Finance has one core functionn: asset supply, asset lending and liquidation, all tied together. In this article we test this definition of finance, show that nothing else is actually finance and look forward to how traditional finance and decentralized finance, DeFi, (e.g. on blockchain) implement this core function.
This is a first principles look at finance.
The core lending primative
Finance provides a basic function in an economy, which is the supply/lending of assets, backed by the threat of liquidation. This is a trifecta. If any of these is missing, you are not talking about finance, you are talking about something else.
Let’s see it!
- Supply: a supplier provides an asset, expecting that asset back and some additional benefit
- Lending: a borrower receives the asset, expecting to return it and provide some additional benefit
- Liquidation: in the exceptional case that the borrower does return the asset, the supplier shall have some other alternate benefit
sequenceDiagram
participant Supplier
participant Borrower
Supplier->>Borrower: Provides asset
alt Return
Borrower->>Supplier: Returns asset + benefit
else Default
Supplier->>Supplier: Benefits from liquidation
end
This diagram shows the prototype of everything in finance. Depending on how the liquidation works, or what third parties are involved, you may see different names and details. The names and details matter, because they often define what laws and regulations apply. In finance, something can be legal or illegal based on what you name it! So pay attention.
Let review some examples of applying this core function. And while we’re doing this, keep in mind that DeFi (e.g. on blockchain) only sees tokens and rules-based systems—it doesn’t care what the names of things are. If two things are the same, but use different names, DeFi can just substitute one for the other.
Example: bank deposit account
A bank deposit account is a classic example of these three primatives. The supplier is the depositor who deposits money to the bank. The borrower is the bank which receives the money and promises to return it on demand, plus some interest as benefit. The liquidation is typically well-defined, through legal systems and bank deposit insurance. This finance function is offered by a bank, and they are the second party to the agreement. The bank pays the legal system or bank deposit insurance some taxes and/or premium in this scheme.
Sequence diagram
sequenceDiagram
participant Depositor
participant Bank
participant Legal system or bank deposit insurance
Depositor->>Bank: Deposits money
Bank->>Legal system or bank deposit insurance: Pays taxes and insurance premium
alt Bank repays
Bank->>Depositor: Returns money + interest
else Bank fails
Legal system or bank deposit insurance->>Depositor: Pays insured amount
end
Non-example: purchasing equity shares
Purchasing equity shares in a company does not constitute finance under this core definition, as it misses the lending and liquidation pillars of the trifecta. An investor exchanges money for ownership—a “thing” granting potential benefits like dividends or voting rights—without any structured repayment or alternate benefit on default. These benefits, whether monetary or otherwise, are not fundamentally different from those derived from buying a portion of a church, a country club membership, or even an orange tree that yields fruit; all involve risk, time value, and possible resale, yet none inherently qualify as finance. Labeling such transactions as “finance” often serves to inflate sophistication, but they are merely asset acquisitions or brokering.
Sequence diagram
sequenceDiagram
participant Buyer
participant Seller/company
Buyer->>Seller/company: Pays money
Seller/company->>Buyer: Transfers shares
note over Buyer: Potential benefits (e.g., dividends, resale), no repayment or liquidation mechanism
Example: selling a call option
Selling a call option embodies the core finance function, fulfilling the trifecta of supply, lending, and liquidation. The supplier—option seller—provides the right to buy an underlying asset at a set strike price, expecting to keep the premium as benefit if unexercised. The borrower—option buyer—receives this right, paying the premium upfront with the intent to exercise if profitable. Liquidation triggers upon exercise: the seller delivers the asset and gains the strike price as alternate benefit, distinct from mere asset exchange. This structure mirrors the unique baseline of finance, where benefits arise from timed obligations and risks, not speculative ownership.
Sequence diagram (simplified)
sequenceDiagram
participant Seller
participant Buyer
Seller->>Buyer: Provides the exclusive right to acquire underlying asset
Buyer->>Seller: Pays premium
alt Expires worthless
Buyer->>Seller: Exclusive right retires
else Exercised
Buyer->>Seller: Pays strike price
Seller->>Buyer: Provides assets
end
There are a couple important notes about equity options. In order to properly write a call you must own the underlying asset. And you must deliver it to a brokerage. And during the time that your call is active, you are unable to remove your underlying from the brokerage. If the equity produces dividends, you receive them. In other words, you do not own the asset at that time. Tax rules and accounting rules in many (all?) jurisdictions ignore this ownership concept, but the below diagram does not.
Sequence diagram (actual)
sequenceDiagram
participant Seller
participant Broker
participant Buyer
Seller->>Broker: Supplies underlying asset/margin
Broker->>Buyer: Assigns exclusive right to acquire asset
Buyer->>Broker: Pays premium
Broker->>Seller: Pays premium
alt Expires worthless
Buyer->>Broker: Exclusive right retires
Broker->>Seller: Returns asset/margin
else Exercised
Buyer->>Broker: Pays strike price
Broker->>Seller: Pays strike price
Broker->>Buyer: Transfers asset
end
This “actual” diagram shows both sides with the broker in the middle. Each leg of the transaction is a separate finance function. And the broker, as the holder of the underlying asset (also known as an owner for some definitions of ownership), participates in both legs.
Non-example: home insurance policy
Ben Franklin founded a fire insurance company, the Philadelphia Contributionship for the Insurance of Houses from Loss by Fire in 1752.
At this time of its founding, this was not contemporaneously considered a finance function. And according to our core definition of finance, it still is not.
Sequence diagram
sequenceDiagram
participant Policyholder
participant Insurer
Policyholder->>Insurer: Pays premium
Insurer->>Policyholder: Provides coverage promise
alt No claim/event
note over Insurer: Retains premium, no payout
else Valid claim reported
Insurer->>Policyholder: Pays reimbursement
end
note over Policyholder: No repayment or liquidation mechanism
Now, an important note, and specifically about this 1752 insurance company (still operating today). They do offer a perpetual policy, you pay a premium as a deposit and they do provide coverage as long as your deposit is with them. You can demand your deposit back and you lose coverage. Such a perpetual policy defeats this classification here and indeed is a finance function.
Example: repurchase agreement (repo)
This is a staple short-term funding tool, often used by banks or institutions. It fits the trifecta perfectly: a supplier provides securities (asset), a borrower receives cash (using the asset as collateral), with repurchase as repayment plus interest, and liquidation via keeping/selling collateral on default.
Sequence diagram
sequenceDiagram
participant Seller
participant Lender
Seller->>Lender: Transfers securities (asset)
Lender->>Seller: Pays cash (loan amount)
alt Repurchase (repays)
Seller->>Lender: Pays cash + repo rate (benefit)
Lender->>Seller: Returns securities
else Default
Lender->>Lender: Keeps/sells securities (liquidation benefit)
end
The reading circle question here is which entity is the supplier and which is the borrower?
The economic reality of a repurchase arrangement is equivalent to a pawn brokering arrangement. Tax and regulatory treatment for these two scenarios very wildly. And typically matters such as classifications of the underlying asset have an impact on which rules apply.
Onward with DeFi
Decentralized finance, DeFi, typically implemented on blockchain, can implement the analog of core finance functions using tokens and smart contracts.
Let’s see how the minimum core function of finance applies in DeFi.
Since we are considering “decentralized” applications, we will assume that parties do not have legal recourse to each other. Using the same basic implementation breaks down quickly:
sequenceDiagram
participant Supplier
participant Borrower
Supplier->>Borrower: Provides asset
alt Return
Note over Borrower: Disappears
else Default
Note over Borrower: Disappears
end
For our next article in the series, we will build up the miminum implementation of finance using DeFi tooling and study its utility along with other blockchain token application patterns to see if they meet our core definition of finance.
Further reading
Our loan-only definition of finance resonates more hundreds of years ago. But for modern works, see: Joseph Schumpeter (1910s) and John Gurley & Edward Shaw (1950s) various works on role of finance in the economy and their definitions.
This first principles are important to understand as we build DeFi and new financial systems.
Footnotes
- We define the owner of an asset as the exclusive entity that may decide to burn/destroy a thing without recourse to anybody else.
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Comments
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