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 risk-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….