The White House is reportedly planning to impose missions on multiple government agencies to take cryptocurrencies seriously.
Cryptocurrencies are part of the world of decentralized finance, or DeFi, in terms of surveillance, regulation, and their potential risks.
The new paper presents several services and products within the DeFi ecosystem with the same risks as unregulated “shadow banking” services such as subprime mortgages and credit default swaps that set the stage for the 2008 financial crisis. It suggests that.
Hillary J. Allen, a law professor at American University Washington College of Law, is the author of the dissertation. Kimberly Adams of the Marketplace asked her why she thinks DeFi is Shadow Banking 2.0.
Hillary J. Allen: In general, this DeFi ecosystem uses technical components such as blockchains, tokens, stablecoins, and smart contracts to provide financial services-like functionality outside of regulated financial systems. The idea is that there is.
Kimberly Adams: Your dissertation suggests that DeFi technology is basically shadow banking 2.0. Can you explain how they can be compared?
Allen: of course. The holistic idea is that trying to find a way to provide the same financial services adds complexity, but it’s a way to circumvent the established regulatory regimes for more traditional versions of those services. And complexity creates opacity. It is difficult to understand where the risks are, how the parties relate to each other, and how they can interact in a crisis.
Therefore, the opacity seen by DeFi is similar to the opacity seen in 2008, with products such as credit default swaps and mortgage-backed securities. I think Shadow Banking 1.0 has some specific features called Shadow Banking in 2008. These features are duplicated with the equivalent of what you get with the DeFi waves of shadow banking. So here I’m talking about stiffness. In 2008, there were financial instruments created in ways that were very difficult to modify or modify in response to changing circumstances, which made the entire financial system more vulnerable. What you see in DeFi is the use of a new type of computer program to automate certain financial transactions. That is what is called a smart contract. They are automating these transactions. And I think it makes the ecosystem more fragile.
Adams: One of these similarities pointed out between Shadow Banking 1.0 and all these unregulated financial products in the banking industry and Shadow Banking 2.0 DeFi is inherently a risk to the broader financial system. That’s what I’m claiming.
Allen: Yes. Therefore, I think that much of the focus of cryptocurrencies and DeFi is on consumer protection or investor protection. There are concerns about fraud, hacking, and how people make money, all of which are very valid concerns. But we’re not just worried about the individuals we’re investing in. And if you want to make an analogy in 2008, you can talk about subprime mortgages, right? People who took advantage of these subprime mortgages were certainly hurt, but the problems they experienced remained because these subprime mortgages were packaged in these rigorous mortgage-backed securities. It had a chain effect on the economy. Credit default swaps have been used to create new forms of leverage, new borrowing methods for these mortgage-backed securities, all of which have magnified the impact of these predatory product issues. And that’s what I’m concerned about with Shadow Banking 2.0 DeFi. As DeFi becomes more and more integrated into the broader financial system, DeFi issues can reach regular banks. And if those banks have problems, they will not be able to expand their credit. And if they can’t expand credit, then the economy begins to grab.
Adams: For example, what is the modern DeFi equivalent of a subprime mortgage?
Allen: There are loans offered by the DeFi ecosystem. They are simple investments in tokens, and such are potentially predatory. They are very opaque. Therefore, when thinking about subprime mortgages, people needed to understand a very confusing kind of financial statement. Now they have to understand the computer code. I think it really goes beyond the knowledge of many investors. Therefore, there are many ways to take advantage of people using these types of crypto-based financial products. And if it suddenly becomes apparent that they are being used, it can undermine the credibility of the product, which can lead to sold out, leading to a cascade effect of all sorts of problems in the DeFi ecosystem. There is a possibility.
Adams: You argue that the way regulators deal with shadow banking 1.0 leading up to the financial crisis provides some lessons at the moment we are. What are those lessons?
Allen: The main lesson is that “wait and see” is a bad policy. Another lesson is that innovation should not always be allowed to go unchecked. This is best seen in the Commodity Futures Modernization Act passed in 2000, which blocked restrictions on credit default swaps and other swaps because they wanted to grow unimpeded by innovation. And I saw what it would be like. So what regulators should do now is to remember that moment in the early 2000s and late 90s and think: It will be too late at some point, so we are taking measures now. “
Adams: At the same time, those who argue that these tools, DeFi, and all these different technologies could actually increase access to those who previously do not have a bank account or who are already blocked from the financial system. There are many. Is there space that allows innovation to potentially open up new markets?
Allen: I think many of those discussions are really just empty possibilities. Why people don’t have access to financial services — the reasons are structural and political, and they need structural and political solutions to fix them. The technology in the hands of the same people running the current system only produces the same kind of results. And remember hearing this rhetoric before about subprime mortgages. This will fix poorly serviced people’s access to housing. So I’m very skeptical of this rhetoric, especially if there’s little to support it, and I think we need to think about the really hard work needed to correct structural inequality. I think it’s nice — I find it appealing — I wish I had this simple technical solution. But what I point out in this paper is that DeFi is not decentralized. There are many intermediaries involved, and if those intermediaries have the same incentives as previous intermediaries and there are no political or structural changes to curb them, this works well for financial inclusion. I don’t think it’s over.
Adams: So what do you think regulators need to do now?
Allen: Generally speaking, what we think we need is generally a more proactive approach to cryptography, as the risks are now so clear — the possibilities are exactly that. And that has been possible for a long time. Cryptography has been around for over a decade, and it’s been a long time in the year of technology. Still, we’re looking for a killer app, right? We are still looking for the main use of it. And in that context, I think regulators, frankly, need to suspend this kind of DeFi innovation to the extent they have the authority to do so. Currently, “as long as they have the authority to do so”, a lot of water is carried there. Regarding the actual steps, I think the most important thing that needs to happen is that banking regulators need to prevent cryptography from integrating with our more widely established financial system. Therefore, banks should not be allowed to invest in cryptocurrencies, act as brokers of customers’ cryptocurrencies, and should not be allowed to issue stablecoins. , Should be completely away from this space.And cryptography, as it currently exists, needs to remain regulated as it is regulated. [Securities and Exchange Commission] And that [Commodity Futures Trading Commission] Frankly, as a speculative investment because it is.
Adams: In other words, the ship may have already left the port in terms of integration into the main banking system.
Allen: I’m starting to leave the harbor. We think time is at the most important stage. I don’t think it’s very integrated yet, but it’s well understood that time is running out as the biggest banks are definitely paying attention to this. As you know, small banks are trying to offer stablecoin. I think systematic problems will be inevitable if we can overcome that moment and truly integrate it into the established financial system.
Related Links: More Insights from Kimberly Adams
See Allen’s paper “DeFi: Shadow Banking 2.0?”. In case you need a review, we’ll give you an overview of the weird financial products that set the stage for the 2008 financial crisis and how DeFi works today.
One of the risks she cites in her dissertation is a DeFi loan. Basically, lend your code to someone else while making more money with interest. The difference is that the bank is not involved.
The website Decrypt has a good explanation for it, stating that these loans are one of the fastest growing sectors of blockchain and cryptocurrencies.
There are also some mainstream banks that are stepping into the DeFi sector. Most notably, JP Morgan launched JPM Coin in 2020. This is a unique digital token backed by the blockchain and associated with the US dollar. According to Allen, that’s exactly what we should worry about.
