DEFI: SHADOW BANKING 2.0?

• Author: Allen, Hilary J.

Table of Contents Introduction 922 I. Shadow Banking 1.0 925 A. Credit Default Swaps 927 B. Mortgage-Backed Securities 929 C. Money Market Mutual Funds 931 II. DeFi 933 A. Introduction to DeFi 934 B. DeFi as Shadow Banking 2.0 937 1. Leverage 937 2. Rigidity 941 3. Runs 943 III. How to Respond 948 A. The Cost-Benefit Calculus 950 1. Decentralization 950 2. Efficiency and Financial Inclusion 959 B. Regulatory Proposals 963 Conclusion 966 INTRODUCTION

"Decentralized finance" or "DeFi" has become one of the hottest trends in finance in the last few years. DeFi is usually discussed in aspirational terms, invoking comparisons to other types of technological innovations: we frequently hear that DeFi will make sending money as easy as sending a photograph or an email. (1) But money is not the same as photographs and emails--the consequences of losing money (both for the affected individual and for confidence in the financial system as a whole) are much greater than the consequences of a lost photograph or email. (2) Because money and finance are the lifeblood of our economy, finance has always been highly regulated in a way that Kodak's provision of photographs and FedEx's delivery of couriered letters never have been. (3)

The existence of strong financial regulation has often spurred attempts to arbitrage it--and that regulatory arbitrage is sometimes facilitated by complex financial innovation. (4) That was what happened in the lead-up to the 2008 crisis, when credit default swaps and mortgage-backed securitizations evolved around existing financial regulation, just as money market mutual funds had decades earlier (5) (because these services provided functional equivalents for banking products but operated outside the regulated banking sphere, they came to be known as "shadow banking," and this Article will refer to them as "Shadow Banking 1.0"). (6) Few steps were taken to rein in these types of innovation, and the increased leverage, rigidity, and fragility they created became evident during the 2008 financial crisis--only in the aftermath of that crisis did legislators and regulators step up with some regulatory fixes. (7) These have helped, but have not fully addressed, the problems associated with Shadow Banking 1.0.

The crisis of 2008 had searing social consequences. The recession that followed had obvious and immediate impacts on employment and wealth, but it also generated a lingering mental and physical toll for the most vulnerable members of our society. (8) Nearly fifteen years after the financial crisis of 2008, we are still learning more about the damage that the crisis caused: recent work has focused on how the crisis has exacerbated inequality; (9) another developing area of literature considers the political repercussions of the crisis (and financial crises more generally), suggesting that such crises can lead to political radicalization. (10) The 2008 crisis was not inevitable, though. Some of the blame can be laid at the feet of financial regulators for taking a "wait and see" approach to Shadow Banking 1.0: in its report on the causes of the crisis, the Financial Crisis Inquiry Commission concluded that "widespread failures in financial regulation and supervision proved devastating to the stability of the nation's financial markets." (11)

Confidence in our traditional financial system (and the regulators that oversee it) was justifiably shaken by the crisis of 2008; this has understandably piqued interest in visions of an alternative decentralized financial system where no one needs to trust any intermediary because intermediaries have been rendered superfluous. Unfortunately, this is an entirely unrealistic goal. DeFi has evolved such that users have to trust in some combination of ISPs, core software developers, miners, wallets, exchanges, stablecoin issuers, oracles, providers of client APIs used to access distributed ledgers, and concentrated owners of governance tokens. (12) In short, DeFi does not so much disintermediate finance as replace trust in regulated banks with trust in new intermediaries who are often unidentified and unregulated. This Article will argue that DeFi innovations that are supposed to displace the need for trust in intermediaries succeed only in making DeFi more fragile than traditional financial services.

I have posed this Article's title, "DeFi: Shadow Banking 2.0?," as a question. There is already abundant evidence that DeFi mirrors and magnifies the fragilities of the shadow banking innovations that resulted in the crisis of 2008; the question is whether policymakers will allow DeFi to grow and become sufficiently integrated with the established financial system such that it can cause widespread harm. This Article argues that such an outcome is not inevitable. Policymakers should take a precautionary approach to DeFi regulation, limiting the use of DeFi where financial regulators are able to exercise jurisdiction and then cordoning off whatever DeFi remains from the established financial system and real-world economy.

This approach will admittedly limit innovation in the DeFi ecosystem, but not all innovation is good innovation. If the risks of innovation outweigh any possible benefits it might deliver, then preventing that innovation is good public policy. In this context, it is important to understand that DeFi is not intended to provide new types of financial products or services--generally, it just aspires to deliver existing financial products and services in a decentralized way. (13) Given that decentralization is an entirely unrealistic goal, we are left with technology that may be interesting from an academic perspective (14) but in practical terms is inefficient in its complexity (and as a result, does not respond well to the needs of those who are underserved by our existing financial system). As such, policymakers would serve us well by taking preemptive steps to prevent the growth of Shadow Banking 2.0.

This Article will proceed as follows. Part I will provide an overview of Shadow Banking 1.0, with a focus on the fragilities of credit default swaps, mortgage-backed securitizations, money market mutual funds, and their contributions to the financial crisis of 2008. Part II will describe how the key fragilities Shadow Banking 1.0 created (namely increased complexity, leverage, rigidity, and susceptibility to runs) will be present, and sometimes magnified, in a DeFi ecosystem built on distributed ledgers, tokens, smart contracts, and stablecoins. Part III argues that the correct regulatory response to these fragilities is not to provide incomplete regulatory fixes to DeFi's individual fragilities but to stop the DeFi ecosystem from growing and integrating with the established financial system. While this kind of regulatory approach will limit innovation, Part III argues that DeFi is not particularly decentralized or efficient and does little to further financial inclusion and that limiting this kind of innovation is, therefore, a good policy outcome.

1. SHADOW BANKING 1.0

   Following the financial crisis of 2008, a significant amount of academic and policy work was done on "shadow banking." (15) Generally speaking, shadow banking describes financial activities that are the functional equivalent of activities carried out in the regulated banking system, but which escape bank regulation. (16) Around the time of the crisis, shadow banking included "such familiar institutions as investment banks, money-market mutual funds (MMMFs), and mortgage brokers; some rather old contractual forms, such as sale-and-repurchase agreements (repos); and more esoteric instruments such as asset-backed securities (ABSs), collateralized debt obligations (CDOs), and asset-backed commercial paper (ABCP)." (17) Because they facilitate new forms of leverage outside of the banking system, (18) credit default swaps are also considered part of the shadow banking system. (19) This Part of the Article will use credit default swaps as well as money market mutual funds and mortgage-backed securitization (a particular type of asset-backed securitization) to illustrate some of the fragilities that this generation of shadow banking introduced into the financial system.

   Although these forms of shadow banking differ in many respects, one thread that unites them is their complexity, which is a destabilizing force in and of itself. Complexity can make financial products--and their possible interactions with the broader financial system--harder to understand, increasing the chance that risks will go unanticipated. (20) Even if risks are anticipated, complexity-induced opacity increases the chance that such risks will be underestimated in good times (causing bubbles), and overestimated in bad times (making panics worse). (21) More generally, there is a whole discipline of complexity science that explores how increased complexity makes systems more fragile (particularly by obscuring how steps that are taken to make individual system components more robust can end up transmitting problems with those components throughout the broader system). (22) Increased complexity writ large is certainly part of the shadow banking story: this Part will explore the particular types of complexity inherent in credit default swaps, mortgage-backed securitization, and money market mutual funds.

   1. Credit Default Swaps

      In finance, "leverage" refers to using debt to acquire financial assets. (23) Bank loans are perhaps the most familiar and simple form of debt: investors--including other financial institutions--can use the money they borrow from banks to increase their exposure to the assets they want to invest in. (24) Another familiar form of leverage entails investors borrowing some of the purchase price for an asset from their broker, which is known as trading on margin. (25) Leverage can multiply profits, but when an investor only puts down a little bit of their own money to buy an asset and borrows the...