Money, Banking and Financial Markets

Primers

Primers

 
 
Posts tagged Collateral
Crypto-assets and Decentralized Finance: A Primer

This week, we saw new heights of turbulence in the tempestuous crypto world. Market capitalization plunged as the loss of confidence in a popular coin—designed to be pegged to the dollar—triggered a run that fueled widespread contagion. At this writing, the estimated value of all crypto assets stands at $1.1 trillion, down nearly 60 percent from the $2.7 trillion peak in early November. What are the broader implications for the crypto world and the traditional financial system? Do we face the prospect of the famously volatile world of crypto-assets and decentralized finance (DeFi) undermining the stability of traditional financial (TradFi) system and the real economy?

So long as all these crypto-assets remain confined to the DeFi world, they pose no threat to TradFi or to economic activity. In practice, the fact that enormous fluctuations in value are met with a global shrug (at least so far) is prima facie evidence that crypto-assets currently are systemically irrelevant.

But will crypto-assets remain so disconnected from TradFi and from real economic activity? Crypto instruments already are escaping the DeFi metaverse in notable ways. These include the use of crypto-assets as a means of payment (see our earlier post on stablecoins), as collateral for loans and mortgages, and as assets in retirement plans. These developments lead us to ask two related questions: First, how will the risks arising from crypto and DeFi evolve? Second, how will regulators deal with them if and when they do?

This post is the first in a series that aims to address these questions. As befits a primer, we start with the basics: characterizing crypto-assets and DeFi. In the process, we define common terms and highlight analogies between DeFi and TradFi (traditional finance). For readers who would like to go deeper, we link to a range of studies that provide useful background information.

In a future post, we will highlight that the problems which frequently arise in TradFi (ranging from fraud and abuse to runs, panics, and operational failure) also appear in DeFi, while the aim of DeFi to avoid any discretionary intervention renders key TradFi corrective tools (such as the court adjudication of incomplete contracts) inoperable. Eventually, we also will post about regulatory approaches that can address the risks posed by DeFi, while supporting responsible financial innovation that lowers transaction costs and broadens consumer choice….

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Steve Cecchetti and Kim SchoenholtzCrypto, Crypto-asset, Decentralized finance, DeFi, Traditional finance, TradFi, Distributed ledger, Blockchain, Permissioned ledger, Permissionless, Permissionless ledger, Permissioned, Native coin, Miner, Security token, Stablecoin, Reserve-backed stablecoin, Algorithmic stablecoin, Collateral, Bitcoin, Ether, Terra, Luna, Utility token, Governance token, Costly verification, Proof of work, Smart contract, Oracle, Total value locked, TVL, Trust, Trustless, Enforcement, Legal recourse, Primer
Adverse Selection: A Primer

Information is the basis for our economic and financial decisions. As buyers, we collect information about products before entering into a transaction. As investors, the same goes for information about firms seeking our funds. This is information that sellers and fund-seeking firms typically have. But, when it is too difficult or too costly to collect information, markets function poorly or not at all.

Economists use the term adverse selection to describe the problem of distinguishing a good feature from a bad feature when one party to a transaction has more information than the other party. The degree of adverse selection depends on how costly it is for the uninformed actor to observe the hidden attributes of a product or counterparty. When key characteristics are sufficiently expensive to discern, adverse selection can make an otherwise healthy market disappear.

In this primer, we examine three examples of adverse selection: (1) used cars; (2) health insurance; and (3) private finance. We use these examples to highlight mechanisms for addressing the problem....

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Steve Cecchetti and Kim SchoenholtzAdverse selection, Asymmetric information, Financial crisis, Health insurance, ACA, Obamacare, Supreme Court, Preexisting conditions, Market for lemons, Used cars, Financial markets, Screening, Signaling, Hidden attributes, Disclosure, Collateral, Banks, Mortgages, Skin in the game, Risk aversion, Primer, Market failure, Complete information
A Primer on Securities Lending

Securities lending (SL) is one of the less-well-publicized shadow banking activities. Like repurchase agreements (repo) and asset-backed commercial paper, SL can be a source of very short-term wholesale funding, allowing a shadow bank to engage in the kind of liquidity, maturity and credit transformation that banks do. And, like other short-term funding sources, it can suddenly dry up, making it a source of systemic risk. When funding evaporates, fire sales and a credit crunch follow.

Indeed, SL played a supporting role in the 2007-09 financial crisis, being partly responsible for the collapse of the large insurance company AIG when the market seized in September 2008 (see chart). While SL has not garnered the attention of capital and liquidity regulation or central clearing, or even repo markets, it is still worth understanding what securities lending is and the risks it poses. That is the purpose of this post...

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Steve Cecchetti and Kim SchoenholtzSecurities lending, Shadow banking, Insurance company, Systemic risk, Collateral, Repo, Wholesale funding, Fire sale, Credit crunch, Cash collateral reinvestment, Asset-backed commercial paper, Primer