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DeFi's Original Sin

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DeFi's Original Sin

Banks before Central Banks

0xHamZ
May 17, 2022
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DeFi's Original Sin

0xhamz.substack.com

Banking vs Central Banking

Crypto’s root use case as a hard money substitute has fixated the community’s attention around central banking and money

History teaches us that the arc of financial development is to do banking before central banking

The Federal Reserve was established in 1913 or ~140 years after independence

In that time the U.S. successfully financed railroads, real estate, wartime weapons, ships via banking channels without a central bank

In the U.S. Civil War era – banks operated as private businesses that issued their own money native to the community

The notion of a central bank was underpinned by Walter Bagehot in the 1873 classic Lombard Street

Bagehot centered the central bank use case as “lending freely against good collateral at a penalty rate”

The modern derivation of this is the so called “lender of last resort”

Central banks were meant to be a backstop – not a faciliatory of economic affairs


Defi Today

Right now there is limited real world utility across any of the crypto stablecoins

Most DeFi is leverage folding chasing its own tail

This can be shown w/ the velocity of money in ETH over time

DeFi yields come from arbitrage price differences / demand for speculation

DeFi is a prime beneficiary of the liquidity lottery played by central banks

But in bear markets with dampened volatility borrow utlization shrinks

We see this today as TVL and USDC/USDT market caps have shrunk dramatically

As the cost of money soars and liquidity tightens utility will need to be centered around real world applications


Banking Framework

Banks borrow short and lend long

This transformation of time is the key use case in earning a fair liquidity premium

The DeFi community talks about overcollateralized / undercollateralized / algorithmic models

But few seriously discuss actual banking

Let’s use an example with DAI

I have $100mm in deposits and I make a $100mm loan

If my cost of liquidity is 4% and my loan is 8% I make 4%

In one year I book $4mm in equity – in 2 years I book $8mm

Loans in this construct creates a profitable, collateralized bank

Overcollateralized lending is just an on-chain pawn shop

Undercollateralized lending is subject to confidence, panic bank runs that are highly visible on-chain


Implicit Debt Ceilings

The biggest hurdle to creating an on-chain bank is the implicit debt ceiling from liquidity pool drainage

Let’s say MakerDAO lends $100mm DAI to Walmart

Walmart has no use for DAI given its payroll / purchase orders are denominated in USD

So Walmart would swap DAI into USDC and transfer it to Coinbase and redeem USDC for USD

Walmart may just to borrow DAI because it has a lower rate than a USD alternative and has an implicit fragility option

Therefore an on-chain bank’s loan book can only scale with it’s liquidity pools

Nobody would borrow $100mm of DAI if there is only $50mm of exit-to-USD liquidity

The debt ceiling problem can be managed by

  • Creating use cases to hold DAI

  • Issuing a form of DAI that is not convertible over a period of time

  • Locking in defined liquidity over a period of time

  • Confidence / resiliency growth whereby DAI is equivalent to savings

Developing actual use cases for someone to hold DAI means MKR can mint DAI and create loans without creating liquidity pool strains

The debt ceiling problem means banking cannot grow without sturdy deposits

With mercenary, yield seeking capital we cannot build an efficient on-chain bank


Savings-As-A-Service

The prime use case for a stablecoin is something you wouldn’t appreciated unless you’ve lived in a non-OECD country

Much of the non-OECD world experience degradation of savings denominated in local currency

This is due to the political failures in reducing fiscal/current account deficits

Countries use inflation as a coordinated playbook to devalue savings and lower borrowing costs

The largest borrower in any country is the government itself

That’s why we see robust dollarization in emerging markets

Having the ability to save in USD in Turkey gives you access to labor-time destroyed by inflation and bank failures

But access dollars is not easy and has high friction costs

Official USD rates are manipulated by governments

DeFi in this lense has a use case as a global savings account that can exist in countries without the presence of branches or institutions

There is no JP Morgan in Liberia

DeFi becoming a savings technology for non-OECD countries allows on-chain banks to have sticky deposits

Sticky deposits mean less mercenary liquidity and higher interest margins on loans

On-chain banking has a captive liquidity layer


Some Ideas for On-Chain Banking

Building an on-chain bank requires sturdy liquidity which I believe can be tapped into from onboarding hard currency demand from non-OECD countries

But there are other areas in DeFi that need significant improvement

  • DeFi needs a yield curve - almost all activity is spot

  • On-chain banking may mean significant liquidity needs to be locked/non-redeemable primitives

  • Borrow/lend tools need to be advanced via loan servicing and on-chain indentures

  • Credit originiation in real markets like strcutured credit, commerical real estate

On-Chain Banking End Game

The end game of on-chain banking is simple

  • On-chain banking is cheaper given cost structure

  • Immediate payment / settlement

  • Tokenization allows for borrow/lend incentives not possible today

Here is a relative comparison of key KPIs of JP Morgan vs MakerDAO

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DeFi's Original Sin

0xhamz.substack.com
4 Comments
Recovering TradFi Chad
Writes Recovering’s Newsletter
May 18, 2022

Excellent post, thanks!

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