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.
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 are 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 When investments go bad, or deposits are withdrawn at abnormally high amounts, the bank faces a liquidity crisis, which can cascade throughout the market and cause panic.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 the risky investment of deposits but from commissions on efficient decentralized matching, analogous to the matching function of apps such as Uber or Tinder.
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.
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.
