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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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