How decentralized finance can mitigate risks that traditional banks cannot.

Tomas J. Philipson & Jeffrey Wernick

The SEC’s attempts to regulate crypto, including the recent actions taken against Kraken and Paxos, and last week’s proposed regulations that would handicap the regular banking operations of crypto firms, are in full swing this month. But the recent partial recovery of crypto markets post-FTX tells us that the main problem was bad actors, not crypto as such.

Indeed, some crypto coins have superior attributes when compared with traditional mediums of exchange. Moreover, we believe that recent evidence suggests that those coins offer a useful competitive alternative to traditional banking by enabling less contagion and lower systemic risk. Because crypto has no middlemen analogous to banks, it cuts out their risky behavior and the potential consequences that follow, such as systemic risk and taxpayer bailouts in pursuit of financial stability.

A cryptocurrency is a private and decentralized medium of peer-to-peer exchange that is not controlled by governments or banks. By cutting out either of these intermediaries, it enhances the speed and efficiency of transactions. It is analogous to email in peer-to-peer communication, which by eliminating the postal service as a middleman has increased speed and reduced fees charged in stamps. Thus, it is easy to understand the determined opposition to crypto from the middlemen who are being eliminated: governments, central banks, or private-sector bankers such as Jamie Dimon.

A good medium of exchange is portable, cheap and fast to transact with and provides a store of value. Crypto is more portable than regular currencies and presents lower transaction costs, especially across nations, as international transactions can involve several middlemen. Importantly, crypto, and particularly stablecoin, offers a superior store in value, as it’s protected from government actions. This explains why Argentinians and Venezuelans faced with high inflation have turned to crypto, and why truckers in Canada did so after their government went after their bank accounts. Critics argue that crypto is used as a means for conducting illegal activity. Like cash, crypto allows for privacy and anonymous transactions, but the share of illegal volume is relatively small for both mediums, and very small compared with their overall value.

Still, we believe the most important benefit of crypto is its potential as a competitive new alternative that can operate to reduce the financial contagion and systemic risks of fractional-reserve banking. Stablecoins such as Tether (USDT) and USD Coin (USDC), which are pegged to verifiable non-crypto assets such as the dollar, illustrate this benefit. By definition, their volatility ought to be the same as that of the peg, but by cutting out the middlemen engaged in fractional-reserve banking, stablecoins offer a useful alternative.

History has repeatedly shown that fractional-reserve banks are an important source of financial instability and systemic risk. Under such banking, only a fraction of deposits is held in reserve, to cover normal withdrawal activity, while the rest is invested for the bank to make a return. When investments go bad, or deposits are withdrawn at abnormally high amounts, the bank faces a liquidity crisis, which can cascade throughout the market and cause panic. These risks are due to the concentration of the third-party-middleman function.

Stablecoin bankers such as AAVE, meanwhile, earn money in a fully collateralized way by more efficiently matching borrowers and lenders through crypto smart contracts. These smart contracts automate the escrowing and mark-to-market processes, thus eliminating the need for traditional financial intermediaries such as banks, resulting in efficient transactions and lower fees. The key to stability is that AAVE’s earnings come not from risky investment of deposits but from commissions on efficient decentralized matching, analogous to the matching function of apps such as Uber or Tinder.

Because this more efficient and commission-based matching does not entail fractional reserves, bank runs should not be an issue. Neither should there be risk of socialized losses caused by excessive risk-taking that can lead to taxpayers’ bailing out the middlemen in the name of financial stability.

Cryptocurrency is the electronic version of Henry Simon’s concept of narrow banking as expressed in the Chicago banking plan proposed during the Depression, which was supported by economists such as Aaron Director and Friedrich Hayek.

During the recent FTX saga in November 2022, decentralized stablecoin-lending platforms such as AAVE were not heavily affected, proving that these carry lower systemic risk. The crypto “banks” that were heavily affected and discussed in the media were only those centralized ones such as Celsius. In fact, as Celsius imploded, public-domain pricing data show that the AAVE coin gained value during the FTX bankruptcy.

The fact that a market can include bad actors shouldn’t lead us to reject that market’s potential value. Bernie Madoff does not discredit asset management, nor do insider traders nullify the value of equity or bond markets. Indeed, the allegations against bad actors at FTX is that they initially got rich via, in part,  a business model similar to that of a partially reserved regular bank. Deposits were put into bad investments, which put the enterprise at risk. While the losses of traditional banks are socialized and borne by taxpayers through FDIC or bailouts, however, FTX losses punished primarily those who took the risks. These privately borne crypto losses will help the market learn how to avoid similar bad actors in the future.

Naturally, markets and governments should aim to lower the costs imposed by bad actors in any market. But such costs are typically minuscule compared with the benefits offered by those markets. Bitcoin, AAVE, and other leading cryptocurrencies are currently trading significantly higher since the troughs that followed the FTX bankruptcy. Crypto has the potential to enhance credit markets by offering a competitive alternative to regular banking — one that reduces the role of the intermediaries that too often are the causes of financial instability and systemic risk.

Tomas J. Philipson is an economist at the University of Chicago and served as a member and acting chairman of the President’s Council of Economic Advisers, 2017­–20. Jeffrey Wernick is a founder of Kruptos and Parallel Economy.

note: this column originally appeared in National Review.

Photo by DrawKit Illustrations on Unsplash