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A ticking crypto time bomb could trigger another financial crisis

We’re seeing increasing interest from mainstream financial institutions dipping their toes in this water. So that has taken me from a place where this was a hypothetical concern to where DeFi poses a very real, clear and present threat to the financial stability of the United States in the wider world.

Why is this danger?

DeFi was designed to replicate existing financial services, but in a supposedly decentralized way. And – spoiler alert – it’s not decentralized at all. It’s a space full of intermediaries who are often unregulated. So what we have is a re-creation of many existing financial products and services in an unregulated space, which draws parallels to the types of financial products and services that gave rise to the GFC.

Bitcoin has been on a precipitous decline since its highs in November last year.

Bitcoin has been on a precipitous decline since its highs in November last year.Recognition:AP

For example, one thing we saw leading up to the GFC was that credit default swaps increased the amount of leverage you had in the system, they multiplied the amount of borrowing on a given asset. With DeFi, we have the potential to create unlimited assets to borrow against, so we are seeing an increase in leverage in the system.

Another thing we saw was new types of mortgage-backed securities that were structured in such a way that the contracts were very rigid and couldn’t easily be changed as things changed. What we are seeing again is the same type of rigidity that was replicated in DeFi with smart contracts. We’re bringing that rigidity back into the system, and what we really need to protect the system from future problems is flexibility.

Finally, there’s this overarching thing where complexity is in and of itself a destabilizing force. When people can’t understand the world, they default to following the herd, and that creates bubbles and panic. Systems are more vulnerable when you have more connections between components that people don’t understand. And that is exactly what we are heading towards with DeFi.

“The more I learned about the technology, the more skeptical I am that anything good can come of it.”

For all of these reasons I think we have a real replication or even magnification of the problems we had before the GFC.

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

That’s really the whole point of what I’m looking at. There are absolutely investor protection concerns in this space — people are losing money, and it’s very painful. So these concerns are very real.

But what I focus on in my work is exactly how is this evolving from just individual harm to an issue that could affect people who have not invested in crypto at all? Here I think it is crucial in terms of regulatory policy to prevent regulated financial institutions such as banks from participating in the crypto economy, because here an individual peculiarity becomes a system problem.

CBA has started offering crypto trading on a trial basis.

CBA has started offering crypto trading on a trial basis.Recognition:Paul Jeffers

In my opinion, it is crucial that banks and other regulated financial institutions are separated from the crypto space. Put up a wall so that problems in the crypto space stay with the people who invest.

The Commonwealth Bank is testing crypto trading through its app, and ANZ recently minted $30 million worth of Australian stablecoins. Do you think such projects are too risky?

Yes. Broker accounts for your clients, although I don’t think it’s a good idea, doesn’t expose the bank to risk unless they implicitly stand behind those accounts. But if you have a bank that issues its own stablecoin, then we’re moving much closer into those waters. And I think that’s a cause for concern.

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Is something like the collapse of Terra a bit of a canary at the moment of crypto coal mining?

Crypto is an asset with nothing behind it, it has no value other than the hope that someone else will buy it from you. And throughout the life of crypto, there has been a lot of easy money that has helped prop up its value, but since easy money leaves the system as interest rates rise and countries face recessions, it doesn’t bode well Good thing there is an unlimited supply of new buyers for these crypto assets.

Without new buyers, these things can go to zero in no time. When a company goes bankrupt, it still has some assets to sell. If the crypto asset fails, there is nothing behind it. This is something people need to be very aware of before investing in this space.

Do you see any positive aspects of DeFi’s rise? Is there a silver lining on the horizon?

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Honestly I have to say no. I’ve been looking at this stuff since 2015 and have been very open minded along the way because I didn’t want to rule out the possibility that there was a killer app or a great use case. But over time and as I’ve learned more about the technology, I’ve become more skeptical that anything good can come of it.

There’s this rhetoric about innovation from policy makers that says you can’t turn innovation off and that innovation is always good. In reality, we need to be more skeptical about innovation. Some innovations are fantastic, but not all innovations are good.

Frankly, what we really need from our policymakers is the courage to say, “Wait, let’s think critically about what this actually does.” Can the promise of decentralization ever be kept? I think the answer is no.

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