No, DeFi is not a repeat of the 2008 crisis

VSHarlie Warzel’s usually quite readable Galaxy Brain newsletter this week bore a provocative title: “Is Crypto Re-Creating the 2008 Financial Crisis?”

Unsurprisingly, it turned out to be a rhetorical question. The Atlantic Author’s Bulletin published an interview with American University law professor Hilary J. Allen, in which she discussed her recent article claiming that decentralized finance is repeating the mistakes of “banking.” parallel” that preceded the financial turmoil of the late 2000s.

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Allen’s thesis is that the high degree of complexity around innovative new DeFi models for borrowing, lending, insuring, and payments will leave the same lack of clarity around impending risks as credit default swaps. (CDS) and debt-backed bonds (CDOs) favored during the pre-crisis housing bubble. “Complexity-induced opacity increases the chances that these risks will be underestimated in good times (causing bubbles) and overstated in bad times (aggravating panics),” she writes.

Allen is urging the US government to step in to regulate the sector before it becomes more integrated into the mainstream financial system. She argues that decentralized applications (dapps) should be licensed and their founders and developers subject to enforcement action if they fail to comply.

This will not sit well with many in the crypto community, where the idea that open-source coders can be accused of wrongdoing is seen as frightening to innovation.

First, let me acknowledge that there is some truth to Allen’s observations on DeFi and that some of the parallels she draws with the financial crisis are legitimate and important.

It is true that the average person cannot hope to understand DeFi. Much like how financial engineers on Wall Street exploited the black box of CDS and CDOs to the eventual detriment of bank customers, this complexity also gives the founders of the DeFi project asymmetric advantages. That’s why “stuff pulling” and other abuses by overconfident investors are common.

Other valid observations from Allen: There’s an awful lot of 2008-style bubble-like behavior in DeFi now, and there’s a lot more centralization with trusted intermediaries than “decentralization” enthusiasts acknowledge.

But there is a fundamental flaw in Allen’s perspective that could lead to a major policy error.

The elephant in the room

The overwhelming difference between DeFI innovators in the 2020s and those on Wall Street in the 2000s is that the latter – the bankers – operated within an overarching political framework that the former – the crypto developers – are unaffected by. With their power to create money through fractional reserve lending, banks function as agents of government monetary policy, a specially sanctioned position that comes with privileged access to Federal Reserve liquidity. . There is an interdependence between governments and banks that has sometimes turned into co-dependency.

Exhibit A: The “too big to fail” problem in the run-up to the financial crisis. It was the idea that a potential collapse of a large, systemically interconnected bank would pose such a catastrophic threat to the economy that the government would still have no choice but to bail out these institutions if they got into trouble – precisely what happened in 2008.

It was a moral hazard problem that, in the 2000s, fueled massive market distortion. Before the crisis, banks faced asymmetric risks. They could enjoy success when the mortgage market was hot, but would suffer no consequences if and when it turned south. The result was a twisted and distorted version of capitalism in which profits were privatized and losses socialized.

In Allen’s reference to this, she primarily uses it to dismiss crypto enthusiasts as naïve, suggesting that their interest in DeFi is driven by a disdain for bailouts. In reality, the actions of the federal government to consolidate the financial system in 2008 were necessary. I think that completely misses the point. One can believe, as I do, that the 2008 bailouts were the lesser of two evils, but at the same time criticize the “too big to fail” dependency system that left the government no choice but to execute them.

And that’s what’s encouraging about crypto. We have the prospect of freeing our financial system from the dependence of too powerful intermediaries who have too long commandeered an excessive proportion of the economy’s resources and political capital.

To achieve this, we do not necessarily need to achieve a utopian standard of total decentralization. (I find Allen’s “gotcha” critiques of crypto not being as decentralized as the narrative suggests rather boring. Every smart person in this space knows that.) Instead, we need a system that is sufficiently open to competition and innovation for a much wider set of participants than exists in the current system. This means that some elements must be decentralized and “permissionless”, while other parts will require the involvement of trusted parties to achieve proper efficiency. What matters is the balance such that each institution is subject to some form of market pressure.

Easy innovation versus hard innovation

And this is what invalidates the comparison innovation by complexity in the two domains. Since banks have an authorized monopoly on money creation, a role so vital that it earns them an implicit protection of taxpayers against losses, the “innovation” they undertake is shaped by incentives and disincentives and very different counterbalances from those of DeFi developers. Banks had the luxury of developing CDS, CDO, and squared CDO products to increase leverage and maximize short-term profits without having to calibrate those bets for the risk of the market turning against them.

In contrast, DeFi developers face a much more fluid and unforgiving market. This is not only because they lack the implicit taxpayer guarantee that banks have, but also because of a central design element of DeFi: the open source “lego” composability of the code and the weak barriers to entry. This design means that anyone with sufficient coding knowledge can launch a new automated market maker, governance token, or stablecoin algorithm without having to seek permission from a government or any other intermediary institution. . And that means they can challenge the incumbents.

Consider the history of DeFi over the past two years. First MakerDAO was the market darling, then Compound, then Aave, then Sushi Swap, then hybrid gaming/DeFi services like Axie Infinity, all founded within months of their sudden surge to success. Contrast that with the winners that emerged from the rubble of the mortgage crisis: JPMorgan Chase and Bank of America. Their roots go back to 1799 and 1904 respectively.

This DeFi momentum, if it can be sustained, will prevent the rigidities that Allen believes will engender the same kind of systemic risk that consumed the banking system in the 2000s. Indeed, the market is constantly correcting the various tokens of winners and losers. It all depends on the price signals.

Also, while it’s true that DeFi isn’t perfectly decentralized and it’s too complicated for the average person, end users of DeFi products have a much greater influence on what gets built than bank customers. . Not only do many of them hold governance tokens, but with their fickle behavior they produce market signals that keep DeFi developers on their toes, which bankers need not worry about so much.

It is certain that investors who take risks will continue to lose money through sweepstakes and code violations, while others will make their fortunes. But this hustle and bustle is quite different from the systemic problems that beset the financial system in the 2000s, when everyone and every risky asset was gaining for an extended period of years before everyone and everything started losing. massively in unison. More importantly, the constant threat of failure means that developers have an incentive to offer more reliable offerings, which is why, despite the horror stories, the system has become more and more robust over time.

What could threaten this market-driven equilibrium? A poorly thought out regulatory model. That’s what.

Want to create systemic risk in DeFi? Then give banks, with their moral hazard-based lending model, an edge over open source developers. Get them to ask permission to get the licenses that the banks are already privileged to have. Make real market-driven innovation very expensive to achieve and make short-term operating innovation virtually risk-free by backing it with government insurance and taxpayer guarantees.

That’s not to say that centralized service providers in this space shouldn’t be held accountable for laws that preserve financial stability and protect consumers. But as a range of competing proposals to regulate stablecoins, DeFi, and the entire crypto industry battle it out in Washington, it means we must heed the lessons of the 2008 crisis — the good lessons, not the bad ones. bad.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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