TradFi and DeFI: Same Problems, Different Solutions

In our recent primer on Crypto-assets and Decentralized Finance (DeFi), we explained that, so long as crypto-assets remain confined to their own world, they pose little if any threat to the traditional finance (TradFi) system. Yet, some crypto-assets are being used to facilitate transactions, as collateral for loans, as the denomination for mortgages, as a basis for ri s k-sharing, and as assets in retirement plans. Moreover, many financial and nonfinancial businesses are seeking ways to expand the uses of these new instruments. So, it is easy to imagine how the crypto/DeFi world could infect the traditional financial system, diminishing its ability to support real economic activity.

In this post, we highlight how the key problems facing TradFi (ranging from fraud and abuse to runs, panics, and operational failure) also plague the crypto/DeFi world. We also examine the different ways in which TradFi and crypto/DeFi address these common challenges.

To summarize our conclusions, while the solutions employed in TradFi are often inadequate and incomplete, features such as counterparty identification and centralized verification make them both more complete and more effective than those currently in place in the world of crypto/DeFi. Ironically, addressing the severe deficiencies in the current crypto/DeFi infrastructure may prove difficult without making highly unpopular changes that make it look more like TradFi—like requiring participants to verify their identity (see, for example, Makarov and Schoar and Crenshaw).

This is the second in our series of posts on crypto-assets and DeFi. In the next one, we will examine regulatory approaches to limit the risks posed by crypto/DeFi while supporting the benefits of financial innovation….

Libra's dramatic call to regulatory action

Facebook’s June 18 announcement that it has created a Geneva-based entity with plans to issue a currency called Libra is sending shock waves through the financial world. The stated objectives of creating Libra are to improve the efficiency of payments and to ease financial access. While these are laudable goals, it is essential that we achieve them without facilitating criminal exploitation of the payments system or reducing the ability of authorities to monitor and mitigate systemic risk. In addition, any broad-based financial innovation should ease the stabilization of consumption.

On all of these criteria, we see Libra as doing more harm than good. And, for the countries whose currencies are excluded from the Libra portfolio, it will diminish seignorage, while enabling capital outflows and, in periods of stress, accelerating capital flight.

Like Bank of England Governor Carney, we have an open mind, and believe that increased competition, coupled with the introduction of new technologies, will eventually lower stubbornly high transactions costs, improving the quality of financial services globally. But in this case, we urge a closed door….

Universal Central Bank Digital Currency?

Digital currency is all the rage. Bitcoin has more than one thousand crypto cousins. There is even a token called dentacoin, whose issuers claim it will transform dentistry! In the past, we have been clear in our views. We agree with BIS General Manager Agustín Carstens: these are exactly like past attempts of people to issue their own private money. As Carstens said on another occasion, these tokens are “a combination of a bubble, a Ponzi scheme and an environmental disaster.”

Regardless of whether the blockchain will revolutionize dental health, the appearance of cryptocurrencies has driven central banks to think about one particular aspect of their business: paper currency issuance.

In this post, we expand on some aspects of our earlier discussion of central bank digital currency (CBDC). What is it and what would its wider introduction mean for the financial system? Our conclusion is unambiguous: Watch out what you wish for! ….

Bitcoin and Fundamentals

Bitcoin is all the rage, again. Last week, the price rose above $10,000 for the first time. Following a Friday announcement by the Commodity Futures Trading Commission, the Chicago Mercantile Exchange, the CBOE Futures Exchange, and the Cantor Exchange appear poised to launch Bitcoin futures or other derivatives contracts, with Nasdaq likely to follow. Portfolio advisers are encouraging cryptocurrency diversification. In London’s Metro, advertisements assure potential investors that “Crypto needn’t be cryptic.” And, as skyrocketing prices gain headlines, less sophisticated investors are diving in.

The danger is that investors will interpret the surging price itself (and the associated hullabaloo) as a sufficient signal to buy, fueling an asset price bubble (and, eventually, a painful crash).

No one can ever say with certainty when an asset price boom is a bubble. Nevertheless, it makes sense to ask what fundamental services Bitcoin provides. More specifically, have the prospects for those services improved sufficiently over the past year to warrant the 10-fold increase in price that has vaulted Bitcoin’s market capitalization into the range of the top 50 U.S. firms?

We strongly doubt it....

Fintech, Central Banking and Digital Currency

How will financial innovation alter the role of central banks? As the structure of banking and finance changes, what will happen to the mechanisms and frameworks for setting monetary and financial policy? Over the past several decades, with the development of inflation targeting, central banks have delivered price stability. And, improved prudential policies are making the financial system more resilient. Will fintech—ranging from the use of electronic platforms to algorithm-driven transactions that supplant the traditional provision and implementation of financial services—change any of this?

This is a very broad topic, some of which we have written about in previous posts. This post considers an innovation suggested by Barrdear and Kumhof at the Bank of England: that central banks should offer universal, unlimited access to deposit accounts. What would this “central bank digital currency” mean for the financial system? Does it make sense for central banks to compete with commercial banks in providing deposit accounts?

We doubt it. It is not an accident that—at virtually every central bank—only commercial banks today have interest-bearing deposits. Changing this would pose a risk of destabilizing the financial system....

What Bitcoin Has Become

We are now in the ninth year of Bitcoin, the first coins (or “Genesis Block”) having been mined (that is, awarded for solving a computational problem) on January 3, 2009. Yet, Bitcoin has clearly failed to meet the grandiose aims of its advocates. Unlike conventional money, it is not widely used as a means of exchange. And, despite claims that its independence of government would make it a stable store of value, it remains anything but.

Instead, the evidence we can find hints that its primary use is to evade capital controls (or, possibly, as an alternative store of value in a repressed financial system). The greatest achievement associated with Bitcoin is not the currency itself, but the blockchain—the distributed ledger technology underlying it—that is now being widely explored in the hopes of slashing costs and improving services in finance and a range of other activities (see our earlier post).

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Money, Banking, and Financial Markets