We are seeing growing interest from established financial institutions dipping their toes in this water. So that took me from a place where it was a hypothetical concern for DeFi being a very real, clear, and present danger to US financial stability in the wider world.
Why is there such danger?
DeFi is designed to replicate existing financial services, but to do so ostensibly commercialized in a decentralized way. And – spoiler alert – it’s not decentralized at all. It is a space riddled with intermediaries, often unregulated. So we have a recreation of a lot of existing financial products and services in a space that is unregulated, which draws parallels to the types of financial products and services that led to GFC.
For example, one thing we saw before the GFC was that credit default swaps increased the amount of leverage you had in the system, it multiplied the amount of borrowing against a particular asset. With DeFi, we have the potential to create unlimited assets to borrow against, so we are seeing increased leverage in the system.
We also saw new types of mortgage-backed securities that were structured in such a way that the contracts were very rigid and could not be changed easily when things changed. What we’re seeing again is the same kind of rigidity recreated in DeFi with smart contracts. We find this rigidity in the system and what we really need to protect the system against future problems is flexibility.
Finally, there is this primordial thing where complexity is in itself a destabilizing force. When people can’t make sense of the world, they default to following the herd, and that creates bubbles, and that creates panic. Systems are more fragile when there are more interconnections between components that people don’t understand. And that’s really where we’re heading with DeFi.
“The more I learn about the technology, the more I’m very skeptical that anything good can come out of it.”
So for all of these reasons, I think we have a real replication or even an amplification of the issues that we had before the GFC.
What are the risks ? Are we talking about individual punters losing their money, or is there a possibility that severe instability in the crypto market will spill over into traditional markets?
That’s really the essence of what I watch. There is absolutely a concern about investor protection in this space – people are losing money, and it is very painful. These concerns are very real.
But what I focus on with my work is exactly how does this turn from simple individual harm into an issue that could affect people who never even invested in crypto in the first place? This is where I think it is essential as a regulatory policy to prevent regulated financial institutions, such as banks, from participating in the crypto economy, because this is where an idiosyncratic problem individual becomes a systemic problem.
In my mind, it is essential that banks and other regulated financial institutions be separated from the crypto space. Put up a wall so that problems in the crypto space stay with the people who invest.
The Commonwealth Bank is testing the provision of crypto trading through its app, and ANZ recently minted $30 million of Australian stablecoins. Are projects like this too risky for you?
Yes. Brokerage accounts for your clients, while I don’t think that’s a good idea, don’t actually put the bank at risk unless they are implicitly behind those accounts. But when a bank issues its own stablecoin, then we get much closer to those waters. And I think that’s worrying.
Is something like the Terra Collapse a bit of a canary in the coalmine moment for crypto?
Crypto is an asset that has nothing behind it, it has no value other than the hope that someone else will buy it from you. And throughout the lifetime of crypto, there has been plenty of easy money that has helped sustain its value, but as easy money leaves the system, as interest rates rise and countries Look at the barrel of recessions, this does not bode well as there is an unlimited supply of new buyers for these crypto-assets.
Without new buyers, these things can disappear in the blink of an eye. If a company goes bankrupt, it still has assets to sell. If the crypto asset goes down, there is nothing behind it. This is something people need to be very aware of before investing in this space.
Do you see any positives to the rise of DeFi? Is there a silver lining?
Honestly, I have to say no. I’ve been looking at things since 2015, and I’ve been very open-minded throughout this journey because I didn’t want to rule out that there was a killer app or a great use case. But over time, and the more I learned about the technology, the more I became very skeptical that anything good could come of it.
From policymakers, there’s this rhetoric about innovation, saying you can’t stop innovation and innovation is always good. In reality, we need to be more skeptical of innovation. Some innovations are fantastic, but not all innovations are good.
What we really need from our policy makers is the courage to frankly say “wait, let’s think critically about what this actually does”. Will he ever be able to keep his promises on decentralization? I think the answer is no.