Decentralised finance (DeFi) resembles the unregulated ‘shadow banking’ whose unruly growth triggered the 2008 financial crisis. And regulators need to move fast to avoid a repeat of the crash, says Hilary Allen, a professor at American University Washington College of Law.
Allen’s research focuses on the impact of new financial technologies—including smart contracts and artificial intelligence—on the stability of our financial system, and on potential regulatory responses to those technologies.
In a new paper, entitled “DeFi: Shadow Banking 2.0?”, Allen argues that if DeFi is permitted to develop without regulation, it could repeat the structural flaws—heightened leverage, rigidity, and runs—that led to the great financial crisis.
In the paper, Allen argues that policymakers should move quickly to cordon off DeFi from the established financial system, preventing it from growing any further.
How shadow banking led to the 2008 crash
In the run-up to the 2008 crash, says Allen, it was a combination of old actors and new legal structures that blind-sided policymakers and led to a dangerous build-up of leverage outside the banking system.
Shadow banking “version 1.0” included “investment banks, money-market mutual funds (MMMFs) and mortgage brokers, sale-and-repurchase agreements (repos) and more esoteric instruments such as asset-backed securities (ABSs), collateralized debt obligations (CDOs) and asset-backed commercial paper (ABCP),” Allen says in her paper.
“Increased complexity can make systems more fragile”
“Few steps were taken to rein in these types of innovation, and the increased leverage, rigidity, and fragility they created became evident during the 2008 financial crisis,” she says.
The problems were worsened by the inherent complexity of shadow banking relationships, says Allen, which acted to propagate shocks to the traditional financial system.
“Increased complexity can make systems more fragile (particularly by obscuring how steps that are taken to make individual system components more robust can end up transmitting problems with those components throughout the broader system),” she says.
Only after the crisis did regulators introduce some fixes, which have helped, if not fully addressed, the problems associated with shadow banking, Allen goes on.
Meanwhile, we are still living with the consequences of the crisis, says Allen.
“The recession that followed had obvious and immediate impacts on employment and wealth, but it also generated a lingering mental and physical toll for the most vulnerable members of our society,” she says.
Why DeFi is shadow banking 2.0
Now warns Allen, we are risking a repeat of 2008 through the rapidly developing DeFi sector, which she labels “shadow banking 2.0”.
DeFi, says Allen, exhibits the same structural flaws as were evident before 2008.
Specifically, she says, DeFi creates hidden systemic leverage, its financial contracts are too rigid and likely to transmit shocks throughout the system, and it is susceptible to bank-like runs from supposedly safe assets.
Worse, suggests Allen, DeFi’s central promise—decentralisation—doesn’t stand up to scrutiny.
“DeFi replaces trust in regulated banks with trust in new intermediaries who are often unidentified and unregulated”
“The crisis of 2008…understandably piqued interest in visions of an alternative decentralized financial system where no one needs to trust any intermediary because intermediaries have been rendered superfluous,” she says.
“Unfortunately, this is an entirely unrealistic goal,” she goes on.
“DeFi users have to trust in some combination of internet service providers (ISPs), core software developers, miners, wallets, exchanges, stablecoin issuers, oracles, providers of client APIs used to access distributed ledgers, and concentrated owners of governance tokens,” she says.
“In short, DeFi doesn’t so much disintermediate finance as replace trust in regulated banks with trust in new intermediaries who are often unidentified and unregulated,” she concludes.
The result is a version of finance that is even worse than the system it seems to replace, says Allen.
“DeFi innovations that are supposed to displace the need for trust in intermediaries succeed only in making DeFi more fragile than traditional financial services,” she says.
Cordon off and starve DeFi
In her paper, Allen calls for policymakers to take a precautionary approach to DeFi regulation, limiting the use of DeFi where financial regulators are able to exercise jurisdiction, then cordoning off whatever remains of DeFi from the established financial system and real-world economy.
“As a priority, regulated banks should be prohibited from issuing stablecoins or providing any decentralised software applications”
Allen takes issue with suggestions that issuers of stablecoins (dollar-linked cryptocurrency tokens) should be subject to bank-like regulations, arguing that this would create moral hazard by extending the public safety net of deposit insurance to the DeFi ecosystem in which stablecoins are deployed.
Instead, she argues, steps should be taken to insulate regulated banks from DeFi.
“As a priority, regulated banks should be prohibited from issuing stablecoins or providing any decentralised software applications (Dapps), holding stablecoin reserves in a deposit account or investing in any Dapp or stablecoin,” says Allen.
US banking regulators already have the authority they need to take these steps, she says.
Another strategy to prevent DeFi from growing into another shadow banking system would be to subject stablecoins and Dapps to a licensing regime, says Allen.
For example, US legislators could insist that a DeFi market operator seeking a licence demonstrate that its Dapp/stablecoin has a purpose that is connected to real-world economic growth, that the applicant has the institutional capacity to manage the associated risks, and that the Dapp/stablecoin is unlikely to have a negative impact on the stability of the financial system or monetary policy, she suggests.
“Until such licensing measures can be put in place,” says Allen, “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.”
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