Shadow Banking 2.0 in Web3 and DeFi (Feat. Hilary Allen) – Crypto Critics' Corner
Today Cas and Bennett are joined by law professor at American University Hilary Allen to discuss whether or not web3 and DeFi are shadow banking 2.0, and if they will lead to another 2008 financial crisis. Hilary's paper available here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4038788 Read more: https://cryptocriticscorner.com/2022/10/27/episode-97-defi-as-shadow-banking-2-0-feat-hilary-allen/ This episode was recorded on August 3rd, 2022 and edited by Griffin Davis.
Today Cas Piancey and Bennett Tomlin are joined by law professor Hilary Allen to discuss whether or not DeFi is Shadow Banking 2.0
This episode was recorded on August 3rd, 2022.
Other episodes mentioned in this episode:
- Episode 71 – Terra, Luna, and Algorithmic Stablecoins
- Episode 72 – We Never Want to Discuss Terra and Luna Again…and yet
- Episode 83 – Contagion and Cascading Liquidations in Cryptocurrency
- Episode 16 – Stablecoins, CBDCs, and the STABLE Act with Rohan Grey
- Episode 12 – Regulatory Capture and Regulatory Arbitrage: Sleeping with your Enemy
Other resources mentioned in this episode:
Where to find Crypto Critics’ Corner:
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- Cas’ Twitter
- Bennett’s Newsletter
- Cas’ Blog
- Bennett’s Blog
- Bennett’s YouTube
This episode was edited by Griffin Davis.
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00:00:05:06 - 00:00:12:10 Cas Piancey Welcome back, everyone. I am Cas Piancey and I'm joined, as usual by my partner in crime, Mr. Bennett Tomlin. How are you today? 00:00:13:06 - 00:00:14:13 Bennett Tomlin I'm doing well, Cas. How are you? 00:00:14:22 - 00:00:26:09 Cas Piancey I'm doing good. We have a very special guest, Professor Hilary J. Allen, who is a professor of law at American University, Washington College of Law. Welcome. And how are you, Hilary? 00:00:26:24 - 00:00:33:13 Hilary Allen I'm doing well. I mean, the world is a dumpster fire, but otherwise I'm doing. 00:00:33:24 - 00:00:53:12 Cas Piancey So we wanted to talk to you about a paper that you wrote about Defi essentially being a shadow banking 2.0. It's called DFI Shadow Banking 2.0. Yeah. Your proposition is that it could be. And will it be? So to start out, I want us to kind of define shadow banking. Can you talk to us about that a little bit? 00:00:53:22 - 00:01:13:05 Hilary Allen Shadow banking has for a long time been used to describe financial services that are the functional equivalent of traditional banking services. But they're done in a way that avoids at least some, if not all, of the regulation that would typically apply to those banking services. 00:01:13:17 - 00:01:42:04 Cas Piancey So people, when they talk about it in normal terms, when they talk about shadow banking, we think of insurance firms, pawnshops, cashier's checks, check cashing, payday lending, currency exchanges and micro loan organizations. But in your paper, you include a few things that I don't think are necessarily associated with it, which are credit default swaps. So anyone who's familiar with 2008 real estate crisis, the overall financial crisis, mortgage backed securities, again related to that. 00:01:42:04 - 00:01:48:08 Cas Piancey And then money market funds. So you're including all of these things that I think aren't necessarily normally associated with. 00:01:48:08 - 00:02:12:08 Hilary Allen That, which are highlighting is that, you know, like so many things, this term means different things to different people because the way I'm using this term is actually very common if you're talking to central bankers or financial regulators, etc., because they really thinking about sort of the building blocks of the 2008 crisis, how those products did the same thing as traditional banking services, but were outside the banking perimeter. 00:02:12:19 - 00:02:36:14 Hilary Allen It is not an unusual usage at all for that world, but as you say, like there is other people who are thinking about this perhaps more in the sort of financial inclusion, consumer protection, you know, predatory inclusion space, who might be using it to talk about things like pawnshops and check cashing, etc.? Anyone who was around in 2008 will know exactly what I'm talking about. 00:02:37:00 - 00:02:47:03 Cas Piancey Well, yeah, I guess I'm wondering if you're referring simply to the complexity of these concepts, if you're talking about the leverage of these concepts, both if there's other aspects to this. 00:02:47:13 - 00:03:09:05 Hilary Allen There are, you know, many angles at which you can sort of worry about shadow banking. One is just sort of the pure regulatory arbitrage aspect of it, right? That you're doing something that we've regulated for a reason from past experience and you're managing to do it without regulation. And why is it regulated for a reason within the banking system? 00:03:09:06 - 00:03:35:02 Hilary Allen Well, part of it is because we've discovered, learned through grievous trial and error over many centuries, that too much leverage in the financial system makes things fragile, makes things more vulnerable to booms and then more vulnerable to busts. And then when those busts happen and people start selling off their assets, that depresses asset prices system wide, which causes more people to deleverage, etc.. 00:03:35:02 - 00:04:03:23 Hilary Allen So that's a well-known sort of cycle. And so leverage is something that we we regulate in banking regulation. And if we see shadow banking that's trying to create that leverage, which can be very profitable on the upside but has major sort of negative consequences on the downside if we're finding ways to do that outside of the regulation that applies to leverage that, that's cause for concern. 00:04:04:15 - 00:04:25:10 Hilary Allen A couple of things that I highlight in the paper is in addition to leverage, some things are susceptible to runs. So, you know, we know about bank runs. They've you know, they've been around for hundreds of years. Banks have this what we call like a maturity mismatch, right? They take deposits from you and then they loan those out. 00:04:25:15 - 00:04:47:21 Hilary Allen You can ask for your deposit back at any time. The bank can ask for you to repay your 30 year mortgage tomorrow in order to give you your deposit back. So that leads to this sort of fragility when people start to panic and all want to get their money out at once, then the bank has to start selling off its assets at a discount and that can put make the bank insolvent again. 00:04:47:21 - 00:05:11:11 Hilary Allen That run dynamic is something that's really well known and has been addressed by banking regulation for a long time. We've had deposit insurance since the 1930s to discourage people from taking their money out of banks. But that run dynamic can happen any time you have this mismatch between sort of short term liabilities and sort of long term obligations. 00:05:11:14 - 00:05:40:02 Hilary Allen In the paper I also talk about, and these are probably less commonly talked about in the context of shadow banking, but there are things that really worry me. One is rigidity, this idea that we need flexibility to deal with uncertainties, updated circumstances. And when you start to structure banking equivalence in certain ways to avoid regulation, sometimes you make them really inflexible. 00:05:40:02 - 00:06:07:05 Hilary Allen And we saw that with mortgage backed securities. And that flexibility to renegotiate or to allow for government intervention can be critical in a crisis. So that's something that I'm worried about. And I'm also worried about something you you mentioned already, which is just complexity. It's just just writ large. So complex systems are more fragile. The more complex something is, the more likely it is that something and anticipated will go wrong. 00:06:07:05 - 00:06:36:17 Hilary Allen When people are structuring banking equivalence to be outside of the regulated perimeter, they usually have to take some complex steps to do that, to, you know, to avoid the regulation. The problem is that that complexity makes everything more fragile. And you couple that with the rigidity and we're in for a bit of a mess. And these were all dynamics that came to sort of head in conjunction with each other runs excess leverage, rigidity, complexity. 00:06:37:05 - 00:06:38:00 Hilary Allen In 2008. 00:06:38:14 - 00:06:56:22 Bennett Tomlin You mentioned the run dynamics there. Could you talk a little bit about some of the things that incentivize people to start using some of the money market funds? And then what contributed, like in the case of the Reserve Primary Fund to the run on the bank? Not really a bank, but the shadow bank. Yeah. 00:06:56:22 - 00:07:21:18 Hilary Allen So as I said, like we've known about bank runs for a long time, it comes down to this classic sort of game theory calculation. Right? A bank probably has enough assets to pay back all the depositors, but if it doesn't, and you can't be sure that it does, then you want to be in line first because then you're more likely to get paid in full. 00:07:22:20 - 00:07:41:15 Hilary Allen So people are incentivized to get to the front of the queue, start pulling out their assets, and then that creates the self-fulfilling prophecy, where then the bank does start selling off its assets at a discount, and then there really isn't enough to go around, whereas there probably would have been if everyone had just sort of stayed put. And that's the idea behind deposit insurance. 00:07:41:15 - 00:07:48:10 Hilary Allen If people know that the government is there to back their deposits, that incentive to get first in line that goes away. 00:07:48:12 - 00:07:59:28 Bennett Tomlin Well, in the example of 2008, the Federal Reserve did basically end up stepping in to cover these uninsured deposits because they were worried about the consequences of that going through to its end. Right. 00:07:59:29 - 00:08:23:27 Hilary Allen Right. So so, I mean, deposit insurance is not, you know, complete. It's only up to a certain amount for per account. But deposit insurance doesn't exist at all for money market mutual funds that kind of perform a similar function. So you buy a share in a money market mutual fund that share the value of that share ultimately depends on what the fund has invested in. 00:08:23:27 - 00:08:50:20 Hilary Allen In the fund invests in, you know, high quality liquid assets and the sort of assumption that that will always be enough to support the $1 per share price and people want their their money market mutual fund shares to be worth a dollar. That's why people buy them in sort of a cash management tool where if you're sort of sweeping funds between your different investment portfolios, it's a place where you can sort of have a stable dollar per share value. 00:08:50:28 - 00:09:13:16 Hilary Allen The portfolio that the money market mutual funds always invested in is always going to fluctuate in value. But they have a special accounting treatment that allows them to keep their share at a dollar per share. But that accounting treatment is only available within boundaries. So if the, you know, the price of the portfolio goes down too far, you quote unquote break the buck and you have to tell people your shares are no longer worth the dollar. 00:09:13:28 - 00:09:40:23 Hilary Allen That's what happened with the Reserve Primary Fund. Not only did its investors start panicking, investors in money market mutual funds generally started panicking. And as you alluded to before, the government craft and by the government means and the Treasury Department and the Fed crafted a bunch of emergency measures that essentially worked like retroactive deposit insurance, even though money market mutual funds are not insured. 00:09:41:04 - 00:09:49:26 Bennett Tomlin And if I remember right, it was a relatively small exposure to Lehman Brothers commercial paper, like less than 5%. That ended up being enough for them to break the bank. 00:09:50:03 - 00:10:12:15 Hilary Allen Yeah, that's right. It's worth highlighting that, you know, when everything shook out, I believe the shares in the money in the Reserve Primary Fund were sort of still worth about $0.97. Right. So this isn't like you're losing your shirt. But the fact of the matter is, when people expect to have a stable value, even a small deviation from that value can cause them to panic. 00:10:13:00 - 00:10:19:10 Bennett Tomlin On that note, can you kind of start to outline some of the similarities you see between this type of shadow banking and defi? 00:10:19:23 - 00:10:50:05 Hilary Allen Sure. Well, the most obvious comparison is money market, mutual funds and STABLECOINS. As I'm sure your listeners are aware, there's a bunch of different types of stablecoins. There is the sort of the quote unquote algorithmic stablecoins like Tara that have nothing backing them. There is no reserve but for other types of stablecoins like tether or usdc, they at least purport to have reserves fully backing their stablecoins. 00:10:50:25 - 00:11:15:00 Hilary Allen So in many ways that looks an awful lot like a money market mutual fund. So there are some differences. One is that there isn't a sort of a formal break. The buck mechanism, right? So there's no requirement that the stablecoin issuer, it has to tell you when their reserves gotten too low. In fact, frankly, the reserve, the Stablecoin issuer doesn't have to tell you anything about their reserve. 00:11:15:00 - 00:11:43:24 Hilary Allen And there are a lot of questions about whether it tether is reserve in particular supports the value of tether. Another difference is that if you have a share in a money market mutual fund, you have a contractual right to go to the fund and say, I want to redeem my share for cash. If you own a stablecoin and you are a little fish, you do not have that right to go to the Stablecoin issuer and say, you know, I want Fiat back for my stablecoin. 00:11:44:00 - 00:12:09:03 Hilary Allen You're basically at the mercy of an exchange. Their willingness to basically trade it for fiat on a particular value. If you are a big fish, then you may have special contractual rights with the stablecoin issuer that does allow you to redeem. And so you can have runs on Stablecoins because the big fish and that's something that all over the world regulators are looking at. 00:12:09:14 - 00:12:34:20 Cas Piancey I think it's worth pointing out that you wrote this paper in February of where you published this paper in February of 2022. And we've already seen a few of the ideas that you proposed as possibilities for runs and issues in the system play out. The one that I immediately was drawn to was this mention of a trusted intermediary failing to do their duty. 00:12:34:29 - 00:13:03:22 Cas Piancey And I immediately thought of Terra Luna and 3AC and this kind of confluence of three individuals or whatever. I guess we can include a few other people, but mostly it just about three people who controlled this. Vast swaths of assets in the system and their ability to overleverage caused this massive run throughout the entire system. And like you just said, the people who were hurt the most were the small fries. 00:13:03:23 - 00:13:07:06 Cas Piancey Like it's not SBF who's hurting right now or anything like that. So. 00:13:07:16 - 00:13:35:16 Hilary Allen Well, to be clear, this actually hasn't been published yet because the way law reviews work is that they take many, many months to publish something. But I first posted the draft in February. You are correct that a lot of the things that I sort of suggested might happen did. And frankly, for anyone who's familiar with history of previous financial meltdowns, problems, etc., it's sort of not hard to see this coming. 00:13:35:16 - 00:13:59:04 Hilary Allen So I mean, you know, I'm a little more steeped in that than most. I, you know, I worked with the Financial Crisis Inquiry Commission. I've done a lot of research on the the 2008 crisis. None of that was a surprise to me. So when I first put this paper out there, it was before the crypto winter, and I came in for a fair degree of criticism from the crypto community. 00:13:59:04 - 00:14:20:10 Hilary Allen People would say things like, Well, you know, there's no leverage in the crypto system, therefore it's safe and it's like, you know, and the idea, you know, what you would hear was that, well, everything's collateralized, so therefore there's no leverage. For something to be over collateralized, you sort of have to have a good idea of what the collateral is worth, right? 00:14:20:10 - 00:14:38:04 Hilary Allen You need to know, you know, vis a vis the loan. And when the collateral is a super volatile asset that can go to close to zero very quickly, then you can have posted a lot of collateral and it can still be under collateralized and there can be a lot of leverage in the system. So, you know, we saw that play out. 00:14:38:08 - 00:15:12:09 Hilary Allen Another thing point that I make in the paper quite stridently is that Defi is not decentralized. You know, at every layer you're trusting a few people. And that's even putting aside the you know, there are intermediaries that fully admit to being centralized, like certain exchanges, etc., like Coinbase doesn't say it's decentralized or something like Terra Luna. The claim was that that was decentralized and you know, the governance was clearly being you know, it was all in the hands of Do Kwon. 00:15:12:09 - 00:15:37:19 Hilary Allen And I think it was criticized for suggesting that these things weren't decentralized. And I think that played out very clearly over the crypto winter. So if you look at what you know as Terra Luna was tanking, you know, everybody's hanging on every tweet from Do Kwon is arranging a special bailout facility for Terra Luna, which ultimately again only benefited the whales and not the small people. 00:15:37:20 - 00:16:03:06 Hilary Allen So, you know, I felt pretty vindicated on that point. And it's something that I find interesting is now this idea of centralized versus decentralized has turned into something of like a purity test in the context of the crypto winter. So anything that failed is besmirched as well. Well, it was centralized all along and I agree it was centralized all along, but so was all of it. 00:16:03:12 - 00:16:08:27 Hilary Allen Some of the rhetoric we hear now is, well, the decentralized stuff will survive and be fun. And I'm like, None of it's decentralized. 00:16:09:22 - 00:16:38:18 Bennett Tomlin Two of the other attributes of shadow banking you draw attention to in your paper that we mentioned are rigidity and leverage. How do you see those two factors as being present in DEFI, despite the claims of there being no leverage? Which just pausing for a moment is an absurd claim to hear someone say about cryptocurrency and defi. We've talked before fundamentally like even Makerdao's Dai, the stablecoin is like adding leverage into the system at a very basic level, and that's one of the best actors in this. 00:16:38:18 - 00:16:44:05 Bennett Tomlin And that hearing that people are making that claim is by itself somewhat humorous to me. 00:16:44:25 - 00:17:09:28 Hilary Allen A point I make in the paper was that if you go back to 2008, credit default swaps were a new way of creating leverage in the system and it was sort of allowing a lot of people to bet against one underlying asset, against the underlying bond or note or whatever the debt instrument was that was referenced. So that really multiplied the amount of leverage in the system. 00:17:09:28 - 00:17:40:24 Hilary Allen But ultimately, you know, leverage was constrained just a little bit by the fact that it had to be tied somewhere to a real world asset. So even if we're constructing, you know, synthetic CDOs squared, which are essentially a securitization of credit default swaps, referencing mortgage backed securities is made from a diversified pool of, you know, mortgages somewhere. There were mortgages somewhere. 00:17:40:24 - 00:18:03:17 Hilary Allen It was it was a tortured exercise, but there were mortgages somewhere. The difference with crypto is that a digital asset is a computer file and there is an unlimited supply of them. So, you know, rather than torturing ourselves, you know, in terms of finding ways to get exposure to one particular asset, now you can just have an unlimited supply of assets to borrow against it. 00:18:03:17 - 00:18:26:18 Hilary Allen And, you know, to be clear, you've got to find someone who's willing to lend to you against that. So it's not completely unlimited, but when the market's frothy, there's an unlimited supply of things to to lend against. That, I think, is a major multiplier of leverage in the system. With regards to rigidity, I mean, smart contracts are what we're talking about here. 00:18:26:19 - 00:18:50:00 Hilary Allen So, you know, I talked about mortgage backed securities being made rigid in the lead up to 2008. That was through legal contracts that, you know, made it harder for these claims to go into bankruptcy where, you know, there is some flexibility and some reorganization. And it made it, you know, having all these contracts securitized, made it harder to renegotiate those mortgages in the first place. 00:18:50:00 - 00:19:14:24 Hilary Allen So, you know, we've got a lot of rigidity. And because of the inability to rejig things as uncertain circumstances arose, it became hard to value these assets because how do these assets work in this new world that they weren't designed for? How do we value that? So rigidity can be a problem and smart contracts take that to the next level. 00:19:14:24 - 00:19:52:06 Hilary Allen Right. Because, you know, those were paper contracts back in 2008. Now we're talking about computer programs that are intended to execute immediately, you know, not allowing any time for adjustment, etc.. There are things you can do to make smart contracts more flexible. You can have them consult with oracles, you can have them reference other smart contracts, etc. But ultimately, if you haven't thought of something before you put it all together, there's no way to vary that. 00:19:52:13 - 00:19:59:17 Hilary Allen And so that really puts a lot of rigidity into the system. And when things go wrong, that's when you need that flexibility. 00:19:59:27 - 00:20:25:19 Cas Piancey One of the things that I immediately thought of tether liquidating Celsius, but now Celsius going to bankruptcy and people questioning whether that liquidation is going to be fulfilled essentially, or whether some of this can somehow get clawed back by people involved in this bankruptcy. You know, customers, secured creditors, unsecured creditors, all the likes of them. And it seems like nobody really has any idea yet what the end result of that is going to be. 00:20:25:19 - 00:20:43:00 Cas Piancey But I think that in a sense involves a bit of this rigidity. It's like, yeah, well, we we're going to margin call them their margin called, we took their money, now they're bankrupt. But we don't know now what the end result of this bankruptcy is going to be and whether Tether is entitled to. However much money they ended up. 00:20:43:10 - 00:20:46:11 Cas Piancey I think it was 1.2 billion in Bitcoin. 00:20:46:24 - 00:21:01:15 Hilary Allen So the good news about going into bankruptcy is it does allow for some discretion and some flexibility. The question is, has the ship already sailed? Has the damage already been done by things that executed before they could be stayed by the bankruptcy? 00:21:01:15 - 00:21:24:01 Bennett Tomlin On a different note, getting more into like how you think these things should be regulated. I was surprised to see someone with a well, largely stronger view and how Stablecoins should be regulated than I did. We've had Rohan Gray on the show before to talk about the Stable Act, which proposed bringing the Stablecoins and the rest of the money transmitters basically into the banking regime and under OCC review. 00:21:24:08 - 00:21:38:22 Bennett Tomlin But in your paper you seem to suggest that you think that these stablecoins are so fundamentally harmful that they shouldn't be allowed to be issued basically. Can you go into a little bit of what your thoughts are on regulation of Stablecoins in the rate? We did handle that? 00:21:38:22 - 00:21:59:07 Hilary Allen You know, Rohan and I have discussed this and I think, you know, we both think they're that they're harmful. I think Rohan view is they're not going anywhere. So let's bring them into the banking system. Where is my view is I think that there's a good chance that these things can implode on their own. So let's let them. 00:21:59:12 - 00:22:23:11 Hilary Allen Right. Let's not make stablecoins too big to fail. Let's not put the whole government guarantee apparatus behind them. You know, I mentioned that we have deposit insurance for for regular bank deposits that comes at a cost. So a bank can do something really risky knowing that if it pays off, it pockets the, you know, the gains. And if it doesn't, well, its depositors will be bailed out. 00:22:23:20 - 00:22:48:16 Hilary Allen I think that's worthwhile, even though we've created some perverse incentives there, because bank runs stop banks from doing the thing that society needs them to do, which is process payments and provide credit to businesses so that they can grow and mortgages to people so that they can buy houses, etc.. But that's a trade off. You have to ask, how does that tradeoff work with Stablecoins? 00:22:48:27 - 00:23:21:26 Hilary Allen What is Stablecoins fund? They fund crypto speculation, right? There's no real world economic payoff, really. It's very self-referential. So do we really want to put government guarantees and create all those perverse incentives for something that doesn't have real world applications? And, you know, I think a lot of the stuff that's being proposed on Stablecoins assumes that Stablecoins are used for real world transactions, and that's simply not the case. 00:23:21:26 - 00:23:39:21 Hilary Allen And people like, well, we'll get there, and I'm not sure that we will because stablecoins suffer from a lot of infirmities in terms of, you know, their technological plumbing is not great. I'd rather sort of hang them out to dry and see them combust on their own rather than bring them in and give them the benefit of the government safety net. 00:23:40:04 - 00:24:16:05 Cas Piancey I totally understand where you're coming from, but I'm wondering if the same kind of argument could be made for money market funds like the only time I'm ever invested in a money market fund is if I'm going to possibly be using that money in the future, essentially to gamble, right? To buy stock, I would assume, from in my brokerage fund or or what I as as a small time investor, as somebody who doesn't invest hundreds of thousands or millions of dollars at a time, I use those money market funds as a gambling mechanism, a way for me to store money briefly as a dollar derivative, and then I trade back into a stock. 00:24:16:05 - 00:24:21:27 Cas Piancey The only difference, I presume, would be that stocks are backing companies is that am I getting that right? 00:24:21:27 - 00:24:41:26 Hilary Allen Or that's one of the answers that I have to your you know, to your question, which is I don't consider stock market investing to be gambling in the same way that I think crypto investing is. I don't want to overstate this because I think the stock market is becoming increasingly untethered from reality, and I think that's a bad development. 00:24:42:09 - 00:25:07:23 Hilary Allen But, you know, ultimately investing in stocks is supposed to provide funds for corporations that engage in productive enterprise. And so if you know, we're talking about do we want to put government guarantees behind something, there's at least an argument to be made that we want to encourage investment in stocks in a way that I don't think we want to sort of encourage investment in crypto. 00:25:08:14 - 00:25:30:23 Hilary Allen But the other thing I would say is there's a lot of debate about how money market mutual funds should be treated. There's a lot of people that say that they shouldn't have been bailed out, that they should be allowed to fail. And maybe that is the right answer. I mean, other people say that, okay, if we're going to bail them out, we should bring them inside the banking perimeter and regulate them as such. 00:25:31:04 - 00:25:57:28 Hilary Allen And given the fact that, you know, investment in stocks is useful, I can see some merit to that. So I see merit in bringing them inside the banking system. I see merit in letting them just fail. But I think for for the stablecoins, because they don't fund any economic productive investment, I think they need to stay out in the let them fail world. 00:25:58:15 - 00:26:16:08 Bennett Tomlin So when you say let them fail, do you just mean wait naturally until there is an organic run on one of these stablecoins and let whatever collateral damage that has occur? Or do you mean like the SEC or CFTC choosing to pursue the issuers of these types of tokens. 00:26:16:20 - 00:26:39:00 Hilary Allen As he sees it? You see, the jurisdictional issues here are somewhat complicated. So I'm just going to put them aside for a second and just say like, you know, assume that like many other countries, we just had one financial regulator. What do I think they should be doing? It's stablecoins. I actually think a ban would be appropriate. And, you know, a lot of people say, well, you know, that's not feasible. 00:26:39:00 - 00:26:59:09 Hilary Allen And I disagree. A lot of stablecoins are issued by centralized issuers. You can just ban them from doing it and you can also ban the exchanges from listing them. And then, you know, that becomes a little more challenging when you're dealing with a decentralized issuer, like for Dai or if you're, you know, dealing with a decentralized exchange like Uniswap. 00:26:59:24 - 00:27:27:24 Hilary Allen But as I mentioned, they're not actually decentralized. You know, all of these things have either just straight up founders you could regulate or they have governance tokens. If you look at the concentration of the ownership in the governance tokens, it's very significant. You know, it's a founder and a couple of venture capitalists. So you can make it illegal to own a governance token in a stablecoin and you wouldn't have to enforce that against everybody. 00:27:27:24 - 00:27:50:08 Hilary Allen You just enforce it against the big fish and you know that that will shut it down. So I think bans on Stablecoins are feasible. I suspect that we're not going to see bans, even though I think they're a good idea. I guess then we get to the point that you mentioned where you just sort of let it combust from a run that is going to hurt some people, which is why I think a ban is better. 00:27:50:18 - 00:28:13:06 Hilary Allen There's investor protection concerns by letting these just sort of be out there. But I think first and foremost, I'm concerned with the people who aren't investing in crypto. They shouldn't have to pick up the tab or be hurt by a stablecoin implosion. And when you bring them inside the banking system, that's where you're potentially, you know, putting them on the line for how a stablecoin operates. 00:28:13:24 - 00:28:22:07 Bennett Tomlin Outside side of Stablecoins. What do you see as the important points of articulation or points to target in terms of crypto or defi regulation? 00:28:22:24 - 00:28:48:10 Hilary Allen So I mean, the thing I think is most critical is that there needs to be a separation of banking and crypto, right? That banks should not be able to invest in crypto, they shouldn't be able to issue crypto, they shouldn't be able to lend against crypto, etc., etc., etc.. So, you know, we've just come through this crypto winter and it's been rough for those in the crypto world, but there's been barely a ripple. 00:28:48:10 - 00:29:18:14 Hilary Allen And I shouldn't say we've come through crypto into crisis, we're still in it. But you know, there's been barely a ripple for the the real world economy or even the traditional financial system. A small market can have major implications if it becomes entangled with the traditional banking system. Right. You know, the subprime mortgage market was not that huge and yet had global repercussions because it was so intertwined with the the traditional financial system. 00:29:18:14 - 00:29:38:08 Hilary Allen And I think, you know, the banks were borrowing against these kind of assets, etc.. So that's what I think needs to not happen. Right? That's what's critically important that we have the separation of banking and crypto because then as I said, crypto can sort of be and not just stablecoins, but you know, crypto in general can be left to sink or swim on its own. 00:29:38:13 - 00:29:52:12 Hilary Allen And so, you know, to to draw the analogy with 2008, it was when banks got intertwined with shadow banking that we had a real problem. And so banks need to be kept separate and apart from from Defi and any other crypto asset. 00:29:53:09 - 00:30:03:18 Bennett Tomlin One of the things you discussed in your paper was a possible licensing regime. Do you still think that is a good way to go about regulating these types of assets? 00:30:04:04 - 00:30:27:11 Hilary Allen So I think this is interesting, but there is a sort of a broader question that's raised about all of this, which is, you know, how do we deal with new financial innovation? Do we just do we let it just run right? Or do we think about it from the beginning and, you know, maybe take some steps to push back against the dangers? 00:30:27:27 - 00:30:59:10 Hilary Allen And it's can be hard at the beginning to figure out what the dangers are. But we don't let other technology just run riot. Right. You know, we don't have self-driving cars on our streets right now in the name of innovation. There should be some guidelines around financial, technological innovation, period. And if we're not going to ban, you know, stablecoins and, you know, this is a sort of a lesser version of that. 00:30:59:10 - 00:31:20:22 Hilary Allen Let's let's think about whether these are the types of things that are worth, you know, what what did they bring to the table that maybe justify us allowing them what is their economic use case? What can they do that can't already be done with what we have? And I think you need to ask about the capacity of the people issuing these things. 00:31:21:03 - 00:31:38:00 Hilary Allen Do they have both the financial and the tech chops to be doing this? Because often you see they have sort of one or the other and not both. And this is a space where you need both and then you need to start thinking more broadly about the systemic effects. And that's a more sort of complicated set of judgments. 00:31:38:00 - 00:31:51:15 Hilary Allen But, you know, if if we don't even have, you know, an economic use case that this does something that you can't already do in another way that is less complicated and therefore less fragile, why even allow it? 00:31:52:16 - 00:32:33:00 Cas Piancey We've seen like a pretty steady decline in the overall market capitalization of Stablecoins in general. I think it's down to like roughly $150 billion right now. I presume you don't think there's any real risk to the economy at large for that? Now, are you proposing this paper because you foresee that there could be a lot more risk in stablecoins and decentralized finance in the future because of another term you mentioned, which surprisingly, I don't know how often we've ever discussed this on the show, but regulatory arbitrage, like, do you think that is what is occurring here? 00:32:33:10 - 00:33:01:06 Hilary Allen I think DEFI is literally regulatory arbitrage. You know, you are providing equivalence of banking services in a way that you don't have to comply with things like capital regulation that limit your leverage, etc.. There is money to be made if you can provide services without having to comply with the regulation. And there is money to be made for traditional banks by shifting some of their, you know, activities into less regulated spaces. 00:33:01:21 - 00:33:15:27 Hilary Allen So that's why my concern really is about whether the banks get into this space. And so that's we come back to my sort of what I view is the most critical regulatory proposal, which is a separation of banking and crypto. 00:33:17:00 - 00:33:25:02 Cas Piancey But essentially what I'm hearing is this idea that like the fear of institutions and banks being like, well, we can regulatory arbitrage now. 00:33:25:16 - 00:33:48:17 Hilary Allen Which happened in 2008. Right. The banks, you know, they were making their loans and then selling them off and those loans were being packaged into mortgage backed securities. And then the banks could buy back the mortgage backed securities. So they would have exposure to the same loans that they initially made, but they didn't have to hold capital against them or as much capital against them anymore because they weren't just straight loans on their books. 00:33:48:17 - 00:33:55:06 Hilary Allen So it's not just, you know, shadow banking for non-banks. Banks play the shadow banking game. 00:33:55:06 - 00:34:23:20 Cas Piancey To my overall understanding of of 2008 and boils down to a couple of books and a few movies. I wonder how long you know, CDOs, CDOs, all these mortgage backed securities and overleveraging. I know these concepts existed for decades before this issue presented itself in the way it did. But how long did it take for institutions to get like neck deep in it? 00:34:23:20 - 00:34:30:06 Cas Piancey Was this over the course of like a year or two that it got like way over the top, or was this like a decade long process? 00:34:30:20 - 00:34:49:23 Hilary Allen So first of all, I would say if one of the movies you watched was the Big Short, then you're good because that's a really good background in all of this. But, you know, there's different ways of viewing it. Like some people will tell you that all of this started in the 1970s, which is when you started to see deregulation of certain financial services. 00:34:50:05 - 00:35:19:29 Hilary Allen Other you know, people will say that this really came to a head during the nineties when the swap market was developing. And then in 1999, we allowed banks to affiliate with different kinds of non-bank financial firms. And then in 2000, we passed a law saying that regulators weren't allowed to regulate swaps because they were this magical innovation that we shouldn't touch because it's going to revolutionize finance. 00:35:20:12 - 00:35:40:22 Hilary Allen And if that sounds familiar to you, it sounds familiar to me, too. We're seeing that same rhetoric. So all of those are sort of steps along the way. But I think the really deep exposure to these subprime mortgages in all these convoluted shadow banking type ways really happened. It started happening in the in the 2000. 00:35:41:19 - 00:36:02:20 Cas Piancey So the suggestion is it ramped up quickly. And I guess I'm wondering if obviously there is that possibility, perhaps that possibility is much lower now because banks were burned so hard in oh seven and eight that there is a bit more of a conservative. I mean, we know that like JPMorgan talked smack about this stuff all the time. 00:36:03:00 - 00:36:06:23 Cas Piancey Do you think they would be quick to just be like, all right, we were wrong, let's go? 00:36:07:00 - 00:36:10:15 Hilary Allen Well, what do you mean by JPMorgan talks smack about this stuff? 00:36:10:17 - 00:36:20:10 Cas Piancey Jamie Dimon. I mean, that's who people generally associate with JPMorgan these days. So I know Jamie Dimon isn't the biggest fan of cryptocurrencies in general. 00:36:20:12 - 00:36:42:03 Hilary Allen The reason why I asked is because Jamie Dimon is very famous for some early critical comments around Bitcoin. But if you look at what's happening at JPMorgan as an institution, you know they're into Onyx. They're actually very perhaps the most of any of the big banks aggressively interested in Defi. So, you know, I think Jp morgan has actually changed its tune institutionally. 00:36:42:18 - 00:36:51:13 Cas Piancey So they say all this stuff people remember them saying all this stuff and they don't mind turning around on those comments because the main concept is to make money. 00:36:51:22 - 00:37:12:18 Hilary Allen In the short term. And that's the critical thing. It's in the short term that that's the focus. And so that is just a, you know, a fundamental issue with how financial institutions conduct their business. One would like to think that people were constrained by their memories of the 2008 crisis. But I think people are goldfish. I mean, not me. 00:37:12:18 - 00:37:22:23 Hilary Allen I you know, I see I see the 2008 crisis looming very quickly, but I wouldn't count on institutional memory of 28 to be a restraining factor in all of this. 00:37:23:03 - 00:37:24:05 Bennett Tomlin Yeah, I probably either. 00:37:25:08 - 00:37:27:07 Hilary Allen Yeah. 00:37:27:07 - 00:37:31:22 Bennett Tomlin Well, thank you very much for joining us and discussing all these topics. We really appreciated it. 00:37:32:06 - 00:37:32:25 Hilary Allen Thanks for your time. 00:37:32:25 - 00:37:33:08 Cas Piancey Thank you for. 00:37:33:08 - 00:37:35:13 Hilary Allen Hosting. It's a pleasure to be here.