Crypto’s aha! moment.

There is this thing that innovation in finance has a bad aftertaste of a fraud. See, finance has these 2 magical powers and we have talked about this before a lot, so please don’t let me bore you, but:

1. Debt moves means from the haves to the have-nots, so it accelerates spending and gives entrepreneurs capital, but it does something else, too: it makes us braver because it turns repayment into a fluid concept. Yes, you’ve got the repayment date, but there is always a way to refinance, change terms or roll forward. And so yes, you could say that people are less worried to be entrepreneurs with borrowed money. This is all the more true when you move up in size. Like, a public company or a country* tends to prolong the debt inevitably forever. (*this mostly, really only, applies to Western countries)
2. Opacity, or the transformation of something to something that is much more. Or, ok, we mean securitization, really. Say, you have a $100 high-risk investment to sell. You slice it into $50 junior (now, super high-risk) tranche and a $50 senior tranche. If the investment turns out to be worth $150, you give back $51 to the senior tranche, but $99 to the junior tranche. If the investment goes to $50, you still pay back $50 to the senior tranche, but $0 to junior tranche. Now this is good because in a strange sort of way, investors generally fall into two categories: a) those who have $X and need to earn a little, but most definitely need to get the $X back, and b) those who have $Y and want to, like, make 2 x $Y, but are also prepared to lose a lot more. So, yes, this is good because you are keeping the economic machine oiled .. getting the money to entrepreneurs .. and animal spirits rise, .. etc etc.

You could now tell me that I don’t know what I am talking about and that 1. and 2. were a recipe for the Global Financial Crisis in 2008, and you would be mostly right, but so am I?

The 1. and 2. lead to the recurring debt->excess->doom cycles, but they are also essential for us — humans — to do anything, really. Society wants more than it can afford. If you’d have to wait until you save to buy a car, things would be slower in the car industry, .. or the tire industry, or pretty much every car parts industry .. extrapolate onto any other industry. If banks couldn’t offload debt from their balance sheets by securitizing it and selling it to investors, they would certainly not be able to lend as much to entrepreneurs, home and, yes, car buyers.

We live off of debt that is cheap to afford because finance has mastered the art of liquifying it. “One purpose of a financial system is to ensure that we are, in general, in a high-investment dynamic rather than a low-investment stasis.”

Here is a thought, the 1. and 2. absolutely and completely require centralization, they require that there is an intermediary between the investor and borrower. Like, for the magic of finance to work, there has to be a “bad bank” that obscures what we are putting money in and under what conditions we are taking money out. It also requires that we believe — hence not everyone can be a bank — because the magic of finance “demands willing suspension of disbelief from its observers, [..] it requires a mystery.”

Crypto cannot do this. By its very definition it cannot, it is trustless. See, I love DeFi:

[..] really it is absolutely cool that there are automatic exchanges, insurers and lenders that you can be a co-owner in, and with the same risk-return profile that a large institution would be in the traditional finance because there is no hierarchy, just code.

But actually, those exchanges, insurers and lenders are just directional bets. Here is how debt, or insurance, or derivatives, or pretty much anything else in DeFi works: you need to put down a collateral.

If you want to borrow a cryptocurrency X. No problem, but first put down a collateral in currency Y, and, note that you need to put more than the amount of debt you are taking out. Or you want to buy a derivative, betting against another party that some underlying Z goes up in value, rather than down. Again, you and the counterparty first have to put down a collateral that is used to pay off gains of the winning side.

There is no debt in DeFi.

Say, you want to open a leveraged long position on cryptocurrency X. The way you do it in DeFi is that you repeat what you’ve done above several times over (because in DeFi you can — it is a code). You buy cryptocurrency Y with your newly borrowed cryptocurrency X and put it down as collateral to borrow more cryptocurrency X. Fine, you are 2x levered. If market moves against you, your position gets liquidated faster, as it would in traditional finance when trading on margin.

The difference is that there is no magic in DeFi. And, sure, that could sound like a good thing, but actually, if you read history of finance, it is not.

My writing is just a redux of Matt Levine’s brilliant Bloomberg column.