DeFi
How crypto is the Amazon of money – DL News
- The social value promised by Defi lies in the elimination of financial intermediaries.
- Don’t fall for the hype when it comes to financial innovation.
Wolfgang Münchau is a columnist for DL News. He is co-founder and director of Eurointelligence and writes a column on European affairs for the New Statesman. The opinions are his own.
As a young financial journalist in the mid-1980s, I met the late Ivan Boesky, an investor who called himself a modern arbitrageur.
He cheated on me.
Old arbitrage involved exploiting price differences between exchanges. If sterling bills of exchange were cheaper in medieval Paris than in Bruges, an investment banker would buy them in Paris and resell them in Bruges.
This would lead to price equalization. Even though everyone is in it for the money, this transaction has social value. This increased the efficiency of markets.
But that’s not what Boesky did. He implausibly claimed that he would arbitrate information – merger arbitrage as he called it.
This seemed intriguing to us, but it turned out to be a euphemism for insider trading.
A few months after we met, he was arrested. What appeared to me to be a financial innovation turned out to be old-fashioned fraud.
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He served time in prison, was banned for life from financial markets, became a government informant and stayed out of the spotlight until his death last month.
Michael Douglas’ Gordon Gekko character in the 1987 film “Wall Street” — the “greed is good” part — was based on Boesky.
What the Boesky experience taught me is that financial innovation doesn’t really exist.
“When someone claims to have created an innovation, it is usually more likely that they have found a way to hide the risks.”
This may seem like a bold statement. But think about it.
Finance is the intermediation between borrowers and lenders, between savers and investors.
You can structure credit in different ways. Or hedge the risk.
But when someone claims to have created an innovation, it’s usually more likely that they’ve found a way to hide the risks. Case in point: U.S. subprime mortgages in the 2000s, which hid bad loans in vast pools of investment-grade products.
Fundamental observation
So how does this apply to crypto, or more specifically decentralized finance?
Let’s start with the tendency of many to confuse the properties of DeFi instruments – tokens, blockchain networks, smart contracts – with the industry itself.
The social value promised by Defi lies in the elimination of financial intermediaries. This is a big deal that would justify some of the significant investment flows into the crypto industry.
What Amazon did initially for books, and then for everything else, is what crypto can do for finance.
The potential of crypto
In finance, you can estimate the current costs of the rent-seeking intermediary in terms of the margin between market interest rates and borrowing rates, or credit card interest rates.
In other words, the gap you see between central bank capital and the rate your bank gives you on deposits, or charges you on debt, is extremely wide.
This is the savings potential that crypto can offer.
This can take some of the hassle out of applying for a mortgage and can connect borrowers and lenders in a way that is not possible with the mostly static institutions of modern finance.
But be wary of claims that go beyond that. In statistics, there is a famous method called “bootstrapping” – a sampling technique that superficially appears to create data out of nothing.
You can bootstrap data, but you can’t bootstrap money, just as a central bank cannot increase the money supply beyond certain thresholds over long periods of time without creating inflation.
Bubbles can persist surprisingly long, even decades. Some people will go on a killing spree while it lasts. If it is not sustainable, it will end.
The natural barrier for DeFi is that ownership of real assets is governed by national laws. A court decision is required to claim the property of a delinquent debtor.
Unsecured loans, which are the business of banks, are difficult in a purely cryptographic world.
Wholesale financial markets already operate with high levels of efficiency and low margins.
From an economic perspective, the main promise of DeFi would lie in those parts of financial markets that suffer the most friction in the form of high transaction costs and barriers to entry.
This would be a social value, but it would still require crypto-friendly regulation.
Social value
This scenario is different from the one I’ve discussed in previous columns about crypto as a potential replacement for fiat currency. This does not require collusion of authorities.
The social value here is the freedom to carry out transactions without state control. What both have in common is the elimination of rent-seeking middlemen.
For DeFi, the middleman argument is the one that matters most. But I find it hard to imagine a world of decentralized finance that operates on a large scale outside of legal systems.
In a fiat currency system, a distinction is made between internal and external money. Domestic money is money created by banks – through loans for example.
Foreign money exists outside of the financial system, like gold. Cryptocurrency can be classified as external currency from the perspective of the non-crypto world.
In this definition, crypto is a bubble that bursts or is fueled by fiat currency that allows crypto investors to liquidate their positions.
But don’t be fooled by the hype of financial innovation. There are many Boeskys in the crypto space.
I think Amazon is the best way to think about Defi. Amazon has brutally cut out the middlemen.
But just as Amazon did not reinvent the book, cryptocurrencies will not reinvent finance.