Matt Levine on stuff that gets lost in translation

I have been referencing Matt Levine a lot lately. No apologies, his Money Stuff column is a regular source of insight and entertainment for banking and finance tragics such as myself and I recommend it. His latest column (behind a paywall but you can access a limited number of articles for free I think) includes a discussion of the way in which the DeFi industry has created analogues of conventional banking concepts like “deposits” but with twists that are not always obvious or indeed intuitive to the user/customer.

We have talked a lot recently about how crypto has recreated the pre-2008 financial system, and is now having its own 2008 financial crisis. But this is an important difference. Traditional finance is in large part in the business of creating safe assets: You take stuff with some risk (mortgages, bank loans, whatever), you package them in a diversified and tranched way, you issue senior claims against them, and people treat those claims as so safe that they don’t have to worry about them. Money in a bank account simply is money; you don’t have to analyze your bank’s financial statements before opening a checking account.

Matt Levine “Money Stuff” column 28 June 2022 – Crypto depositors

How banks can create safe assets is a topic that I have looked at a number of times but this post is my most complete attempt to describe the process that Matt outlines above. To me at least, this is a pretty fundamental part of understanding how finance works and Matt also did a good post on the topic that I discussed here.

One of the key points is that the tranching of liabilities also creates a division of labour (and indeed of expertise and inclination) …

There is a sort of division of labor here: Ordinary people can put their money into safe places without thinking too hard about it; smart careful investors can buy equity claims on banks or other financial institutions to try to make a profit. But the careless ordinary people have priority over the smart careful people. The smart careful heavily involved people don’t get paid unless the careless ordinary people get paid first. This is a matter of law and banking regulation and the structuring of traditional finance. There are, of course, various possible problems; in 2008 it turned out that some of this information-insensitive debt was built on bad foundations and wasn’t safe. But the basic mechanics of seniority mostly work pretty well.

The DeFi industry argues that they want to change the ways that traditional finance operates for the benefit of users but it also expects those users to be motivated and engaged in understanding the details of the new way of doing things. A problem is that some users (maybe “many users”?) might be assuming that some of the rules that protect depositors (and indeed creditors more generally) in the conventional financial system would naturally be replicated in the alternative financial system being created.

Back to Matt …

The reason people put their money in actual banks is that we live in a society and there are rules that protect bank deposits, and also everyone is so used to this society and those rules that they don’t think about them. Most bank depositors do not know much about bank capital and liquidity requirements, because they don’t have to; that is the point of those requirements.

The problem according to Matt is ….

Broadly speaking crypto banking (and quasi-banking) is like banking in the state of nature, with no clear rules about seniority and depositor protection. But it attracts money because people are used to regular banking. When they see a thing that looks like a bank deposit, but for crypto, they think it will work like a bank deposit. It doesn’t always.

This feels like a problem to me. As the industry becomes more regulated I would expect to see the issues of seniority and deposit protection/preference more clearly spelled out. For the time being it does seem to be very much caveat emptor and don’t assume anything.

Tony – From the Outside

Author: From the Outside

After working in the Australian banking system for close to four decades, I am taking some time out to write and reflect on what I have learned. My primary area of expertise is bank capital management but this blog aims to offer a bank insider's outside perspective on banking, capital, economics, finance and risk.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: