Ticking crypto timebomb could spark another financial crisis

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We’re see­ing increas­ing inter­est from estab­lished finan­cial insti­tu­tions dip­ping their toes into that water. So, that has tak­en me from a place where this was a hypo­thet­i­cal con­cern to DeFi being a very real clear and present dan­ger to the finan­cial sta­bil­i­ty of the Unit­ed States in the world more broadly.

Why is there such a danger?

DeFi is designed to repli­cate exist­ing finan­cial ser­vices, but to do it in what is osten­si­bly mar­ket­ed as a decen­tralised way. And — spoil­er alert — it’s not decen­tralised at all. It is a space rife with inter­me­di­aries, who are often unreg­u­lat­ed. So what we have is a re-cre­ation of a lot of exist­ing finan­cial prod­ucts and ser­vices in a space that is not reg­u­lat­ed, which draws par­al­lels with the types of finan­cial prod­ucts and ser­vices that led to the GFC.

Bitcoin has been on a steep slide since its highs of November last year.

Bit­coin has been on a steep slide since its highs of Novem­ber last year.Cred­it:AP

For exam­ple, one thing that we saw in the lead up to the GFC was that cred­it default swaps mag­ni­fied the amount of lever­age you had in the sys­tem, it mul­ti­plied the amount of bor­row­ing against a par­tic­u­lar asset. With DeFi we have the poten­tial to cre­ate lim­it­less assets to bor­row against, so we’re see­ing an increase in lever­age in the system.

Some­thing else we saw was new types of mort­gage-backed secu­ri­ties that were struc­tured in a way that the con­tracts were very rigid, and couldn’t be amend­ed eas­i­ly when things changed. What we’re see­ing again is that same kind of rigid­i­ty recre­at­ed in DeFi with smart con­tracts. We’re get­ting this rigid­i­ty back in the sys­tem and what we real­ly need to pro­tect the sys­tem against future prob­lems is flexibility.

Final­ly, there’s this over­ar­ch­ing thing where com­plex­i­ty is in and of itself, a desta­bil­is­ing force. When peo­ple can’t make sense of the world they default to fol­low­ing the herd, and then that cre­ates bub­bles, and it cre­ates pan­ic. Sys­tems are more frag­ile when you have more inter­link­age between com­po­nents that peo­ple don’t under­stand. And that’s very much where we’re head­ing with DeFi.

“The more I learned about the tech­nol­o­gy, the more I am very scep­ti­cal that there is any­thing good that can come out of this.”

So for all of those rea­sons, I think we’ve got a real repli­ca­tion or even mag­ni­fi­ca­tion of the prob­lems that we had lead­ing up to the GFC.

What are the risks? Are we talk­ing about indi­vid­ual pun­ters los­ing their mon­ey, or is there a pos­si­bil­i­ty seri­ous insta­bil­i­ty in the cryp­to mar­ket could bleed through into tra­di­tion­al markets?

That’s real­ly the crux of what I’m look­ing at. There’s absolute­ly a con­cern about investor pro­tec­tion in this space — peo­ple are los­ing mon­ey, and it is very painful. So those con­cerns are very real.

But what I am focus­ing on with my work is exact­ly how does this bleed out from just the indi­vid­ual harm into a prob­lem that could affect peo­ple who nev­er even invest­ed in cryp­to in the first place? This is where I think it’s crit­i­cal as a mat­ter of reg­u­la­to­ry pol­i­cy to stop reg­u­lat­ed finan­cial insti­tu­tions, such as banks, from par­tic­i­pat­ing in the cryp­to econ­o­my because that is where an indi­vid­ual idio­syn­crat­ic prob­lem becomes a sys­temic problem.

CBA has started providing crypto trading in a trial.

CBA has start­ed pro­vid­ing cryp­to trad­ing in a tri­al.Cred­it:Paul Jef­fers

In my mind, it’s crit­i­cal that banks and oth­er reg­u­lat­ed finan­cial insti­tu­tions be sep­a­rat­ed from the cryp­to space. Put up a wall so that issues in the cryp­to space stay with the peo­ple who invest.

Com­mon­wealth Bank is tri­alling pro­vid­ing cryp­to trad­ing through their app, and ANZ recent­ly mint­ed $30 mil­lion Aus­tralian sta­ble­coins. Are projects like that too risky in your view?

Yes. Bro­ker­age accounts for your cus­tomers, whilst I don’t think it’s a great idea, don’t actu­al­ly expose the bank to any risk unless they are implic­it­ly stand­ing behind those accounts. But when you have a bank issu­ing its own sta­ble­coin, then we’re tip­toe­ing much clos­er into those waters. And I think that is cause for concern.

Load­ing

Is some­thing like the Ter­ra col­lapse a bit of a canary in the coal mine moment for crypto?

Cryp­to is an asset that has noth­ing behind it, it has no val­ue oth­er than the hope that some­one else will buy it from you. And for the entire life of cryp­to, there’s been a lot of easy mon­ey around that helped prop up its val­ue, but as the easy mon­ey is leav­ing the sys­tem, as inter­est rates go up and coun­tries are star­ing down the bar­rel of reces­sions, that doesn’t bode well for there being an unlim­it­ed sup­ply of new buy­ers for these crypto-assets.

With­out new buy­ers, these things can go to zero in a heart­beat. If a cor­po­ra­tion goes bank­rupt, it still has some assets to sell-off. If the cryp­to asset fails, there’s noth­ing behind it. That’s some­thing that peo­ple need to be very aware of before they invest in this space.

Do you see any pos­i­tives from the rise of DeFi? Is there a sil­ver lining?

Load­ing

Hon­est­ly, I have to say no. I’ve been look­ing at the stuff since 2015, and I’ve been very open-mind­ed along that jour­ney because didn’t want to rule out there being a killer app or a great use case. But as time has gone on, and the more I learned about the tech­nol­o­gy, the more I am very scep­ti­cal that there is any­thing good that can come out of this.

From pol­i­cy­mak­ers, there’s this rhetoric about inno­va­tion, say­ing that you can’t shut down inno­va­tion and that inno­va­tion is always good. In real­i­ty, we need to be more scep­ti­cal of inno­va­tion. Some inno­va­tion is fan­tas­tic, but not all inno­va­tion is good.

What we real­ly need from our pol­i­cy­mak­ers is frankly the brav­ery to say “hold on let’s think crit­i­cal­ly about what this actu­al­ly does”. Can ever live up to the promis­es it makes about decen­tral­i­sa­tion? I think the answer is no.

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