The newsletter from Charlie Warzel’s newsletter had an interesting headline last week: “Is Crypto Re-Creating the 2008 Financial Crisis?” The
The piece was about the rise of decentralized finance (Defi), a catchall term for the new wave of crypto projects and protocols that are built on Ethereum and that promise to upend traditional financial services.
As Warzel notes, the growth of Defi has been staggering, and as it turned out the title was a rhetorical question. Charlie Warzel interviewed Hilary J. Allen, an American University law professor. In the interview, she discussed her recently published paper which argued that decentralized finance is repeating the mistakes of “shadow banking”, the phenomena that preceded the financial crisis of the late 2000s. Allen’s paper, which is co-authored with Joanna Green, a Wharton School professor is called “Defi Is the New Subprime: Lessons From 2008 for Decentralized Finance.”
In the interview, Allen argues that Defi is a repeat of the 2008 crisis because it is based on the same model of shadow banking. Shadow banking is the practice of using debt to finance activities that are not regulated by traditional banking laws. This includes things like hedge funds, private equity, and venture capital.
In the paper, Allen and Green argue that Defi is shadow banking because it is based on borrowing and lending outside of the traditional banking system. Allen’s thesis is that the With high levels of complexity surrounding DeFi’s innovative new mechanisms for borrowing, lending, insurance, and payments. There is a glaring lack of clarity around the looming risks that credit default swaps (CDS) and collateralized debt obligations (CDOs) fostered during the pre-financial-crisis real estate bubble.
Allen writes that “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),”.
Allen isn’t the only one with this opinion. Independent researcher Hasu has also argued that the growth of Defi is reminiscent of pre-crisis conditions. In a recent blog post, he wrote that “the explosive growth in synthetic assets and derivatives” is leading to a “situation eerily similar to the pre-crisi”.
The overwhelming difference between Defi innovators in the 2020s and those of Wall Street in the 2000s is that the latter – the bankers – operated within an all-encompassing political framework that the former – the crypto developers – are untouched by. Bankers had the power to create new money through fractional reserve lending, with privileged access to the Federal Reserve’s liquidity. They had the power to buy and sell government debt, with the implicit understanding that bailouts would always be there if things went wrong. They had the power to influence elected officials through their ownership of the media and their campaign contributions. They had the power to change laws in their favor. In short, they had captured the state.
The crypto developers, by contrast, are completely outside of the existing political framework. They are not beholden to anyone and they have no vested interest in preserving the status quo. Their only interest is in building new protocols and applications that will improve upon existing ones. This makes them a much more radical force for change than anything we’ve seen before.
So, while it is possible that Defi is a repeat of the 2008 crisis, it is more likely that it represents something entirely new. The old guard has been thrown out and the new guard is just getting started. There is no telling what they will build or how high they will take us. But one thing is for sure: the world will never be the same.
What do you think? Is Defi a repeat of the 2008 crisis or something entirely new? Let us know in the comments below!