Tag: Regulation

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

Crypto sceptics unite

Stephen Diehl has done a post linking to a letter that a group of people working in the industry have submitted to US policy makers regarding how to engage with the crypto and DeFi movement. One of the key arguments Stephen makes is that the term “blockchain” has become so ubiquitous as to be largely meaningless.

My bias is that scepticism is virtually always the right starting place but Stephen notes that crypto scepticism is of course a broad church …

Crypto skepticism is not a homogeneous school of thought, and there is no central doctrine or leaders to this movement other than a broad north star of working to minimize fraud and protect the public from undue financial harm. There are crypto skeptics who think there might be some redeeming qualities in some crypto assets, and there are those who want it all to “die in a fire” and everywhere in between. The guiding principle of this letter is to find a middle way that at least most people can agree on and phrase it in a manner such that it can be best understood by our policymakers, who are deeply confused by even minimal jargon and technical obscurantism.

Countering the crypto lobbyists, Stephen Diehl

For what it is worth, I count myself in the camp who remain open to there being something of substance amongst the hype. Like any debate, the potential for crypto and DeFi to contribute something useful to future of finance can only benefit from agreeing on exactly what is meant by terms we use to debate the merits of the new, new thing. Stephen cites “blockchain”, to that I would add “digital money”.

Tony – From the Outside

Moneyness: DeFi needs more secrecy, but not too much secrecy, and the right sort of secrecy

Another good post from JP Koning’s “Moneyness” blog on the need for DeFi to strike a balance partly between its native potential for transparency, the desire of customers to keep some secrets and the need to meet the same kinds of Know Your Customer – Anti Money Laundering laws that the conventional banking system is required to comply with.

Here is a short extract …

To make their tools palatable for Main Street, DeFi tool makers will have to unwind some of the native anonymity (potentially) afforded by blockchains by collecting and verifying identifying information from users. This way the tools can screen out criminals, assuring legitimate businesses that their clean funds aren’t being tainted by dirty money.

The implication is that DeFi tools will have to become privacy managers, just like old-school banks are. Users will have to trust the tools to be discreet with their personal information, only breaking their privacy when certain conditions are required, such as law enforcement requests.

… and a link to source post.

Tony – From the Outside

Never let the facts stand in the way of a good story

Shout out to Tim Harford for this introduction to the study of how, in his words, ignorance can be deliberately produced. The technical term “agnatology” is I suspect unlikely to catch on but the underlying message is one worth understanding. At a minimum it is a handy addition to your Scrabble dictionary.

The article was originally published in March 2017 but I only came across it recently via this podcast interview Harford did with Cardiff Garcia on “The New Bazaar”. The context in 2017 was the successful campaign for the US presidency that Donald Trump ran during 2016 with a bit of Brexit thrown in but this is a challenge that is not going away anytime soon.

Harford notes that it is tempting to think that the answer to the challenge posed by what has come to be known as a post truth society lies in a better process to establish the facts

The instinctive reaction from those of us who still care about the truth — journalists, academics and many ordinary citizens — has been to double down on the facts.

He affirms the need to have some agreement on how we distinguish facts from opinions and assertions but he cautions that this is unlikely to solve the problem. He cites the tobacco industry response to the early evidence that smoking causes cancer to illustrate why facts alone are not enough.

A good place to start is by delving into why facts alone are not enough – a few extracts from the article hopefully capture the main lessons

Doubt is usually not hard to produce, and facts alone aren’t enough to dispel it. We should have learnt this lesson already; now we’re going to have to learn it all over again…

Tempting as it is to fight lies with facts, there are three problems with that strategy…

The first is that a simple untruth can beat off a complicated set of facts simply by being easier to understand and remember. When doubt prevails, people will often end up believing whatever sticks in the mind…

There’s a second reason why facts don’t seem to have the traction that one might hope. Facts can be boring. The world is full of things to pay attention to, from reality TV to your argumentative children, from a friend’s Instagram to a tax bill. Why bother with anything so tedious as facts?…

In the war of ideas, boredom and distraction are powerful weapons.
The endgame of these distractions is that matters of vital importance become too boring to bother reporting…

There’s a final problem with trying to persuade people by giving them facts: the truth can feel threatening, and threatening people tends to backfire. “People respond in the opposite direction,” says Jason Reifler, a political scientist at Exeter University. This “backfire effect” is now the focus of several researchers, including Reifler and his colleague Brendan Nyhan of Dartmouth…

The problem here is that while we like to think of ourselves as rational beings, our rationality didn’t just evolve to solve practical problems, such as building an elephant trap, but to navigate social situations. We need to keep others on our side. Practical reasoning is often less about figuring out what’s true, and more about staying in the right tribe…

We see what we want to see — and we reject the facts that threaten our sense of who we are…

When we reach the conclusion that we want to reach, we’re engaging in “motivated reasoning”…

Even in a debate polluted by motivated reasoning, one might expect that facts will help. Not necessarily: when we hear facts that challenge us, we selectively amplify what suits us, ignore what does not, and reinterpret whatever we can. More facts mean more grist to the motivated reasoning mill. The French dramatist Molière once wrote: “A learned fool is more foolish than an ignorant one.” Modern social science agrees…

When people are seeking the truth, facts help. But when people are selectively reasoning about their political identity, the facts can backfire.

So what are we to do?

Harford cites a study that explores the value of scientific curiosity

What Kahan and his colleagues found, to their surprise, was that while politically motivated reasoning trumps scientific knowledge, “politically motivated reasoning . . . appears to be negated by science curiosity”. Scientifically literate people, remember, were more likely to be polarised in their answers to politically charged scientific questions. But scientifically curious people were not. Curiosity brought people together in a way that mere facts did not. The researchers muse that curious people have an extra reason to seek out the facts: “To experience the pleasure of contemplating surprising insights into how the world works.”

It is of course entirely possible that Tim Harford’s assessment is just calling to my own bias. I will admit that one the things that I always looked for when hiring, or working, with people was curiosity. These people are surprisingly rare but (IMHO) worth their weight in gold. An intellectually curious mind makes up for a lot of other areas where the person might not be perfect in terms of skills or experience. The general point (I think) also ties to the often cited problem that people with lots of knowledge can sometimes be prone to not being so street smart. Nassim Taleb makes this argument in nearly everything he writes.

So Tim Harford might not be offering the entire answer but I think his article is worth reading on two counts

  • Firstly as a cautionary tale against expecting that all debates and disputes can be resolved by simply establishing the “facts”
  • Secondly as a reminder of the power of a curious mind and the value of the never-ending search for “what am I missing?”

Let me know what I am missing

Tony – From the Outside

The problem with regulating stablecoin issuers like banks

One of my recent posts discussed the Report on Stablecoins published in November 2021 by the President’s Working Group on Financial Markets (PWG). While I fully supported the principle that similar types of economic activities should be subject to equivalent forms of regulation in order to avoid regulatory arbitrage, I also wrote that it was not obvious to me that bank regulation is the right answer for payment stablecoin issuance.

This speech by Governor Waller of the Fed neatly expresses one of the key problems with the recommendation that stablecoin issuance be restricted to depositary institutions (aka private banks). To be honest I was actually quite surprised the PWG arrived at this recommendation given the obvious implication that it would benefit the bank incumbents and impede innovation in the ways in which US consumers can access money payment services

“However, I disagree with the notion that stablecoin issuance can or should only be conducted by banks, simply because of the nature of the liability. I understand the attraction of forcing a new product into an old, familiar structure. But that approach and mindset would eliminate a key benefit of a stablecoin arrangement—that it serves as a viable competitor to banking organizations in their role as payment providers. The Federal Reserve and the Congress have long recognized the value in a vibrant, diverse payment system, which benefits from private-sector innovation. That innovation can come from outside the banking sector, and we should not be surprised when it crops up in a commercial context, particularly in Silicon Valley. When it does, we should give those innovations the chance to compete with other systems and providers—including banks—on a clear and level playing field”

“Reflections on stablecoins and Payments Innovations”, Governor Christopher J Waller, 17 November 2021

The future of payment stablecoins is, I believe, a regulated one but I suspect that the specific path of regulation proposed by the PWG Report recommendations will (and should) face a lot of pushback given its implications for competition and innovation in the financial payment rails that support economic activity.

I don’t agree with everything that Governor Waller argues in his speech. I am less convinced than he, for example, that anti trust regulation as it stands offers sufficient protection against big tech companies operating in this space using customer data in ways that are not fully aligned with the customers’ interests. That said, his core argument that preserving the capacity for competition and financial innovation in order to keep the incumbents honest and responsive to customer interests is fundamental to the long term health of the financial system rings very true to me.

For anyone interested in the question of why the United States appears to be lagging other countries in developing its payments infrastructure, I can recommend a paper by Catalini and Lilley (2021) that I linked to in this post. This post by JP Koning discussing what other countries (including Australia) have achieved with fast payment system initiatives also gives a useful sense of what is being done to enhance the existing infrastructure when the system is open to change.

Tony – From the Outside

Self regulation in DeFi

This article in Wired offers a useful summary of how some motivated individuals are attempting to use the transparency of the system to control bad actors.

It is short and worth reading in conjunction with this paper titled “Statement on DeFi Risks, Regulations, and Opportunities Commissioner Caroline A. Crenshaw that sets out a US regulator’s perspective on the question of how DeFi should be regulated. This extract from the paper covers the main thrust of her argument in favours of formal regulation

While DeFi has produced impressive alternative methods of composing, recording, and processing transactions, it has not rewritten all of economics or human nature. Certain truths apply with as much force in DeFi as they do in traditional finance:

– Unless required, there will be projects that do not invest in compliance or adequate internal controls;

– when the potential financial rewards are great enough, some individuals will victimize others, and the likelihood of this occurring tends to increase as the likelihood of getting caught and severity of potential sanctions decrease; and

– absent mandatory disclosure requirements,[10] information asymmetries will likely advantage rich investors and insiders at the expense of the smallest investors and those with the least access to information.

Accordingly, DeFi participants’ current “buyer beware” approach is not an adequate foundation on which to build reimagined financial markets. Without a common set of conduct expectations, and a functional system to enforce those principles, markets tend toward corruption, marked by fraud, self-dealing, cartel-like activity, and information asymmetries. Over time that reduces investor confidence and investor participation.

Conversely, well-regulated markets tend to flourish

“Statement of DeFi Risks, Regulations and Opportunities” by Commissioner Caroline A Crenshaw, The International Journal of Blockchain Law, Vol. 1, Nov. 2021.

Tony – From the Outside