The Breakdown - Why Crypto Isn’t Just the Great Financial Crisis, Part 2

Starting point is 00:00:04 Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexus.io, Arculus, and FtX, and produced and distributed by CoinDesk. What's going on, guys? It is Sunday, April 17th, and that means it's time for Long Read Sunday. Before we dig into this week's essay, however, a few housekeeping notes. There are two ways to enjoy the breakdown. You can listen on the Coin Desk Crypto Podcast Network. That feed features the breakdown and other Coin desk shows.

Starting point is 00:00:41 Or you can listen on the Breakdown Only feed, which has just this show. Both episodes come out on the same day, CoinDesk in the afternoon, and the breakdown only feed in the evening. Whichever feed you listen to, if you're enjoying the show, please subscribe to it, give it a five-star rating, give it a review, or if you want to dig deeper into the conversation, and really, what a better time to do that than on a Sunday, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.org slash breakdown pod. Also, a disclosure as always, in addition to them being a sponsor of the show, I also work with FTX. Now, today we are digging into an area of discourse around crypto, an area that I might call

Starting point is 00:01:22 FUD, that is emerging and I think likely to increase as the great national debate about crypto regulation heats up. And that's the idea of comparing the crypto industry to the Great Financial Crisis. There are a number of reasons that this comes up. Some of them are attempts to draw parallels between financial instruments that were created in the lead-up to the GFC and crypto instruments that are part of Defi now. You'll often see stable coins, for example, in the hot seat. But another reason for these parallels has to do with just the lived experience of the

Starting point is 00:01:55 regulators that we happen to have. The Great Financial Crisis was the most defining financial event. of their careers. And so of course, they're going to look for parallels in an attempt to divert or head off that sort of potential systemic failure from happening ever again. The risk, of course, is that looking for those parallels actually creates a scenario where you just start to see them everywhere, even if they don't really belong. I think the vast majority of the time that I've seen these arguments come up, they're shared by folks with only the loosest understanding of either the crypto industry or what actually went into creating the great financial crisis itself.

Starting point is 00:02:31 The discourse tends to be fooled with scary-sounding terms like shadow banks that the participants in that discourse don't necessarily really understand. I, it appears, am not the only one who feels like this, and so today I'm reading a piece by Michael Casey, the chief content officer at Coin desk, called No Defyy Is Not a Repeat of the 2008 crisis. Decentralized finance does not equal shadow banking and too big to fail. Charlie Wazel's generally quite readable Galaxy Brain newsletter carried a provocative headline this week. Is crypto recreating the 2008 financial crisis? Not surprisingly, it turned out to be a rhetorical question. The Atlantic writer's newsletter carried an interview with American University Law Professor

Starting point is 00:03:11 Hillary J. Allen, in which she discussed her recent paper arguing that decentralized finance is repeating the mistakes of shadow banking that preceded the financial turmoil of the late 2000s. Allen's thesis is that the high degree of complexity around DeFi's innovative new models for borrowing, lending, insurance, and payments will leave the same lack of clarity around looming risks that credit default swaps, CDS, and collateralized debt obligations, CDOs, fostered during the pre-crisis housing bubble. Quote, complexity-induced opacity increases the chance that such risks will be underestimated in good times, causing bubbles, and overestimated in bad times making panics worse, she writes.

Starting point is 00:03:49 Allen is urging the U.S. government to step in to regulate the sector before it becomes more integrated into the mainstream financial system. She argues that decentralized applications, DAPs should be licensed, and their founders and developers subject to enforcement actions if they are non-compliant. That won't sit well with many in the crypto community, where the idea that open source coders can be charged with wrongdoing is seen as chilling to innovation. First, let me acknowledge there's some truth in Allen's defy observations, and that some of the parallels she draws to the financial crisis, are legitimate and important. It's true, the average person can't hope to understand Defi. Much like how Wall Street's financial engineers exploited the black box of CDS's and CDOs to the eventual detriment of bank customers, that complexity also gives DeFi project founders asymmetric advantages. It's why rug pulls and other abuses of overly trusting investors are common.

Starting point is 00:04:40 Another valid observation from Allen? There's an awful lot of 2008 bubble-like behavior in defy now, and there's a lot more centralization with trusted intermediaries than decentralization enthusiasts acknowledge. But there's a fundamental flaw in Allen's perspective, one that could lead to a major policy error. Looking for ways to step up your crypto game, then go with Nexo. For starters, you get free crypto for each purchase or swap. How about earning guaranteed yields? Up to 17% paid out daily. Ideal for you hardcore hodlers. You don't even need to sell. Instead, borrow instant cash against your assets. Get the most out of your crypto with Nexo. at nexo.io.

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Starting point is 00:06:13 with up to 85% lower fees than competitors. There are no fixed minimum fees, no ACH transaction fees, and no withdrawal fees. One of the largest exchanges in the U.S. FDXUS is also the only leading exchange that supports both Ethereum and Solana NFTs. When you trade NFTs on FTX, you pay no gas fees. Download the FTX app today and use referral code breakdown to support the show. The elephant in the room. The overwhelming difference between defy innovators in the 2020s and those of Wall Street in the 2000s

Starting point is 00:06:48 is that the latter, the bankers, operated within an all-encompassing political framework that the former, the crypto developers, are untouched by. With their power to create money through fractional reserve lending, banks function as the government's agents of monetary policy, a specially sanctioned position that comes with privileged access to the Federal Reserve's liquidity. There's an interdependence between governments and banks that has at times morphed into codependence. Exhibit A, the too big to fail problem in the lead-up to the financial crisis. This was the idea that a potential collapse in a big, systemically interconnected bank would pose such a catastrophic threat to the economy that the government would always have no

Starting point is 00:07:25 option but to bail out such institutions if they ran into trouble. Precisely what happened in 2008. It was a moral hazard problem that in the 2000s fueled a massive market distortion, before the crisis banks faced asymmetric risks. They could profit from successes while the mortgage market was hot, but faced no consequences if and when it turned south. The result was a warped, distorted version of capitalism, in which profits were privatized and losses socialized. In the reference that Alan makes to this, she mostly uses it to dismiss crypto enthusiasts as naive, suggesting their interest in defy is motivated by a disdain for bailouts. In reality, the federal government's actions to shore up the financial system in 2008 were necessary. I think this completely misses the point.

Starting point is 00:08:07 One can believe, as I do, that the 2008 bailouts were the lesser of two evils, but at the same time criticized the too big-to-fail system of dependency that left the government no option but to execute them. And that's what's hopeful about crypto. We have the prospect of freeing our financial system from dependency on the overly powerful intermediaries that have, for too long, commandeered an excessive portion of the economy's resources and political capital. To achieve that, we don't necessarily need to attain some utopian standard of total decentralization. I find the gotcha critiques from the like of Allen about how crypto's not as decentralized as the narrative suggests, rather tiresome.

Starting point is 00:08:43 All the smart people in this space know this. Rather, we need a system that is sufficiently open to competition and innovation for a significantly wider set of participants than exists in the current system. That means certain elements should be decentralized and permissionless, while other parts will require the involvement of trusted parties to achieve appropriate efficiency. What matters is the balance such that every institution is subject to some form of market pressure. Easy Innovation versus hard innovation. And that's what makes the innovation by complexity comparison invalid across both realms. Since banks have a licensed monopoly over monetary creation, a role so vital that it earns

Starting point is 00:09:20 them implicit taxpayer protection against losses, the quote-unquote innovation they undertake is shaped by very different incentives and checks and balances than that of defy developers. Banks had the luxury to develop CDs, CDOs, and CDO's squared products to boost leverage and maximize short-term profits without having to calibrate those bets for the risk that the market might turn against them. By contrast, defy developers face a much more fluid and unforgiving market. That's not only because they don't have the implicit taxpayer guarantee that banks have, but also because of a core design element of defy, the open-source Lego composability of code and low barriers to entry. That design means that anyone with sufficient coding knowledge can spin up a new automated market

Starting point is 00:10:01 maker, a new governance token, or a new stablecoin algorithm without having to ask permission from a government or any other intermediating institution. And that means they can challenge the incumbents. Consider the story of defy over the past two years. First, MakerDAO is the darling of the market, then compound, then Ave, then sushi swap, then hybrid gaming defy services like Axi Infinity, all founded with months of their sudden surge to success. Compare that with the winners that emerged from the rubble of the mortgage crisis, J.P. Morgan Chase and Bank of America. They trace their roots back to 1799 and 1904, respectively. This defy dynamism, if it can be sustained, will prevent the rigidities that Alan worries will breed the same kind of

Starting point is 00:10:40 systemic risk that consume the banking system in the 2000s. That's because the market is constantly correcting the different winners and losers' tokens. It's all about price signals. Also, while it's true that defy is not perfectly decentralized and that it's too complicated for the average person, end users of defy products have far greater influence over what gets built than do banks' customers. Not only do many of them hold governance tokens, but with their fickle behavior, they produce market signals that keep defy developers on their toes, something bankers don't have to worry about nearly as much. For sure, risk-taking investors will continue to lose money from rugpoles and code breaches, while others will make fortunes. But this hurly-burly is quite different from the

Starting point is 00:11:18 systemic problems that beset the financial system in the 2000s, when everyone and every risk asset was winning for a sustained period of years before everyone and everything started massively losing in unison. Most importantly, the constant threat of failure means there's an incentive for developers to come up with more trustworthy offerings, which is why, despite the horror stories, the system has steadily become more robust over time. What might threaten this market-driven balance? An ill-thought-out, regulatory model. That's what? Want to build up systemic risk in defy? Then give banks with their moral hazard-based lending model an advantage over open-source developers. Make the latter seek permission to obtain the licenses that banks are already privileged to have. Make it very costly for

Starting point is 00:11:58 real market-focused innovation to occur and make short-term exploitative innovation virtually riskless by backing it with government insurance and taxpayer guarantees. This is not to say that centralized service providers in the space shouldn't be held accountable to laws that preserve financial stability and protect consumers. But as a range of competing proposals for regulating stablecoins defy and the broad crypto industry do battle in Washington, it does mean that we should heed the lessons from the 2008 crisis. The right lessons, not the wrong ones. All right, back to NLW here. I think that this last line, the right lessons, not the wrong ones, is incredibly important. My argument is, of course, not that we shouldn't try to understand history and be concerned when we see

Starting point is 00:12:41 real parallels. My concern is that there's a temptation to see a lot of wealth created fast and new types of financial instruments that the regulators don't understand and assume that they must be nefarious in some way, assume that they must be the province of bad actors. I also think that there tends to be a misassignment of blame. To the extent that regulators are concerned that big opaque actors like hedge funds, for example, getting involved in defy, is an issue. Or the risk that a stable coin run that starts in crypto but spills over to the traditional financial system by way of those opaque hedge fund actors is a real risk, I would assert that the risk is in the opacity of the financial institutions dealing with those financial products,

Starting point is 00:13:36 not necessarily the products themselves. In fact, one of the things that makes these defy and crypto products so different is just how auditable they are, how visible they are. There is an opportunity for that inherent transparency to build a lot of resiliency into this system, but not when you're focused on just the instruments and not the institutions that are wielding them. This is the beginning of what's going to likely be a much bigger conversation about defy specifically.

Starting point is 00:14:04 We've exited the era of will they ban Bitcoin and Cryptoids? altogether, and we've turned a corner, as I've mentioned numerous times before, in terms of what seems like the U.S. government's openness and interest in this new space. But the devil will absolutely be in the details, and it'll be incredibly important to help educate regulators, to help them truly understand these instruments, and to deal with real critiques and real risks, not just these imagined ones. So thanks to Michael Casey for writing a great piece that advances that dialogue. Thanks to my sponsors, nexus.io, Arculus, and FTX for supporting the show and allowing me to bring that dialogue to you guys. Thanks, of course, to you for listening. Until tomorrow,

Starting point is 00:14:49 be safe and take care of each other. Peace. Hey, breakdown listeners, come join CoinDesk's Consensus 2020, the festival for the decentralized world this June 9th through the 12th in Austin, Texas. This is the only festival showcasing and celebrating all sides of blockchain. crypto ecosystems, Web3, and the Metaverse, and is designed for crypto-newbies, investors, entrepreneurs, developers, and creators. Don't miss speakers like Kathy Wood, SBF, CZ, Punk 6529, and Joe Lubin to name just a few. Use code breakdown to get 15% off your pass at coindesk.com slash consensus 2022.

The Breakdown - Why Crypto Isn’t Just the Great Financial Crisis, Part 2

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