Ticking crypto timebomb could spark another financial crisis

Were seeing increasing interest from established financial institutions dipping their toes into that water. So, that has taken me from a place where this was a hypothetical concern to DeFi being a very real clear and present danger to the financial stability of the United States in the world more broadly.

Why is there such a danger?

DeFi is designed to replicate existing financial services, but to do it in what is ostensibly marketed as a decentralised way. And – spoiler alert – its not decentralised at all. It is a space rife with intermediaries, who are often unregulated. So what we have is a re-creation of a lot of existing financial products and services in a space that is not regulated, which draws parallels with the types of financial products and services that led to the GFC.

For example, one thing that we saw in the lead up to the GFC was that credit default swaps magnified the amount of leverage you had in the system, it multiplied the amount of borrowing against a particular asset. With DeFi we have the potential to create limitless assets to borrow against, so were seeing an increase in leverage in the system.

Something else we saw was new types of mortgage-backed securities that were structured in a way that the contracts were very rigid, and couldnt be amended easily when things changed. What were seeing again is that same kind of rigidity recreated in DeFi with smart contracts. Were getting this rigidity back in the system and what we really need to protect the system against future problems is flexibility.

Finally, theres this overarching thing where complexity is in and of itself, a destabilising force. When people cant make sense of the world they default to following the herd, and then that creates bubbles, and it creates panic. Systems are more fragile when you have more interlinkage between components that people dont understand. And thats very much where were heading with DeFi.

The more I learnt about the technology, the more I am very sceptical that there is anything good that can come out of this.

So for all of those reasons, I think weve got a real replication or even magnification of the problems that we had leading up to the GFC.

What are the risks? Are we talking about individual punters losing their money, or is there a possibility serious instability in the crypto market could bleed through into traditional markets?

Thats really the crux of what Im looking at. Theres absolutely a concern about investor protection in this space – people are losing money, and it is very painful. So those concerns are very real.

But what I am focusing on with my work is exactly how does this bleed out from just the individual harm into a problem that could affect people who never even invested in crypto in the first place? This is where I think its critical as a matter of regulatory policy to stop regulated financial institutions, such as banks, from participating in the crypto economy because that is where an individual idiosyncratic problem becomes a systemic problem.

In my mind, its critical that banks and other regulated financial institutions be separated from the crypto space. Put up a wall so that issues in the crypto space stay with the people who invest.

Commonwealth Bank is trialling providing crypto trading through their app, and ANZ recently minted $30 million Australian stablecoins. Are projects like that too risky in your view?

Yes. Brokerage accounts for your customers, whilst I dont think its a great idea, dont actually expose the bank to any risk unless they are implicitly standing behind those accounts. But when you have a bank issuing its own stablecoin, then were tiptoeing much closer into those waters. And I think that is cause for concern.

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Is something like the Terra collapse a bit of a canary in the coal mine moment for crypto?

Crypto is an asset that has nothing behind it, it has no value other than the hope that someone else will buy it from you. And for the entire life of crypto, theres been a lot of easy money around that helped prop up its value, but as the easy money is leaving the system, as interest rates go up and countries are staring down the barrel of recessions, that doesnt bode well for there being an unlimited supply of new buyers for these crypto-assets.

Without new buyers, these things can go to zero in a heartbeat. If a corporation goes bankrupt, it still has some assets to sell-off. If the crypto asset fails, theres nothing behind it. Thats something that people need to be very aware of before they invest in this space.

Do you see any positives from the rise of DeFi? Is there a silver lining?

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Honestly, I have to say no. Ive been looking at the stuff since 2015, and Ive been very open-minded along that journey because didnt want to rule out there being a killer app or a great use case. But as time has gone on, and the more I learnt about the technology, the more I am very sceptical that there is anything good that can come out of this.

From policymakers, theres this rhetoric about innovation, saying that you cant shut down innovation and that innovation is always good. In reality, we need to be more sceptical of innovation. Some innovation is fantastic, but not all innovation is good.

What we really need from our policymakers is frankly the bravery to say hold on lets think critically about what this actually does. Can ever live up to the promises it makes about decentralisation? I think the answer is no.