❗Help close the gap: We still need to raise $40,000 by the end of March. Donate now
Could crypto and DeFi set us up for another financial crisis?
Mar 9, 2022

Could crypto and DeFi set us up for another financial crisis?

HTML EMBED:
COPY
According to law professor Hilary J. Allen, leaving decentralized finance tech unregulated could have ripple effects on the entire economy.

The White House is reportedly planning to task multiple government agencies to get serious about cryptocurrencies.

In terms of oversight, regulation and their potential risks, cryptocurrencies are part of the world of decentralized finance, or DeFi.

A new paper suggests several services and products within the DeFi ecosystem pose similar risks to unregulated “shadow banking” services like subprime mortgages and credit default swaps, which set the stage for the 2008 financial crisis.

Hilary J. Allen, a law professor at American University’s Washington College of Law, is the author of that paper. Marketplace’s Kimberly Adams asked her why she thinks DeFi is shadow banking 2.0.

Hilary J. Allen: The idea generally is that this DeFi ecosystem is trying to provide functional equivalents of financial services outside of the regulated financial system, using technological building blocks — like the blockchain, like tokens, like stablecoins, like smart contracts.

Kimberly Adams: In your paper, you suggest that DeFi technology is basically shadow banking 2.0. Can you explain how they’re comparable?

Allen: Sure. The overarching idea is that there is increased complexity when you’re trying to find a way to provide the same financial services, but in a way that gets around the regulatory regime that has been established for the more traditional versions of those services. And complexity creates opacity; it’s hard to see where risk lies, it’s hard to understand how parties relate to one another and how they’re likely to interact in the crisis.

So I think the opacity that we’re seeing from DeFi has an analog in the opacity we saw in 2008 with products like credit default swaps, mortgage-backed securities, those kinds of things. I think that there are some specific features of shadow banking 1.0, the 2008-era shadow banking, that are replicated with the functional equivalents that we’re getting in the DeFi wave of shadow banking. So here I’m talking about rigidity. We had financial products in 2008 that were created in a way that were very hard to amend, to modify as circumstances changed, and that made the whole financial system more brittle. What we’re seeing with DeFi is we’re using new types of computer programs to automate certain financial transactions. That’s what smart contracts are called. They’re automating these transactions. And that is increasing, I think, the brittleness of the ecosystem.

Hilary J. Allen (Courtesy Allen)

Adams: One of these parallels that you’re pointing out between shadow banking 1.0 and all of these unregulated financial instruments in the banking industry and shadow banking 2.0 DeFi is inherently you’re arguing the risk to the broader financial system.

Allen: Yeah. So I think a lot of the focus on crypto and DeFi has been on consumer protection or investor protection. It’s concerned about scams and hacks, and how do people get their money out, etc., and all of those are very valid concerns. But we’re not just worried about the individuals who are investing. And if you want to analogize back to 2008, we can talk about the subprime mortgages, right? The people who took out those subprime mortgages were certainly harmed, but the problems that they experienced had a cascade effect for the rest of the economy because those subprime mortgages were packaged into these rigid mortgage-backed securities. Credit default swaps were used to create new forms of leverage, new ways of borrowing against these mortgage-backed securities, and all of that magnified the impact of the problems with these predatory products. And that’s what I’m concerned about in DeFi in shadow banking 2.0. If DeFi becomes increasingly integrated into our broader financial system, then problems in DeFi could be transmitted to regular banks. And if those banks suffer problems, then they won’t be able to extend credit. And if they can’t extend credit, then the economy starts to seize up.

Adams: What is the modern DeFi equivalent of, say, a subprime mortgage?

Allen: There are loans being offered in the DeFi ecosystem. They’re just straight-up investments in tokens and things like that that potentially are predatory. They’re very opaque. So when we think about subprime mortgages, people had to understand sort of financial documentation that was very confusing. Now, they have to understand computer code, which is really beyond the ken of, I think, a lot of investors. So there are a lot of ways to take advantage of people using these kinds of crypto-based financial products. And if suddenly it comes to light that they are being taken advantage of, that can damage confidence in the products, which could lead to a sell-off, which could lead to all kinds of cascading effects of problems in the DeFi ecosystem.

Adams: You argue that the way that regulators handled shadow banking 1.0 leading up to the financial crisis provides some lessons for the moment that we’re in now. What are those lessons?

Allen: I think the chief lesson is that ‘wait and see’ is bad policy. Another lesson, I think, is that innovation shouldn’t always be allowed to proceed unchecked. That was most epitomized by the Commodity Futures Modernization Act that was passed in 2000 that prevented regulation of credit default swaps and other swaps because they wanted to let innovation grow unhindered. And we saw how that turned out. So what I think regulators should be doing now is remembering back to those moments in the early 2000s and late ’90s and think about, “Hmm, perhaps we should be more proactively thinking about how this stuff could cause problems for our broader financial system and taking steps now because, at a certain point, it’ll be too late.”

Adams: At the same time, there are a lot of folks out here arguing that these tools and that DeFi and all these different technologies may actually increase access to people who have been traditionally unbanked or people who are already blocked out of the financial system. Is there space to allow the innovation to potentially open opportunities for new markets?

Allen: I think a lot of those arguments are really just sort of empty potential. The reason why people don’t have access to financial services — the reasons are structural, they’re political, and they require structural and political solutions to fix them. Technology in the hands of the same people who run the current system, you know, is just going to result in the same kinds of outcomes. And remember that we heard this rhetoric before with regards to subprime mortgages, that this was going to fix access to housing for underserved populations. So I think we need to be very skeptical of this rhetoric, especially when there’s sort of very little to back it up, and be thinking about really the hard work we need to do to fix structural inequalities. It would be lovely — I can see the appeal — it would be nice if there was just this easy technological solution. But a point that I make in the paper is that DeFi is not decentralized. There are a lot of intermediaries involved, and if those intermediaries have the same incentives as intermediaries have always had, and we don’t have political or structural change to rein them in, then I don’t see this ending well for financial inclusion.

Adams: So what do you think regulators need to be doing right now?

Allen: Generally speaking, what I think we need is a more precautionary approach to crypto in general because the risks are very clear right now — the potential is just that potential. And it’s been potential for a long time. Crypto technology has been around for over a decade, and that is a long time in tech years. And still, we’re looking for the killer app, right? We’re still looking for the key use of it. And so given that context, I think regulators, frankly, need to be putting a pause, to the extent that they have the authority to do so, on this kind of DeFi innovation. Now, “to the extent that they have the authority to do so” is carrying a lot of water there. In terms of practical steps, I think the most important thing that needs to happen is that the banking regulators need to prevent crypto from integrating with our broader established financial system. So banks shouldn’t be allowed to invest in crypto, they shouldn’t be allowed to act as a broker for crypto for their customers, they shouldn’t be allowed to issue stablecoins, they should be kept entirely out of this space. And then crypto, as it exists now, should continue to be regulated as it has been regulated by the [Securities and Exchange Commission] and the [Commodity Futures Trading Commission] as, frankly, a speculative investment, because that’s what it is.

Adams: I mean, hasn’t that ship kind of already left the harbor in terms of integration into the main banking system?

Allen: It’s starting to leave the harbor. I think we’re at the point where time is of the essence. It’s not so integrated yet, I think, but your point is well taken that time is running out because the largest banks are definitely eyeing this. You know, smaller banks are trying to offer stablecoins. If we get past that moment and this becomes truly integrated into our established financial system, then I think systemic problems are inevitable.

Related links: More insight from Kimberly Adams

Check out Allen’s paper, “DeFi: Shadow banking 2.0?” It contains a good summary of the weird financial instruments that set the stage for the 2008 financial crisis, in case you need a refresher, and goes into greater detail about how DeFi works today.

One risk she also cites in her paper is DeFi loans — essentially, lending your crypto to someone else while making more money on the interest. The difference is that there are no banks involved.

The website Decrypt has a good explainer on that and said that these loans make up one of the fastest-growing sectors in blockchain and cryptocurrency.

There are also some mainstream banks dipping their toes into the DeFi sector. Most notably, JPMorgan launched the JPM Coin in 2020 — its own digital token, backed by the blockchain and tied to the U.S. dollar. According to Allen, that is exactly what we should worry about.

The future of this podcast starts with you.

Every day, the “Marketplace Tech” team demystifies the digital economy with stories that explore more than just Big Tech. We’re committed to covering topics that matter to you and the world around us, diving deep into how technology intersects with climate change, inequity, and disinformation.

As part of a nonprofit newsroom, we’re counting on listeners like you to keep this public service paywall-free and available to all.

Support “Marketplace Tech” in any amount today and become a partner in our mission.

The team

Daniel Shin Producer
Jesús Alvarado Associate Producer