Lately, this blog has pivoted from something I know reasonably well (bank capital adequacy) to things that I don’t – cryptoassets, stablecoins, central bank digital currencies and DeFi. My last post looked at a paper by Nic Cater and Linda Jeng titled “DeFi Protocol Risks: the Paradox of DeFI”. This week I want to flag another useful paper (well at least from my newbie perspective) written by Fabian Schär that was published in the St Louis Fed Review (Second quarter 2021).
I have to confess that I am not yet fully convinced that the DeFI applications developed to date do much more than offer novel ways of trading risk in new forms of securities or crypto assets. That does not mean that the technology will not someday add value to the financial system that will be increasingly called onto support an increasingly digital economy and ultimately the Metaverse.
Schär’s exploration of the risks of DeFI (Section 3) covers very similar ground to the Carter and Jeng paper I flagged above. What I did find useful was Section 2 that lays out the building blocks that DeFi is based on.
Schär concludes …
DeFi has unleashed a wave of innovation. On the one hand, developers are using smart contracts and the decentralized settlement layer to create trustless versions of traditional financial instruments. On the other hand, they are creating entirely new financial instruments that could not be realized without the underlying public blockchain. Atomic swaps, autonomous liquidity pools, decentralized stablecoins, and flash loans are just a few of many examples that show the great potential of this ecosystem.
While this technology has great potential, there are certain risks involved. Smart contracts can have security issues that may allow for unintended usage, and scalability issues limit the number of users. Moreover, the term “decentralized” is deceptive in some cases. Many protocols and applications use external data sources and special admin keys to manage the system, conduct smart contract upgrades, or even perform emergency shutdowns. While this does not necessarily constitute a problem, users should be aware that, in many cases, there is much trust involved. However, if these issues can be solved, DeFi may lead to a paradigm shift in the financial industry and potentially contribute toward a more robust, open, and transparent financial infrastructure.
As noted above, I am not sure that all of the innovations generated by DeFi to date are going to make the world (or at least the financial system) a better place. That said, I am a traditional banker so what would I know. I remain open to the idea (indeed optimistic) that the technologies, applications and concepts being developed under the DeFi framework have the potential to deliver some value. The extent of improvement in conventional banking and finance is sometimes under appreciated but there is still plenty of room for improvement.
Shär’s paper is relatively short (roughly 20 pages) and worth a read if you are new to the topic like me and interested in this area of finance. It also has an extensive list of references that are worth reviewing for leads in areas worth exploring in more depth.
Nic Carter and Linda Jeng have produced a useful paper titled “DeFi Protocol Risks: the Paradox of DeFi” that explores the risks that DeFi will need to address and navigate if it is to deliver on the promises that they believe it can. There is of course plenty of scepticism about the potential for blockchain and DeFi to change the future of finance (including from me). What makes this paper interesting is that it is written by two people involved in trying to make the systems work as opposed to simply throwing rocks from the sidelines.
Linda Jeng has a regulatory back ground but is currently the Global Head of Policy at Transparent Financial Systems. Nic is a General Partner at a seed-stage venture capital film that invests in blockchain related businesses. The paper they have written will contribute a chapter to a book being edited by Bill Coen (former Secretary General of the Basel Committee on Banking Supervision) and Diane Maurice to be titled “Regtech, Suptech and Beyond: Innovation and Technology in Financial Services” (RiskBooks).
Linda and Nic conceptually bucket DeFi risks into five categories:
interconnections with the traditional financial system,
operational risks stemming from underlying blockchains,
smart contract-based vulnerabilities,
other governance and regulatory risks, and
… and map out the relationships in this schematic
Conclusion: “No Free Lunch”
The paper concludes around the long standing principle firmly entrenched in the traditional financial world – there is “no free lunch”. Risk can be transformed but it is very hard to eliminate completely. Expressed another way, there is an inherent trade off in any system between efficiency and resilience.
Many of the things that make DeFi low cost and innovative also create operational risk and other challenges. Smart contracts sound cool, but when you frame them as “automated, hard-to-intervene contracts” it is easy to see they can also amplify risks. Scalability is identified as an especially hard problem if you are not willing to compromise on the principles that underpinned the original DeFI vision.
The paper is worth a read but if you are time poor then you can also read a short version via this post on Linda Jeng’s blog. Izabella Kaminska (FT Alphaville) also wrote about the paper here.
As we contemplate new forms of money (both Central Bank Digital Currencies and new forms of private money like stablecoins), JP Koning makes the case that the modern payment systems available in the conventional financial system have improved more than is often appreciated …
The speeding up of modern payments is a great success story. Let me tell you a bit about it.To begin with, central banks and other public clearinghouses have spent the last 15-or-so years blanketing the globe with real-time retail payments systems. Europe has TIPS, UK has Faster Payments, India has IMPS, Sweden has BiR, Singapore FAST. There must be at least thirty or forty of these real-time retail payments system by now.
The speed of these new platforms get passed on to the public by banks and fintechs, which are themselves connected to these core systems.
That is not to say they are perfect but it is helpful to properly understand what has been done already in order to better understand what the new forms truely offer.
Cryptocurrency, or stablecoins to be more precise, can be viewed as the latest variation in a long history of privately produced money
The experience of the United States during the Free Banking Era of the 19th century suggests that ” … privately produced monies are not an effective medium of exchange because they are not always accepted at par and are subject to bank runs”
Stablecoins are not as yet a systemic issue but could be, so policymakers need to adjust the regulatory framework now to be ready as these new forms of private money grow and and potentially evolve into something that can’t be ignored
Policy responses include regulating stablecoin issuers as banks and issuing a central bank digital currency
I am not convinced that a central bank digital currency is the solution. I can see a case for greater regulation of stablecoins but you need to be clear about exactly what type of stablecoin requires a policy response. Gorton and Zhang distinguish three categories …
The first includes cryptocurrencies that are not backed by anything, like Bitcoin. We call these “fiat cryptocurrencies.” Their defining feature is that they have no intrinsic value. Second, there are specialized “utility coins,” like the JPMorgan coin that is limited to internal use with large clients. Finally, there are “stablecoins,” which aspire to be used as a form of private money and so are allegedly backed one-for-one with government fiat currency (e.g., U.S. dollars)
I am yet to see a completely satisfactory taxonomy of stablecoins but at a minimum I would break the third category down further to distinguish the ways in which the peg is maintained. The (relatively few?) stablecoins that actually hold high quality USD assets on a 1:1 basis are different from those which hold material amounts of commercial paper in their reserve asset pool and different again from those which employ algorithmic protocols to maintain the peg.
However, you do not necessarily have to agree with their taxonomy, assessments or policy suggestions to get value from the paper – three things I found useful and interesting:
The “no-questions-asked ” principle for anything that functions or aims to function as money
Some technical insights into the economic and legal properties of stablecoins and stablecoin issuers
Lessons to be learned from history, in particular the Free Banking Era of the 19th century
The “no-questions-asked” principle.
Money is conventionally defined in terms of three properties; a store of value, a unit of account and a medium of exchange. Gorton and Zhang argue that “The property that’s most obvious, yet not explicitly presented, is that money also must satisfy the no-questions-asked (“NQA”) principle, which requires the money be accepted in a transaction without due diligence on its value“. They freely admit that they have borrowed this idea from Bengt Holmstrom though I think he actually uses the term “information insensitive” as opposed to the more colloquial NQA principle.
Previous posts on this blog have looked at both Holmstrom’s paper and other work that Gorton has co-authored on the optimal level of information that different types of bank stakeholders require. If I understood Holmstrom correctly, he seemed to extend his thesis on the value of being able to trade on an “information insensitive” basis to argue that “opacity” in the debt market is something to be embraced rather than eliminated. I struggle with embracing opacity in this way but that in no way diminishes the validity of the distinction he draws between the relative value of information in debt and equity markets and its impact on liquidity.
Gorton and Zhang emphasise the importance of deposit insurance in underwriting confidence in and the liquidity of bank deposits as the primary form of private money. I think that is true in the sense that most bank deposit holders do not understand the mechanics of the preferred claim they have on the assets of the bank they have lent to but it seems to me that over-collateralisation is equally as important in underwriting the economics of bank deposits.
Insights drawn from a technical analysis of stablecoins and stablecoin issuers.
The paper delves in a reasonable amount of detail into the technicalities of whether stablecoins are economically or legally equivalent to demand deposits and the related question of whether stablecoin issuers might be considered to be banks. The distinction between the economic and the legal status is I think especially useful for understanding how banking regulators might engage with the stablecoin challenge.
The over arching point is that stablecoins that look and function like bank demand deposits should face equivalent levels of regulation. That does not necessarily mean exactly the same set of rules but something functionally equivalent.
One practical outcome of this analysis that I had not considered previously is that they deem Tether to be based on an “equity contract” relationship with its users whereas the other stablecoins they analyse are “debt contracts” (see below). The link between Tether and a money market fund and the risk of “breaking the buck” has been widely canvassed but I had not previously seen the issue framed in these legal terms.
This technical analysis is summarised in two tables (Table 2: Stablecoins and their Contracts as of June 30, 2021 and Table 3: Stablecoins, Redemptions, and Fiat Money as of June 30. 2021) that offer a useful reference point for understanding the mechanics and details of some of the major stablecoins issued to date. In addition, the appendix to the paper offers links to the sources used in the tables.
Lessons to be learned from history
It may have been repeated to the point of cliche but the idea that “those who cannot remember the past are condemned to repeat it” (George Santayana generally gets the credit for this but variations are attributed to Edmund Burke and Sir Winston Churchill) resonates strongly with me. The general argument proposed by Gorton and Zhang is that lots of the ideas being tried out in stablecoin design and DeFi are variations on general principles that were similarly employed in the lightly regulated Free Banking Era but found wanting.
Even if you disagree with the conclusions they draw, the general principle of using economic history to explore what can be learned and what mistakes to avoid remains a useful discipline for any practitioner of the dark arts of banking and money creation.
Summing up in the authors’ own words
The paper is long (41 pages excluding the Appendix) but I will wrap up this post with an extract that gives you the essence of their argument in their own words.
Tony – From the Outside
The more things change, the more they stay the same. It is still the case that regulation is being outpaced by innovation—thereby creating an uneven playing field—as it is easier and cheaper for more technologically advanced firms to offer similar products and services.
In this case, it is also true that the problems associated with privately produced money are the same as they were one hundred and fifty years ago. We stress three points from our review of history. First, the use of private bank notes was a failure because they did not satisfy the NQA principle. Second, the U.S. government took control of the monetary system under the National Bank Act and subsequent legislation in order to eliminate the private bank note system in favor of a uniform currency—namely, national bank notes. Third, runs on demand deposits only ended with deposit insurance in 1934.
Currently, it does not appear that stablecoins are used as money. But, as stablecoins evolve further, the stablecoin world will look increasingly like an unregulated version of the Free Banking Era—a world of wildcat banking. During the Free Banking Era, private bank monies circulated at time-varying discounts based on geography and the perceived risk of the issuing bank. Stablecoin prices are independent of geography but not independent of the perceived risk of their backing assets. If they succeed in differentiating themselves from fiat cryptocurrencies and become used as money, then they will likely trade at time-varying discounts as well. Policymakers have a couple of ways to address this development, and they better get going.
William’s perspective is explicitly Tether sceptical. However, he also includes a long Twitter thread from Jim Bianco attempting (in Bianco’s words) “to pushback on the FUD about USDT”. I am not sure Williams adds anything new to the sceptical view but it is useful to see the counter-narrative offered by Bianco covered in the newsletter. That said, my read of Bianco’s contribution is that it is more a defence of the general promise of a decentralised DeFi system, than it is a defence of Tether itself.
The Tether part of the newsletter is a long read at 25 pages (there is always the podcast if you prefer) but it does offer a comprehensive account of the sceptical position on Tether and a flavour of the counter argument.
One of the challenges in banking and finance is figuring our what is “new and useful” versus what is simply a “new way of repeating past mistakes” and stablecoins offer a rich palette for exploring this question. I remain open to the possibility that stablecoins will produce something more than a useful tool for managing trading in cryptoassets. The potential to make low value international payments cheaper and faster seems like one of the obvious places where the existing financial system could be improved on.
However, it seems equally likely that stablecoin innovation will repeat mistakes of the past so these post mortems are always useful. I recommend reading Irony Holder’s account in full (especially for the code error in the smart contract) but this is what I took away:
Part of the problem with IRON seems to be that the developers prioritised “efficiency”. In my experience the pursuit of efficiency has an unfortunate tendency to result in systems that are neither robust nor resilient – two highly desirable qualities in anything that facilitates the transfer of value. That observation (“efficient is rarely if ever resilient”) is of course based on the hard lesson that the conventional financial system learned from way it operated in the lead up to the Global Finance Crisis.
Algorithmic stablecoins like IRON appear to down play, or avoid completely, the need for high quality collateral. Experience in the conventional financial system suggests that collateral (ideally lots of it) is a feature of robust and resilient payment systems.
Yield farming around the IRON-USDC pair was producing extraordinary returns. High returns are a feature of the crypto asset world but maybe high returns on a stablecoin should have been a red flag?
I have over four decades of experience in the conventional financial system but I am a “noob” in this space (crypto-DeFi-digital) so the observations above should be read with that caveat in mind. It also important to remember that the issues above do not necessarily extend to other types of stablecoin. My understanding is that the algorithmic approach has not achieved as much traction as fiat and crypto collateralised approaches.
Hopefully you find the links (and summary) useful but also tell me what I am missing.
In my last post I flagged a great article from Marc Rubinstein using MakerDAO to explain some of the principles of Decentralised Finance (DeFi). One of the points I found especially interesting was the parallels that Rubinstein noted between 21st century DeFi and the free banking systems that evolved during the 18th and 19th centuries
I wound up confessing that while I am a long way from claiming any real DeFi expertise, I did believe that it would be useful to reflect on why free banking is no longer the way the conventional banking system operates.
In that spirit, it appears that the IRON stablecoin has the honour of recording the first bank run in cryptoland.
We never thought it would happen, but it just did. We just experienced the world’s first large-scale crypto bank run.
The core of an algorithmic stablecoin is that you have some other token that is not meant to be stable, but that is meant to support the stablecoin by being arbitrarily issuable. It doesn’t matter if Titanium is worth $65 or $0.65, as long as you can always issue a few million dollars’ worth of it. But you can’t, not always, and that does matter.
Money Stuff by Matt Levine 18 June 2021
Algorithmic is of course just one approach to stablecoin mechanics. I hope to do a deeper dive into stablecoins in a future post.
What is interesting for students of banking is the parallels that Rubinstein notes between MakerDAO and the free banking systems that evolved during the 18th and 19th centuries. Scotland is one of the poster children of this style of banking and we can see a legacy of that system (albeit much more regulated and so not true free banking) in the form of the private bank notes that the three Scottish banks still issue in their own name. He quotes Rune Christensen (founder of MakerDAO) describing the way in which his project accidentally developed a form of fractional reserve banking”
In the very beginning of the project, I remember we didn’t even realise, in the beginning of Maker, that we were essentially just building a protocol that did the same things as fractional reserve banking, did something very similar to how a banking balance sheet works and we were just implementing that as a blockchain protocol. We thought we were doing something completely, totally different from how money usually worked in the traditional sense.”(source)
“Reinventing the Financial System” Marc Rubinstein Net Interest Newsletter, 12 June 2021
This statement should be qualified by the fact that they can only do this (i.e. replicate fractional reserve banking) because the currency of the decentralised bank is a form of money called Dai. Fractional Reserve Banking has proved to be a risky form of financial technology in the conventional banking system which has developed a range of tools to manage that risk (e.g. capital adequacy and liquidity requirements, deposit preference arrangements often coupled with deposit insurance to insulate the “money” part of the bank balance sheet from risk, high levels of supervision and other restrictions on the types of assets a bank can lend against).
MakerDAO has a stabilisation mechanism that employs “smart contracts” that manage the price of Dai by managing its supply and demand. The pros and cons of the various stabilisation mechanisms that underpin stable coins like Dai is a topic for another day.
Rubinstein describes the MakerDAO lending and “money” creation process as follows:
The bank he devised to create his money … works like this:
An investor comes into Maker DAO for a loan. He (yep, usually he) has some collateral he’s happy to keep locked in a vault. Right now, that collateral is usually a crypto asset like Ethereum. For every $100 worth of crypto assets, Maker is typically prepared to lend $66 – the gap adding a buffer of protection against a possible fall in the value of the collateral. Maker accepts the collateral and advances a loan, which it does by issuing its Dai money.
At this stage I am not sure where this is headed. It is not clear, for example, if the purpose of this “bank” is simply to create more Dai via trading in crypto-assets or to build something that translate outside CryptoLand. Rubinstein quotes Rune Christensen himself stating that
I don’t think that it will necessarily replace everything… The traditional financial system will actually largely remain the way it is. It will just replace certain parts of it that right now are really bad and really old… those things will be replaced with DeFi and blockchain, but the actual bank itself probably will remain.”
I am a long way from figuring this out but Marc’s post is I think worth reading for anyone who want to understand where these new (or possibly reinvented) forms of finance are heading. To the extent that DeFi is reinventing things that have been tried before, I suspect it would be useful to reflect on why free banking is no longer the way the conventional banking system operates. That is another topic for another day.
He starts with the observation that, after a decade since its inception, we seem to have arrived at the consensus that Bitcoin is best thought of as something like a digital version of gold (or “digital gold”).
That was not necessarily the original intent and battles have been fought between different factions in the Bitcoin community over differing visions.
The most recent example being the “Blocksize War” that played out between 2015 and 2017 where an initiative to increase transaction capacity by expanding the size of each Bitcoin block was defeated by others in the community who saw this as a threat to the network decentralisation they believed to be fundamental to what Bitcoin is.
Weisenthal notes that other players in the Crypto/DeFi domain have a different vision – Ethereum is currently one of the dominant architects of this alternative vision (but not the only one).
The distinguishing feature of Ethereum in Weisenthal’s thesis is that, in addition to being a cryptocurrency, it is also a “token”
He argues that, whereas Bitcoin requires a fundamental act of faith in the integrity of Bitcoin’s vision of the future of money, token’s have a broader set of uses to which you can assign value.
Once you introduce tokens the focus shifts to what precisely do you intend to do with them – in Weisenthal’s words “… once you’re in the realm of tokens, you don’t need faith, but you still need a point“
He notes that we have already seen some dead ends play out – Initial Coin Offerings were a big thing for a while but not any more partly due to many of the projects not stacking up but also because many of them were just another form of IPO that were still unregistered (hence illegal) securities offerings in the eyes of the law.
We have also seen some developments like Non Fungible Tokens that are interesting from a social perspective but not necessarily going to shake the foundations of the status quo.
A third possibility is that DeFi starts to become a real force that starts to shake up the existing players in the conventional financial system.
This third option is the one that Weisenthal (and I) find most interesting but there is still a long way to go.
This is most definitely a topic where I am likely to be missing something but Weisenthal’s article offers an interesting discussion on the contrasting visions, assumptions and objectives of the two currently dominant tribes (Bitcoin and Ethereum). Most importantly it highlights the fact that the vision of DeFi being pursued by Ethereum (or alternatives such as Solana) is radically different to the vision of the future of money being pursued by Bitcoin.
Marc Rubinstein lays out a detailed account of his initial explorations of decentralised finance. His professional background (like mine) is grounded in the conventional financial system so I found this very useful. Even better it is a short read with some hard numbers (time and cost) on the user experience.
My only quibble is that he calls these decentralised financial entries “banks”. Call me pedantic but none of the institutions discussed are banks and I think the distinction still matters if we want to understand how much of conventional banking will remain as this new chapter in financial innovation plays out.
Link to Marc’s blog here – www.netinterest.co/p/my-adventures-in-cryptoland