Could Crypto and DeFi Prepare Us for Another Financial Crisis?

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The White House reportedly intends to instruct several government agencies to take cryptocurrencies seriously.

In terms of oversight, regulation, and their potential risks, cryptocurrencies are part of the world of decentralized finance, or DeFi.

A new article suggests that several services and products within the DeFi ecosystem pose similar risks to unregulated “shadow banking” services such as subprime mortgages and credit default swaps, which have paved the way for the 2008 financial crisis.

Hilary J. Allen, a law professor at American University’s Washington College of Law, is the author of this article. Marketplace’s Kimberly Adams asked her why she thought DeFi was shadow banking 2.0.

Hillary J. Allen: The general idea is that this DeFi ecosystem tries to provide functional equivalents of financial services outside the regulated financial system, using technological building blocks – like blockchain, like tokens, like stablecoins, like smart contracts.

Kimberly Adams: In your article, you suggest that DeFi technology is essentially shadow banking 2.0. Can you explain how they are comparable?

Allen: Sure. The general idea is that there is increased complexity when trying to find a way to provide the same financial services, but in a way that circumvents the regulatory regime that has been established for more traditional versions of these services. And complexity creates opacity; it is difficult to see where the risk lies, it is difficult to understand how the parties relate to each other and how they are likely to interact in the crisis.

So I think the opacity we see from DeFi has an analogue in the opacity we saw in 2008 with products like credit default swaps, securities backed by mortgages, this kind of things. I think there are some specific characteristics of shadow banking 1.0, the shadow banking of 2008, that are replicated with the functional equivalents that we get in the DeFi wave of shadow banking. So I’m talking about stiffness here. In 2008, we had financial products that were created in a way that was very difficult to amend, to change as circumstances changed, and that made the whole financial system more fragile. What we’re seeing with DeFi is that we’re using new types of computer programs to automate certain financial transactions. This is what smart contracts are called. They automate these transactions. And that increases, I think, the fragility of the ecosystem.

Hilary J. Allen (Courtesy of Allen)

Adam: One of those parallels that you’re pointing out between shadow banking 1.0 and all these unregulated financial instruments of the banking industry and shadow banking 2.0 DeFi is inherently that you’re discussing risk to the wider financial system.

Allen: Yeah. So I think a lot of the focus in crypto and DeFi has been on consumer protection or investor protection. He’s concerned about scams and hacks, and how do people get their money out, etc., and all of those concerns are very valid. But we don’t just worry about people investing. And if you want to draw a 2008 analogy, we can talk about subprime mortgages, right? The people who took out these subprime mortgages were certainly harmed, but the problems they encountered had a cascading effect on the rest of the economy because these subprime mortgages were bundled into these back-to-back securities to rigid mortgages. Credit default swaps have been used to create new forms of leverage, new ways to borrow against these mortgage-backed securities, and all of this has magnified the impact of the problems with these predatory products. And that’s what worries me about DeFi in shadow banking 2.0. If DeFi becomes more and more integrated into our broader financial system, then DeFi’s problems could be transmitted to mainstream banks. And if these banks have problems, they will not be able to grant credit. And if they can’t extend credit, then the economy starts to seize up.

Adam: What is the modern DeFi equivalent of, say, a subprime mortgage?

Allen: Loans are offered in the DeFi ecosystem. It’s just direct investments in tokens and things like that that are potentially predatory. They are very opaque. So when we think about subprime mortgages, people had to understand a very confusing kind of financial documentation. Now they have to understand the computer code, which I think is really beyond the knowledge of many investors. So, there are many ways to take advantage of people who use this kind of crypto-based financial products. And if it suddenly appears that they are being exploited, it can damage trust in the products, which could lead to a sell-off, which could cause all sorts of cascading effects of problems in the DeFi ecosystem.

Adam: You argue that the way regulators handled Shadow Banking 1.0 before the financial crisis provides lessons for the moment we currently find ourselves in. What are these lessons?

Allen: I think the main lesson is that “wait and see” is bad policy. Another lesson, I think, is that innovation shouldn’t always be allowed to go unchecked. This was most exemplified by the Commodity Futures Modernization Act which was passed in 2000 which prevented the regulation of credit default swaps and other swaps because they wanted to let innovation develop unhindered. And we saw how it happened. So what I think regulators should do now is remember those times in the early 2000s and late 90s and think, ‘Hmm, maybe we should think more proactively how these things could cause problems for our broader financial system and take action now because at some point it will be too late.

Adam: At the same time, there’s a lot of people here arguing that these tools and that DeFi and all these different technologies can actually increase access for people who have traditionally been unbanked or people who are already excluded from the financial system. Is there room for innovation to potentially open up opportunities for new markets?

Allen: I think a lot of these arguments are really just kind of empty potential. The reason people don’t have access to financial services — the reasons are structural, they’re political, and they require structural and political solutions to address them. Technology in the hands of the same people who run the current system, you know, is just going to lead to the same kinds of results. And remember, we’ve heard this rhetoric before when it comes to subprime mortgages, that this is going to fix access to housing for underserved populations. So I think we need to be very skeptical of this rhetoric, especially when there’s very little to back it up, and really think about the hard work we need to do to fix structural inequalities. It would be nice – I can see the appeal – it would be nice if there was just this simple technological solution. But one point I make in the paper is that DeFi is not decentralized. There are a lot of intermediaries involved, and if those intermediaries have the same incentives that intermediaries have always had, and we don’t have a political or structural change to curb them, then I don’t see this ending well for financial inclusion.

Adam: So what do you think regulators need to do now?

Allen: Overall, I think we need a more cautious approach to crypto in general, because the risks are very clear right now – the potential is just that potential. And it’s been potential for a long time. Cryptographic technology has been around for over a decade, and that’s a long time in tech years. And yet, we’re looking for the killer app, aren’t we? We’re still looking for the key use of it. And so, given that context, I think regulators, frankly, need to pause, to the extent that they have the power to do so, on this kind of DeFi innovation. Now, “as far as they have the power to do it”, that’s carrying a lot of water over there. In terms of practical steps, I think the most important thing that needs to happen is that banking regulators need to prevent crypto from integrating into our broader established financial system. So banks shouldn’t be allowed to invest in crypto, they shouldn’t be allowed to act as a broker for crypto for their clients, they shouldn’t be allowed to issue stablecoins, they should be fully kept out of this space. And then crypto, as it currently exists, should continue to be regulated as it has been by the [Securities and Exchange Commission] and the [Commodity Futures Trading Commission] like, frankly, a speculative investment, because that’s what it is.

Adam: I mean, hasn’t this ship already left port in terms of integration into the mainstream banking system?

Allen: He begins to leave the port. I think we’ve come to the point where time is running out. It’s not that integrated yet, I think, but you’re right that time is running out because the bigger banks are definitely eyeing it. You know, smaller banks are trying to offer stablecoins. If we get past that point and it becomes really integrated into our established financial system, then I think systemic issues are bound to happen.

Related Links: More from Kimberly Adams

Check out Allen’s article, “DeFi: shadow banking 2.0? » It contains a good summary of the weird financial instruments that set the stage for the 2008 financial crisis, in case you need a refresher, and explains in more detail how DeFi works today.

A risk she also cites in her article is that of DeFi lending – essentially lending your crypto to someone else while making more money on interest. The difference is that there are no banks involved.

The website Decrypt has a good explainer on this and said such lending is one of the fastest growing sectors in blockchain and cryptocurrency.

Some mainstream banks are also dipping their toes into the DeFi sector. Especially, JPMorgan launched the JPM Coin in 2020 – its own digital token, backed by the blockchain and tied to the US dollar. According to Allen, this is exactly what we should be worried about.

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