Defi and Shadow Banking 2.0

Leverage, rigidity and bank runs.

14 year ago, the world’s financial system came to the brink of collapse. Central banks scrambled to react. Businesses shuttered. People lost their homes. Many governments fell. Faith in our institutions shattered. The Occupy movement was launched. So was Bitcoin.

What brought on the Great Financial Crisis? The “shadow banking system” — a system of unregulated financial activities that are just like their regulated cousins, except that they’re, well, unregulated. The GFC was precipitated by “financial innovation”: new tricks that allowed traditional financial activities to take place while evading the controls instituted to head off the kinds of systemic collapses that plagued nations for centuries.

The shadow banking system’s “innovations” produced three effects:

I. Leverage: regulated banks must place limits on how much their customers can borrow and gamble with. “Credit swaps” allowed for effectively unlimited leverage, so that every routine transaction in the real economy could result in fortunes changing hands in the shadow banking world.

II. Rigidity: To reduce the risk presented by this over-leveraging, shadow banks created brittle, rigid contracts that dictated automatic sell-offs or margin calls when certain things took place. In…