies lacks the objectivity found in traditional economic decisions.
The abstract nature of crypto markets, combined with the extreme volatility of assets, meme coins, and rug pulls, makes them significantly more vulnerable to behavioral biases than centralized assets. This vulnerability underscores the importance of understanding the future of decentralization in finance.
Overview of the Elgar Companion
The Elgar Companion to Decentralized Finance, Digital Assets, and Blockchain Technologies, edited by Henrik Cronqvist and Desiree-Jessica Pely, delves into the future of decentralization in finance through a series of comprehensive chapters.
The book begins with an overview of the status quo and the impact of DeFi on existing financial systems, illustrated by Khan and Sandner (Chapter 1). This is followed by a deep dive into decentralized lending by Irresberger, John, and Salehm (Chapter 2), and Bullman’s (Chapter 3) prediction of the role that crypto will play in future payments.
A critical discussion on regulation and the role of central banks is also included. Fama, Gobbi, and Lucarelli (Chapter 4) analyze crypto’s interaction with monetary policy, while Clarke and Hrnic (Chapter 5) address concerns over crypto destabilizing currencies in emerging economies. Florysiak (Chapter 6) covers MiCAR (Markets in Crypto Assets Regulation) and the growing number of utility coins, followed by Gersbach and Wattenhofer’s (Chapter 7) blueprint for an eFranc. Charoenwong and Bernardi (Chapter 8) discuss cryptocurrency thefts over the past decade.
The book also explores the functionality and design of digital assets. Brauneis, Mestel, and Rauch (Chapter 9) examine automated market makers built on smart contract blockchains, while Fabi, Kassoul, and Prat (Chapter 10) provide an extensive literature review on market makers. Molina and Roccatagliata (Chapter 11) cover mechanism design and changes to Ethereum gas prices, with Öz and Hoops (Chapter 12) considering the impact of maximum extractable value on tokenized assets. Kaiser (Chapter 13) explores the impact of scale on cross-chain infrastructure, and Mazur and Polyzos (Chapter 14) provide an overview of non-fungible tokens (NFTs).
The concluding section looks at DeFi through the lens of sustainability. Urquhart (Chapter 15) evaluates the environmental, social, and governance (ESG) implications of Bitcoin, while Meyer, Welpe, Sandner, and Ponte (Chapter 16) argue that regenerative finance could provide societal benefits in the future. Carmona and Gomez (Chapter 17) study the impact of DeFi on global financial inclusion.
In summary, The Elgar Companion to Decentralized Finance, Digital Assets, and Blockchain Technologies offers a comprehensive examination of the evolving landscape of decentralized finance, digital assets, and blockchain technologies. It provides valuable insights into the behavioral, regulatory, and technological aspects shaping the future of finance.
The Elgar Companion to Decentralized Finance, Digital Assets, and Blockchain Technologies
Edited by Henrik Cronqvist, The George L. Argyros School of Business and Economics, Chapman University, US and Desiree-Jessica Pely, Institute for Capital Markets and Corporate Finance, Ludwig-Maximilians-Universität München, Germany is available now.
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Read the introduction and other free chapters on Elgaronline.