Things worth keeping as we reinvent finance

I did a post yesterday covering Matt Levine’s take on some of the less obvious ways in which the Crypto/DeFi industry is reinventing finance. At the risk of being repetitive, his column today is also worth reading if only to reinforce the point that maybe there are some elements of the existing financial system (such as a predefined loss hierarchy in which the senior stakeholders get paid first) are worth preserving.

Matt offers a summary of the options currently being pursued by some of the Crypto/DeFi players in the absence of a regulatory framework …

In crypto:

1. There are no regulatory capital requirements, and crypto banks often seem quite proud to be running at roughly zero equity. Tether, the biggest crypto bank, boasts of its 0.2% capital ratio; if the value of its assets declines by more than 0.2%, depositor money is at risk. Tether also boasts of its transparency, and while that is a bit silly, it is the case that for many other crypto-bank-type entities it is harder to guess how much equity capital they have.

2. There is no prudential supervision, and crypto banks think nothing of concentrating, like, a third of their customers’ money in a single loan. We talked last week about Voyager Digital Ltd., another crypto bank, which had about a 4.3% capital ratio but loaned out more than twice its total capital to one hedge fund that went bust.

3. Also, because there is no prudential supervision, crypto banks will sometimes concentrate their money in loans to their affiliates. The fact that Ver is both an investor in CoinFlex and a big borrower from CoinFlex is pretty standard in crypto even though it would be very bad in traditional banking. It is bad because, if your big borrower is also your big backer, you might be inclined to give him a special deal like, for instance, promising not to foreclose on his collateral even if he doesn’t meet margin calls.

Matt Levine. Money Stuff, 29 June 2022

Matt concludes …

I keep saying that crypto is having its 2008 financial crisis, but it’s much more interesting than that, isn’t it? In 2008, (1) traditional well-understood principles of credit and collateral and seniority and bankruptcy and banking law were applied to somewhat new and aggressively structured instruments, and (2) regulators invented a few novel approaches to limit the damage. In the crypto crisis, every lender and exchange can kind of make up its own principles from scratch and see what they can sell to people. In a sense crypto is having many different tiny 2008 crises all at once; the crisis is always the same — short-term demand deposits funding risky lending — but everyone gets to invent a new way to address

I am a fan of creative destruction as a force for making our financial system and economy stronger and more fit for purpose. There is clearly plenty of room for improvement but I am with Matt with regard to the importance of retaining the “traditional well-understand principles of credit and collateral and seniority and bankruptcy and banking law”. I would probably add a decent buffer of capital and liquidity and maybe a sound regulatory framework that encapsulates some of the things that traditional finance has learned over the past few centuries of trial and error.

Let me know what I am missing …

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.

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