Crypto Time Bomb Could Spark Another Financial Crisis

We are seeing growing interest from established financial institutions dipping their toes in that water. So that has taken me from a place where this was a hypothetical concern that DeFi is a very real, clear and present danger to the financial stability of the United States in the world at large.

Why is there such a danger?

DeFi is designed to replicate existing financial services, but to do so in what is ostensibly marketed as a decentralized form. And, spoiler alert, it’s not decentralized at all. It is a space riddled with intermediaries, who are often unregulated. So what we have is a recreation of a lot of existing financial products and services in a space that is not regulated, which draws a parallel to the types of financial products and services that led to the GFC.

Bitcoin has been in a steep decline from its highs in November of last year.

Bitcoin has been in a steep decline from its highs in November of last year.Credit:access point

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

Another thing 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 easily changed when things changed. What we are seeing again is the same kind of rigidity recreated in DeFi with smart contracts. We are bringing this rigidity back into the system and what we really need to protect the system against future problems is flexibility.

Finally, there is this general thing where complexity is itself a destabilizing force. When people can’t understand the world, they default to following the herd, and that creates bubbles and panic. Systems are more fragile when there are more interconnections between components that people don’t understand. And that is where we are headed with DeFi.

“The more I learn about the technology, the more skeptical I am that anything good can come of it.”

So for all those reasons, I think we have a real replica or even an extension of the problems that we had before the GFC.

What are the risks? Are we talking about individual gamblers losing their money, or is there a chance that serious instability in the cryptocurrency market could spill over into traditional markets?

That’s really the crux of what I’m seeing. There is absolute 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’m focusing on with my work is exactly how this bleeds from individual harm to a problem that could affect people who never invested in crypto in the first place. This is where I think it is critical as a matter of regulatory policy to prevent regulated financial institutions like 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 on a trial basis.

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

In my opinion, it is critical that banks and other regulated financial institutions break away from the crypto space. Put up a wall so that the problems in the crypto space remain with the people who invest.

Commonwealth Bank is testing cryptocurrency trading through its app, and ANZ recently minted $30 million in Australian stablecoins. Are projects like that too risky in your opinion?

Yes. Brokerage accounts for your clients, while I don’t think that’s a great idea, doesn’t really expose the bank to any risk unless they’re implicitly behind those accounts. But when you have a bank that issues its own stablecoin, then we’re getting much closer to those waters. And I think that’s cause for concern.

Charging

Is something like the collapse of Terra a canary at the time of the coal mine for cryptocurrencies?

Crypto is an asset that has nothing behind it, it has no other value than the hope that someone else will buy it from you. And throughout the life of cryptocurrencies, there has been a lot of easy money that helped prop up its value, but as easy money leaves the system, as interest rates rise and countries look down the barrel of recessions, that doesn’t bode well that there is 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. If the crypto asset fails, there is nothing behind it. That is something that people should be very aware of before investing in this space.

Do you see any positive aspects of the DeFi boom? Is there a positive side?

Charging

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

From policymakers, there is this rhetoric about innovation, saying you can’t shut down innovation and innovation is always good. Actually, we should be more skeptical about innovation. Some innovations are great, but not all innovations are good.

What we really need from our policymakers is frankly the courage to say “wait, let’s think critically about what this actually does.” Will it ever be able to live up to the promises it makes on decentralization? I think the answer is no.

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