Bitcoin

TradFi and DeFI: Same Problems, Different Solutions

In our recent primer on Crypto-assets and Decentralized Finance (DeFi), we explained that, so long as crypto-assets remain confined to their own world, they pose little if any threat to the traditional finance (TradFi) system. Yet, some crypto-assets are being used to facilitate transactions, as collateral for loans, as the denomination for mortgages, as a basis for risk-sharing, and as assets in retirement plans. Moreover, many financial and nonfinancial businesses are seeking ways to expand the uses of these new instruments. So, it is easy to imagine how the crypto/DeFi world could infect the traditional financial system, diminishing its ability to support real economic activity.

In this post, we highlight how the key problems facing TradFi (ranging from fraud and abuse to runs, panics, and operational failure) also plague the crypto/DeFi world. We also examine the different ways in which TradFi and crypto/DeFi address these common challenges.

To summarize our conclusions, while the solutions employed in TradFi are often inadequate and incomplete, features such as counterparty identification and centralized verification make them both more complete and more effective than those currently in place in the world of crypto/DeFi. Ironically, addressing the severe deficiencies in the current crypto/DeFi infrastructure may prove difficult without making highly unpopular changes that make it look more like TradFi—like requiring participants to verify their identity (see, for example, Makarov and Schoar and Crenshaw).

This is the second in our series of posts on crypto-assets and DeFi. In the next one, we will examine regulatory approaches to limit the risks posed by crypto/DeFi while supporting the benefits of financial innovation….

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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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Russian Sanctions: Questions and Answers

This post is authored jointly with our friend and colleague, Professor Richard Berner, Co-Director of the NYU Stern Volatility and Risk Institute.

Russia’s invasion of Ukraine is altering global security and economic relationships. In this post, we focus on the financial and trade sanctions imposed on Russia. These sanctions are the most powerful and costly punishments imposed on a major economy at least since the Cold War. Their speed, breadth and coordinated global support appear unprecedented.

Not surprisingly, the impact is immediately visible. The damage to the Russian economy and financial system includes, but is not limited to, a plunge of the ruble (by about 40 percent versus the dollar over the past month amid heightened volatility); runs on domestic banks; a sharp hike in the central bank’s policy rate; imposition of capital controls; shutdown of the Russian stock market; collapse in the value of Russian companies traded on foreign stock exchanges; removal of Russian equities from global indexes; and the collapse of Russia’s sovereign credit rating to junk status.

The purpose of this post is to pose and provisionally answer a series of questions raised by this new sanctions regime.…

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Stablecoin: The Regulation Debate

Last month, the President’s Working Group on Financial Markets (PWG) called for the introduction of a regulatory framework for “payment stablecoins”—private crypto-assets that (unlike the highly volatile Bitcoin) are pegged 1:1 to a national currency and “have the potential to be used as a widespread means of payment.” Most notably, to limit the risk of runs, the Report calls for legislation restricting stablecoin issuance to insured depositories.

In this post, we first document the rapid growth of stablecoin usage. We then highlight the features which make stablecoins subject to run risk that, in the absence of appropriate governmental controls, could destabilize the financial system. Next, we consider the three regulatory approaches that Gorton and Zhang (GZ) propose for making stablecoins resilient: the first, and the one favored by the PWG, is to limit stablecoin issuance to insured depositories; the second is to require 1:1 backing of stablecoins with sovereign securities (in the case of the United States and the U.S. dollar, these would be U.S. Treasury issues); and the third is to require 1:1 backing with central bank reserves. We conclude with a brief discussion of whether central bank digital currencies are an appropriate means to displace stablecoins.

To foreshadow our conclusions, we view the PWG proposal as the preferred alternative. However, absent near-term prospects for legislative action, we hope that the Financial Stability Oversight Council (FSOC) will consider—as GZ suggest—using its powers under the Dodd-Frank Act to designate the issuance of payments stablecoins as an activity that is “likely to become” systemically important. FSOC designation would authorize the Federal Reserve to promote uniform standards without waiting years for legislation that authorizes a new regulatory framework.

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Central Bank Digital Currency: The Battle for the Soul of the Financial System

While the conflict is largely quiet and out of public view, we are in the midst of an epic battle for the soul of the financial system. Central banks are thinking about whether they should substitute publicly issued digital currency for the bank-issued digital money that people use every day. How this plays out can profoundly reshape the financial system and make it less stable.

The forces driving government decisions are unusual because there is a widespread fear of losing an emerging arms race. No one wants to face plunging demand for their currency or surging outflows from their financial institutions should another central bank introduce an attractive new means of exchange. But that pressure to prepare for the financial version of military mobilization can lead to a very unstable global system that thwarts monetary control.

Central bank digital currency (CBDC) can take many forms. While some may be benign, the most radical version—one that is universally available, elastically supplied, and interest bearing—has the potential to trigger destabilizing financial shifts, weaken the supply of credit, and undermine privacy….

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Libra's dramatic call to regulatory action

Facebook’s June 18 announcement that it has created a Geneva-based entity with plans to issue a currency called Libra is sending shock waves through the financial world. The stated objectives of creating Libra are to improve the efficiency of payments and to ease financial access. While these are laudable goals, it is essential that we achieve them without facilitating criminal exploitation of the payments system or reducing the ability of authorities to monitor and mitigate systemic risk. In addition, any broad-based financial innovation should ease the stabilization of consumption.

On all of these criteria, we see Libra as doing more harm than good. And, for the countries whose currencies are excluded from the Libra portfolio, it will diminish seignorage, while enabling capital outflows and, in periods of stress, accelerating capital flight.

Like Bank of England Governor Carney, we have an open mind, and believe that increased competition, coupled with the introduction of new technologies, will eventually lower stubbornly high transactions costs, improving the quality of financial services globally. But in this case, we urge a closed door….

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Finance and the Blockchain: A Primer

Blockchain is all the rage. We are constantly bombarded by reports of how it will change the world. While it may alter many aspects of our lives, our suspicion is that they will be in areas that we experience only indirectly. That is, blockchain technology mostly will change the implementation of invisible processes—what businesses think of as their back-office functions.

In this post, we briefly describe blockchain technology, the problem it is designed to solve and the impact it might have on finance.

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Bitcoin and Fundamentals

Bitcoin is all the rage, again. Last week, the price rose above $10,000 for the first time. Following a Friday announcement by the Commodity Futures Trading Commission, the Chicago Mercantile Exchange, the CBOE Futures Exchange, and the Cantor Exchange appear poised to launch Bitcoin futures or other derivatives contracts, with Nasdaq likely to follow. Portfolio advisers are encouraging cryptocurrency diversification. In London’s Metro, advertisements assure potential investors that “Crypto needn’t be cryptic.” And, as skyrocketing prices gain headlines, less sophisticated investors are diving in.

The danger is that investors will interpret the surging price itself (and the associated hullabaloo) as a sufficient signal to buy, fueling an asset price bubble (and, eventually, a painful crash).

No one can ever say with certainty when an asset price boom is a bubble. Nevertheless, it makes sense to ask what fundamental services Bitcoin provides. More specifically, have the prospects for those services improved sufficiently over the past year to warrant the 10-fold increase in price that has vaulted Bitcoin’s market capitalization into the range of the top 50 U.S. firms?

We strongly doubt it....

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Cash is king, but $100 bills are for crooks

People have been saying for years that cash will disappear. So far, they have been spectacularly wrong. Over the past decade, the face value of U.S. dollar paper currency in public hands has doubled. Today, there is nearly $1.6 trillion in banknotes outstanding, more than 80 percent of which is in $100 bills (see chart)! In fact, there are thirty-nine $100 bills in circulation for each of the 326 million residents of the United States.

Why is 90 percent of the U.S. increase in circulation accounted for by $100 bills? One possible explanation is that, with nominal interest rates near zero, the opportunity cost of holding cash has dwindled, reducing the incentive to deposit rising inventories of cash in a bank. The second, and more compelling, reason for the big increase in large-denomination notes is more troubling: it facilitates illicit activity. Money laundering, tax evasion, drug dealing, human trafficking, and a whole host of other criminal activities run on cash. Big banknotes are a convenient way to transfer funds anonymously with finality. A $100 bill weighs less than a gram, so $1,000,000 weighs roughly 10kg and is small enough to fit in a medium-size briefcase.

To put it simply, most of the U.S. currency in circulation is almost surely being used by criminals....  

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Fintech, Central Banking and Digital Currency

How will financial innovation alter the role of central banks? As the structure of banking and finance changes, what will happen to the mechanisms and frameworks for setting monetary and financial policy? Over the past several decades, with the development of inflation targeting, central banks have delivered price stability. And, improved prudential policies are making the financial system more resilient. Will fintech—ranging from the use of electronic platforms to algorithm-driven transactions that supplant the traditional provision and implementation of financial services—change any of this?

This is a very broad topic, some of which we have written about in previous posts. This post considers an innovation suggested by Barrdear and Kumhof at the Bank of England: that central banks should offer universal, unlimited access to deposit accounts. What would this “central bank digital currency” mean for the financial system? Does it make sense for central banks to compete with commercial banks in providing deposit accounts?

We doubt it. It is not an accident that—at virtually every central bank—only commercial banks today have interest-bearing deposits. Changing this would pose a risk of destabilizing the financial system....

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What Bitcoin Has Become

We are now in the ninth year of Bitcoin, the first coins (or “Genesis Block”) having been mined (that is, awarded for solving a computational problem) on January 3, 2009. Yet, Bitcoin has clearly failed to meet the grandiose aims of its advocates. Unlike conventional money, it is not widely used as a means of exchange. And, despite claims that its independence of government would make it a stable store of value, it remains anything but.

Instead, the evidence we can find hints that its primary use is to evade capital controls (or, possibly, as an alternative store of value in a repressed financial system). The greatest achievement associated with Bitcoin is not the currency itself, but the blockchain—the distributed ledger technology underlying it—that is now being widely explored in the hopes of slashing costs and improving services in finance and a range of other activities (see our earlier post).

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Virtual Frenzies: Bitcoin and the Blockchain

Bitcoin has prompted many people to expect a revolution in the means by which we make and settle everyday payments. Our view is that Bitcoin and other “virtual currency schemes” (VCS) lack critical features of money, so their use is likely to remain very limited.

In contrast, the technology used to record Bitcoin ownership and transactions – the block chain – has potentially broad applications in supporting payments in any currency. The block chain can be thought of as an ever-growing public ledger of transactions that is encrypted and distributed over a network of computers. Even as the Bitcoin frenzy subsides, the block chain has attracted attention from bank and nonbank intermediaries looking for ways to economize on payments costs. Only extensive experimentation will determine whether there are large benefits.

Again, however, we are somewhat skeptical...

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