Shadow Banking 2.0

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Prof. Hilary Allen of American University Washington College of Law has a very important 27-page essay entitled DeFi: Shadow Banking 2.0?. In it, she details a whole other set of externalities that, being beyond my limited understanding of banking and finance, I didn't discuss in my EE380 Talk. Prof. Allen summarizes her work:

TL;DR: DeFi is neither decentralized, nor very good finance, so regulators should have no qualms about clamping down on it to protect the stability of our financial system and broader economy.

Her arguments are supported by a less detailed, slightly earlier paper, DeFi risks and the decentralisation illusion by Sirio Aramonte, Wenqian Huang and Andreas Schrimpf of the Bank for International Settlements. Below the fold I comment on both of them.

Prof. Allen's perspective on the risks of DeFi comes from experience:

In 2010, she worked with the Financial Crisis Inquiry Commission, which was appointed by Congress to study the causes of the financial crisis of 2007-2008.

Thus she starts with an overview of "Shadow Banking 1.0", explaining the mechanisms by which credit default swaps, mortgage-backed securitizations and money-market mutual funds contributed to the Global Financial Crisis of 2008. These mechanisms were innovations that:

• Evaded regulation of leverage, allowing greatly increased leverage and thus risk in the financial system.
• In order to evade regulation, greatly increased rigidity through the use of contract terms which while benign in normal times, in times of stress proved counter-productive.
• Greatly increased the likelihood of "bank runs", because of the combination of greater leverage and greater rigidity.

Prof. Allen continues with an overview of how DeFi would replicate existing financial services assuming the gaslighting were true. She identifies the same risks:

These new versions may avoid much of the regulation that typically applies to the existing financial services they are emulating, but they still have many of the same (or worse) fragilities as those existing services. Specifically, (i) the unlimited production of tokens can introduce more leverage into the system, potentially outstripping the leverage associated with credit default swaps in the lead-up to the 2008 crisis; (ii) smart contracts are designed to be even more rigid than the mechanisms that turned mortgage-backed securitizations into “suicide pacts” during the crisis; and (iii) stablecoins share many of the features of money market mutual funds that made them susceptible to runs in 2008 (and again in 2020).

And she adds the additional risk caused by the inherent complexity of DeFi being implemented in software:

Most investors (including established financial institutions) are used to reviewing balance sheets and written disclosures to assess investments. Few are able to read the computer code of the smart contracts that make up the Dapps – and even those who can will struggle to find flaws simply by looking at the code in the abstract. While it’s possible for the operators of Dapps to provide written disclosures to their users, written disclosure documents may prove to be highly inconsistent with how the code of the relevant smart contracts actually functions – and there’s no way for investors (or regulators) to verify this unless they can run a beta test, or at the very least read the code. Finally, added complexity arises as a result of the convoluted governance structure that often controls the Dapps’ software, as well as the governance structure of the permissioned [sic] ledgers on which the Dapps run. This means that if a problem were to occur and emergency intervention needed to be provided within the DeFi ecosystem to head-off catastrophic spillover effects for the rest of the financial system, it could be difficult to figure out who to provide emergency support to.

Prof. Allen then turns to the issue of how these risks might be mitigated through regulation:

DeFi is not yet an entrenched part of our financial system, and regulators still have the opportunity to take a precautionary approach that will have a real impact on how DeFi develops. Regulators may be able to ensure that DeFi never reaches a scale at which it could threaten the stability of our broader financial system – and if steps are taken from the outset to limit the growth of DeFi and its integration with the traditional financial system regulation, regulators won’t need to respond directly to the destabilizing problems

But she issues this warning:

If the DeFi ecosystem does grow and become integral to broader economic functioning, regulators will need to respond to those destabilizing problems – but experience with regulating Shadow Banking 1.0 suggests that those kids of reforms will be an incomplete solution. The more effective approach is to deploy regulation to separate DeFi from the established financial system, and limit its growth more generally: subjecting DeFi to bank-like regulation too early runs the risk of legitimizing and turbocharging the growth of DeFi in a way that would not be possible without regulatory imprimatur (essentially making Shadow Banking 2.0 a self-fulfilling prophecy).

She proposes several regulatory actions:

As a priority, regulated banks should be prohibited from: issuing stablecoins or providing any Dapps; holding stablecoin reserves in a deposit account; or investing in any Dapp or stablecoin (banking regulators already have the authority they need to take these steps)
...
Gorton and Zhang have noted that when it comes to stablecoins at least, Congress has the authority to “tax competitors of [the US dollar] out of existence.” An alternative or complementary strategy would be for Congress to adopt a licensing regime for Dapps and stablecoins where the applicant would need to demonstrate: (i) that the Dapp/stablecoin has a purpose that is connected to real-world economic growth; (ii) that the applicant has the institutional capacity to manage both the financial and technological risks associated with the Dapp/stablecoin; and (iii) that the Dapp/stablecoin is unlikely to have a negative impact on the stability of the financial system or on monetary policy.
...
Until such licensing measures can be put in place, the SEC and CFTC should continue to regulate stablecoins and Dapps as speculative investments where appropriate, and the Financial Stability Oversight Council and the Office of Financial Research should continue to monitor the DeFi ecosystem for potential spillovers that could harm the financial system and real economy.

I have some serious doubts about the effectiveness of regulatory actions. First, the regulations are likely to be significantly weakened or even completely vitiated by the revolving door that has emerged between the US cryptocurrency industry and Federal regulators. For example, Tony Newmyer reports that As the Fed considers minting the first digital dollar, it is tapping experts from a crypto company with a stake in the outcome:

As Federal Reserve officials consider whether to launch a digital version of the dollar, several former officials of one company with a direct stake in the outcome are working to inform the project, a new report based on public records finds.

At least five employees of Circle, which issues the world’s second-most popular stablecoin, have left the company over the past three years to work at the Boston Federal Reserve Bank as it researches how a U.S. digital currency might work.
...
The migration of Circle employees to the Boston Fed is documented in a study by the nonprofit Tech Transparency Project, which looks at ties between the crypto industry and the government. The report illuminates the the rapid emergence of a revolving door between the surging sector and policymakers rushing to develop new rules for it.

Second, even if regulators can take an action against an actor in this space, it may simply be stonewalled. For example Martin C. W. Walker reports in The Sun Always Shines in Cryptoland that:

At the end of 2020, the SEC brought an action against Ripple Labs and two senior executives for an unregistered, ongoing digital asset securities offering.
...
The case has yet to come to court because of a protracted document discovery process. Ripple has made multiple requests for internal SEC documents and communications relating to the case even though it is Ripple being sued. One of the most noteworthy delays was caused by a request shortly before the end of the document discover process for “29,947 RFAs (requests for admission), set forth in 5,097 pages, which refer to more than 1,500 separate documents.”[ii] According to the SEC, Ripple claimed the request were “neither difficult to answer, nor burdensome”.
.
Some might question why Ripple would avoid getting to court, sooner rather than later, in order to settle the legal status of it’s sales of the XRP once and for all. ... as the SEC Complaint made clear Ripple makes most of its revenues from sales of cryptocurrency rather than payments software. In fact, as Garlinghouse admitted to the Financial Times, Ripple would be loss making without cryptocurrency sales.

A firm being sued for illegal issuance of securities might be tempted to pause sales and have a moment of reflection but not Ripple. Looking at the quarterly sales reports issued by Ripple since the SEC action began a clear picture emerges of accelerated crypto sales.

Third, even if the legal process concludes with a penalty, it may be just a cost-of-doing-business. Crypto Lender BlockFi to Pay $100 Million In Settlement with SEC, States By Matt Robinson, Joe Light, and Zeke Faux reports that:

BlockFi Inc. is poised to pay $100 million to settle allegations from the Securities and Exchange Commission and state regulators that it illegally offered a product that pays customers high interest rates to lend out their digital tokens, according to people familiar with the matter.

The penalties, which could be announced as soon as next week, are among the toughest levied on a cryptocurrency firm amid a U.S. clampdown on the industry. The SEC and state investigators have been probing whether the accounts offered by BlockFi are akin to securities that should be registered with regulators.

But:

As part of its agreement with regulators, BlockFi will no longer be able to open new interest-yielding accounts for most Americans, the people said.

The regulators weren't able to stop BlockFi's existing business.

Fourth, regulators are hampered by jurisdictional issues. For example, Binance, the exchange which does two of every three derivative and one of every two spot transactions, is registered in the Cayman Islands and has always obscured its effective domicile. The licensing requirements on stablecoins and Dapps for which Prof. Allen advocates would have to address these issues:

such a licensing regime would limit the growth of DeFi ... However, with a more decentralized Dapp or stablecoin ... there may be some confusion about who should apply for the license. If such a Dapp or stablecoin were launched without a license, enforcement action could be brought against the original founder ... or if control has been handed over to a DAO, against the managers of the DAO ... or significant beneficial owners of DAO governance tokens ...

While regulators may sometimes struggle to assert jurisdiction over the relevant people (either because regulators cannot determine their identities, or because they are located outside of the United States and lack US assets to enforce judgments against), the licensing regime could still help contain Dapps and stablecoins by prohibiting centralized intermediaries (like wallets and exchanges) from providing any services in connection with an unlicensed Dapp or stablecoin. ... if DeFi were forced to live up to its claims of decentralization by operating without any centralized intermediaries, it would be very difficult for users to access DeFi or for DeFi services to scale up, and this would limit the real-world fallout from any DeFi failures.

The point here is that regulators have leverage because the decentralization that these systems claim is, in practice, illusory. Aramonte et al write:

While the main vision of DeFi’s proponents is intermediation without centralised entities, we argue that some form of centralisation is inevitable. As such, there is a “decentralisation illusion”. First and foremost, centralised governance is needed to take strategic and operational decisions. In addition, some features in DeFi, notably the consensus mechanism, favour a concentration of power.

They later expand on the first point:

But full decentralisation in DeFi is illusory. A key tenet of economic analysis is that enterprises are unable to devise contracts that cover all possible eventualities, eg in terms of interactions with staff or suppliers. Centralisation allows firms to deal with this “contract incompleteness” (Coase (1937) and Grossman and Hart (1986)). In DeFi, the equivalent concept is “algorithm incompleteness”, whereby it is impossible to write code spelling out what actions to take in all contingencies.

This first-principles argument has crucial practical implications. All DeFi platforms have central governance frameworks outlining how to set strategic and operational priorities, eg as regards new business lines. Thus, all DeFi platforms have an element of centralisation, which typically revolves around holders of “governance tokens” (often platform developers) who vote on proposals, not unlike corporate shareholders. This element of centralisation can serve as the basis for recognising DeFi platforms as legal entities similar to corporations. While legal systems are in the early stages of adapting, decentralised autonomous organisations (DAOs), which govern many DeFi applications, have been allowed to register as limited liability companies in the US state of Wyoming since mid-2021.

Aramonte et al Graph 3

This is an area in which the extreme Gini coefficients of cryptocurrencies are helpful, as they limit the number of targets for regulatory action. Aramonte et al point out that:

Many blockchains also allocate a substantial part of their initial coins to insiders, exacerbating concentration issues

Unfortunately, this concentration of wealth also provides the means, motive and opportunity for regulatory capture. Prof. Allen continues the analogy with Shadow Banking 1.0:

The growth of Shadow Banking 1.0 was not inevitable; a series of policy choices allowed it to develop. This is illustrated most obviously by Congress’ passage of the Commodity Futures Modernization Act in 2000, which prevented the SEC and CFTC from regulating swaps – and which Congressman Bliley justified as necessary in part because “[d]erivative instruments...reflect the unique strength and innovation of American capital markets” and because “U.S. markets and market professionals have been global leaders in derivatives technology and development.” We hear the same rhetoric with regard to stablecoins and other DeFi projects, and this kind of rhetoric could encourage regulators to accommodate the growth of DeFi.

She adds:

It became apparent following the 2008 crisis that some Shadow Banking 1.0 innovation was not a “rational demand-side response to market imperfections”. Instead, the innovation was often driven by supply-side incentives: financial institutions could profit from offering financial products that capitalized on interest in the “next big thing”, notwithstanding that the result was sometimes socially-useless over-innovation that hid risks from purchasers and created risks for the broader economy. There are similarly perverse incentives for innovation in the tech industry, which can encourage firms to pursue innovation that is “buzzy” enough to attract venture capital funding, even if it is not particularly good technology.

Aramonte et al Graph 2

There is an issue that deserves more attention than either Prof. Allen or Aramonte et al devote to it. They correctly point out that the algorithms cannot "expect the unexpected". Both focus on the risks DeFi poses to the financial system. In normal times these risks are potential; they become actual in times of stress. In such times there is a risk that is easy to expect but hard to mitigate; the demand for transactions increases enormously, but the supply of transactions is effectively fixed, so the price of a transaction spikes. As shown in Aramonte et al's Graph 2, this can happen even in normal times as demand rises above supply.

In the kind of market meltdown that would imperil the financial system demand would be vastly greater than supply. This leads to two questions worthy of attention:

• Not just the bid-ask spread but also the fees would spike to unprecedented levels. How would "smart contracts" react to being unable to afford to execute their pre-programmed transactions?
• The pool of pending transactions would explode. How would "smart contracts" react to their pre-programmed transactions suffering long delays, so that when executed they faced market conditions very different from those when they were submitted?

A useful area of research would be "stress tests" using simulations of the Ethereum blockchain and real "smart contracts".

Update 2^nd March 20022: Matt Levine writes:

In crypto philosophy, intermediaries are not supposed to be noble and libertarian; they are supposed to be unable to stop you. But here:

1. People have asked the big crypto exchanges to block transfers by Russians, and the exchanges have refused on ideological grounds, both of which suggest that this matters, that the big exchanges are important intermediaries who can effectively block transfers by Russians. Sure sure sure you own your own Bitcoin on the blockchain, etc., but in practice you rely on centralized intermediaries to turn your rubles into Bitcoins, to turn your Bitcoins into spendable money, and often to keep custody of your Bitcoins for you. And those intermediaries are subject to political pressures and view themselves as political actors.
2. The big crypto exchanges apparently will restrict trading and withdrawals by accounts linked to “entities who have been legally sanctioned”: A big crypto exchange has a compliance department and views itself as subject to the laws of the states where it operates, including sanctions laws. If you are a sanctioned Russian oligarch who keeps Bitcoin at Coinbase you presumably have lost access to your Bitcoins, which — like your Swiss bank accounts and London house — are property that exists in the Euro-American world and so are subject to sanctions.