Hilary J. Allen is a Professor at the American University Washington College of Law, where she teaches courses in corporate law and financial regulation. She has published numerous articles on fintech and financial stability regulation in academic journals and the popular press. Prior to entering academia, Professor Allen spent seven years working in the financial services groups of prominent law firms in London, Sydney, and New York; and in 2010, she worked with the Financial Crisis Inquiry Commission appointed by Congress to study the causes of the financial crisis of 2008.
There is a lot of hype surrounding cryptocurrencies and DeFi technology, with excitement around the potential innovations they offer financial systems. Often lacking in the discussion is an objective and critically informed viewpoint, leading to confusion and misunderstanding. In today’s conversation, we get the balanced perspective that we need with Professor Hilary Allen, who has a wealth of experience in banking, law, financial regulation, corporate finance, and business administration. She is a law professor at the American University of Washington College of Law and her research focuses on the impact of new financial technologies on the stability of the current finance system. She has written many academic papers on the subject, including the book Driverless Finance, which provides readers with a balanced perspective on the opportunities and threats of fintech innovations. In our candid and fascinating conversation with Professor Allen, we learn about the threats and opportunities DeFi technologies pose to the financial system. We hear what shadow banking is, the similarities that decentralized finance has with shadow banking, the risks of cryptocurrencies, if innovation in finance is always positive, why regulation is essential, whether DeFi is actually decentralized, the basics of stablecoins, how you can help affect change in the financial system, if you should invest in cryptocurrencies, and much more. Tune in to get the clarity you need about the world of crypto with expert Professor Hilary Allen!
Key Points From This Episode:
We start the show by learning what shadow banking is and how it is associated with the financial crisis in 2008. [0:04:05]
Professor Allen explains what DeFi is and gives us some examples. [0:07:16]
Learn about some of the innovations that DeFi technology proposes. [0:09:21]
Similarities between shadow banking activities and DeFi technology. [0:11:06]
Other risks that Professor Allen sees with the DeFi system. [0:12:12]
What effect replacing intermediaries with algorithms have on financial systems. [0:16:03]
The effect complexity has on a financial system. [0:17:19]
She explains what financial stability is and the objective of financial regulation. [0:19:27]
How the financial stability of the existing system compares to the DeFi system. [0:21:01]
Whether stability of the existing financial system is exposed to problems within DeFi. [0:22:14]
Which DeFi innovations pose the biggest risk to the current financial system. [0:23:23]
Find out if stablecoins could affect monetary policy. [0:25:23]
The regulatory lessons from the 2008 financial crisis that are relevant to DeFi. [0:26:28]
Outline of the problems that the existing financial system has. [0:30:44]
How successful DeFi has been at being decentralized. [0:33:14]
If Professor Allen has any concerns that regulation might stifle innovation in DeFi. [0:36:06]
Find out if financial innovation is always a good thing. [0:37:41]
What the best possible regulatory outcomes are regarding crypto and DeFi. [0:39:30]
Whether it is too late to regulate cryptocurrencies. [0:42:48]
Why Professor Allen thinks some politicians are pushing crypto-friendly agendas. [0:43:52]
How people can affect change in the right direction regarding the financial system. [0:46:08]
Read the Transcript:
To start off, can you tell us what shadow banking is?
Shadow banking is this term of art. It's not about shadowy super coders. People in the crypto space hear that and think you're making a reference to Elizabeth Warren, but actually, the term shadow banking's been around longer than that. Shadow banking is really any banking type activities that happen outside of the regulated banking system. If you can find ways of things that look like making loans or like creating deposits that happen outside of the traditional banking system, that would be considered shadow banking.
Now, we hear a lot about shadow banking related to the financial crisis. What were some of the main shadow banking innovations, if we can call them that, that led up to the crisis in 2008?
For example, you heard a lot about that time about credit default swaps, which were a way of essentially making a bet on how a bond moved. That was sort of a way of increasing the leverage in the system of making sort of a borrowing in the system in a way that hadn't been allowed previously within the strictures of traditional regulated banking. You had a lot of repo happening, which repo is one of the scariest things that happens in the financial system and most people don't know much about it. It's banks lending to each other based on collateral, but it's structured as a sale and repurchase. It's not technically a loan, but it works like a loan, and that's sort of the glue that holds our banking system together.
But if the collateral for those loans suddenly starts to be distrusted, which is what happened in 2008, when things like mortgage-backed securities, which had been the collateral for so much of this lending, people started to realize, oh yeah, no, this stuff is not so good. We're not going to lend against that. The banks stopped lending to each other. Then, we had basically, that's what precipitated the end of Lehman. That's what really brought the crisis to a head. You might be saying, well, you're talking about banks, isn't that regular banking? No, this type of sale and repurchase agreement was structured in a special way to avoid a lot of the traditional sort of banking rules and regulation, even though it was happening between banks.
Even though those protections were put in place, they still played a role in the financial crisis?
Which protections do you mean?
Around like the repro and the CDS?
They definitely played a role in the financial crisis. As I said, credit default swaps multiplied the amount of leverage in the system. Repo is, as I said, the lifeblood of the system and none of that stuff has really been fixed, which is one of my broader points about shadow banking is we learned how dangerous a lot of this stuff was in 2008, but it really has proved largely impossible to put the genie back into the bottle. Now, the size of these markets have shrunk through attrition. That has happened, but regulation really can't quite figure out how to put the genie back in the bottle with these things.
Now, you've got a paper where you refer to DeFi as Shadow Banking 2.0? is the title of the paper. How do you describe what DeFi is?
Just a note on that question mark, the reason why I have that question mark is all related to what I was just saying about putting the genie back in the bottle. Once this comes out of the bottle, you can't put it back in. Then we do have shadow banking 2.0, but there were steps that we can do to prevent DeFi from getting to that place. And so, what I mean by DeFi, this is an industry term. It stands for decentralized finance and spoiler alert, it's not decentralized, but that's the terminology that is used.
Basically, what we're seeing is we're seeing attempts to create on the blockchain versions of financial products that are already available. For example, deposits, loans, et cetera, and purportedly, this is being done without any centralized intermediaries, but as I said, it's not decentralized there. In fact, the space is rife with intermediaries, from the centralized exchanges, wallet providers, all of these intermediaries are critical, centralized providers like Celsius who's been in the news a lot. Those guys really were never really pretending to be decentralized, notwithstanding that they're participating in DeFi.
You have some other players that are purporting to be more decentralized. For example, you hear about MakerDAO and Dai being more decentralized, notwithstanding how powerful Rune Christensen is. We used to hear about Terra LUNA being entirely decentralized, notwithstanding that Do Kwon was clearly calling all the shots and that became even more evident as it started to fail. It's funny because decentralization seems to have become this post crypto winter purity test thing, so anything that fails amongst the crypto communities at all, that's because it was centralized. Then, anything that survives that passes the purity test is considered decentralized, notwithstanding that there are big players very much in control of all of this.
What are some of the innovations proposed by DeFi?
I mean, stablecoins are an important part of the system. It can't work really without stablecoins. A stablecoin is a crypto asset, so basically, a computer file that lives on a blockchain. Unlike most other crypto assets, which are notoriously volatile, it is designed to maintain a pegged value. There's all different kinds of ways that they try to achieve that peg. Some stablecoins are backed with asset reserves, whether they're fully backed or not is a matter of significant conjecture, especially if you're talking about something like Tether, which many people have asserted is a complete fraud. Others are like Terra LUNA, algorithmic stablecoins, which means that there's no assets behind them at all, but they purport to use sort of computer programs that incentivize trading in order to keep their peg that didn't work for Terra LUNA clearly.
The stablecoin is really the lifeblood of DeFi because you need something that is more consistent in its value in order to do these transactions. That's a big part of it, but then you have really some equivalence of what we've already seen. You can stake your stablecoins or the crypto assets you buy with them for some kind of yield and that's like getting an interest on a deposit account. You can get a loan in crypto, but typically there, you have to stake some of your crypto upfront. That serves as collateral for the loan. That's the kind of thing we're talking about.
You're referring to it as shadow banking 2.0. Are there significant similarities that you see between original shadow banking and what we're seeing now?
Yeah, because basically, what we're getting is largely the same as what we have already just with sort of different technological underpinnings. Because we're getting the same kinds of products, we've got the same kinds of problems that have pervaded financial services for centuries. We've sort of figured out how to deal with a lot of them through trial and error, where a lot of people got hurt. We've developed regulatory regimes to address the worst of these, and that's that's banking regulation, but shadow banking provides these same services outside of the regulated banking perimeter but that doesn't mean that they haven't eliminated all the problems that banking regulation is there to address things like bank runs or... I mean, bank runs is the most obvious one. Plenty of people have said that what we've seen happening with stablecoins during this crypto winter is essentially the equivalent of a bank run.
Can you talk about some of the other risks that you see in the DeFi system?
When we look at some of the products that characterized shadow banking circa 2008, one of the huge problems was new and inventive ways of creating leverage in the system. That's what makes financial systems more fragile, because when people use borrowed money to buy something, that allows them to maximize their returns in good times, but if the price of that thing falls, then they're in a lot more trouble because the amount they owe stays the same, but yet the thing they bought with it is a lot less valuable. Leverage is just the quintessential fragility that we see in financial systems.
What we see with DeFi are new ways of creating leverage. In 2008, people tied themselves up in knots to turn mortgages into financial products that could be borrowed against. You had the subprime mortgage and then you turned that into a mortgage-backed security, and then you took a bunch of mortgage-backed securities and you turned them into collateralized debt obligations. Then, you used credit default swaps to bet against those. Then, you took a basket of those credit default swaps and you turned them into a synthetic CDO square, but at the base of all of that, there was a house somewhere. All those contortions came from trying to make more assets out of that one house.
With crypto or DeFi, I mean, crypto more broadly, there's no limitations on how many houses they are. Anyone can create a crypto asset out of nothing. Now, whether someone will lend against it or not depends on the willingness of the parties involved, but people can sometimes get a little carried away. People can lose their heads. We're seeing people lending against all kinds of crypto assets. There's really sort of an unlimited pool of things that can be lent against in the crypto space. I think leverage is a real problem.
Another problem I see, and this one gets a little less play, but I think it's critical or at least it could be critical in the future is this idea of inflexibility or rigidity. One of the problems that we had circa 2008 about the mortgage-backed securities was that they couldn't be easily amended. The contracts involved couldn't be easily amended. They were designed to be bankruptcy remote, so they couldn't go into a bankruptcy court to reorganize things. Because they were so rigid, it meant it made it harder to alter the terms of the deal for the people who had bought the houses, who first of all, could have really used the relief, and second of all, it probably would've prevented a lot of the foreclosures if modifications had been easier and that's better from the system's perspective.
Losing that flexibility can have systemic consequences. I think that is something we need to be very attentive to when we're thinking about DeFi, which runs using smart contracts. Now, smart contracts are not actually contracts, they're computer programs, but they are absolutely designed for rigid self execution. They are supposed to not consult people. They may consult a data feed or an Oracle, or there are ways that you can have them consult other programs, but they basically, when they're put together, have to contemplate all the states of the world that they will ever encounter. And so, in unusual events, these could perform in really unanticipated and unhelpful ways. I think that's something that we need to be very careful about if people are trying to put more financial services together using smart contracts.
Maybe to generalize on that point a little bit, what effect do you think replacing intermediaries with algorithms has on a financial system?
This is a really critical question, not just in DeFi, but FTX has a proposal before the CFTC. They want to do away with certain intermediaries to allow retail traders to trade in crypto futures on margin, and they want to get all the clearing houses out of the middle. This is, as you raise, like a broader issue for the crypto ecosystem. I think if you look at how complex systems work, the more efficient you make them, the more fragile you make them. There's a certain point in which efficiency delivers diminishing marginal returns. You can make it a little more efficient, but it comes at a great cost in terms of the robustness of the system. All of these intermediaries, they are speed bumps in the process, but those speed bumps can be invaluable in sort of putting, allowing for discretion, redundancy, points for regulatory bailouts, honestly, if you need them. You get rid of all of that and there's no redundancy in the system and it becomes very fragile. I think that's something we need to be really worried about.
To piggyback on that, what effect does complexity have on a financial system?
I mean, complexity is a huge problem for any system that we sort of rely heavily upon. We see this all the time with power grids. Things are so complex that a seemingly minor problem can cascade through the system because of unexpected interactions between components. Then, we end up with rolling power outages. And so, a point that I think needs to be made about the crypto ecosystem is that this is so complex that we are potentially setting ourselves up for rolling power outages in the financial system. Complexity is in and of itself a destabilizing force. And so, what you should really be doing when you design a system that people have to rely on is in addition to including the redundancies that I mentioned earlier, make it as simple as you possibly can.
But the thing about crypto is that it's being made intentionally more Byzantine and complex because it's trying to get intermediaries out of the way. A centralized system is almost inevitably simpler and more efficient than having a decentralized system. I understand the sort of why people want a decentralized system. It would be great to get intermediaries out of the way given how poorly banks have performed, et cetera, but the problem is that intermediaries are getting added right back in and intermediaries with all the same incentives. We're stuck with the intermediaries and then we have a unnecessarily convoluted and complex base layer that makes the system more fragile, and also, it makes it really hard for consumers to actually understand what they're dealing with. If you're buying a crypto asset, you're not just having to deal with the kind of financial disclosures you used to have to deal with, you also have to be able to scour the code to make sure that there aren't holes in there that would allow a hacker to steal all your assets.
This may be an unfair question to ask when we have limited time, because you've written a pretty substantial paper answering the question, how do you explain what financial stability is?
I can do a short version on this. Financial stability is a situation where the financial system is not experiencing a financial crisis and is also robust enough, so that shocks that come in aren't going to create a financial crisis. To be clear, and I think this is important, sometimes when we talk about financial stability, people just think about the financial system and then stop there. But that's not actually why we care. The financial system... or at least it shouldn't be why we care. Sometimes I worry that it is, but the financial system shouldn't be the end in itself. We're worried about the broader economy and the financial system does a lot of things that the broader economy requires. It provides credit, it processes payments, things like that. Those are the services that need to keep chugging along. Financial stability means that we have a system set up so that those services can keep chugging on even if a problem or a threat emerges.
As an extension to that question, maybe the answer's obvious, what is the objective of financial stability regulation?
It's basically what I just said. We're trying to prevent financial crises, but it's not just about preventing financial crises because you can't always predict where those are coming from. Yes, you're on the lookout for threats, but you're also focusing on just making the system more robust to whatever comes at you.
How does the financial stability of the existing system compare to the DeFi system?
There are definitely instabilities in the traditional financial system. I think the thing that makes it more robust than DeFi is the regulation and the hard-won lessons about where to provide government support, where to suspend obligations when necessary. I mean, it's not popular to say, but it doesn't seem fair when the banks are getting the bailouts. But for hundreds of years, we've recognized that sometimes banks need to be able to borrow money in an emergency to be able to keep loaning money to the broader economy. That whole mechanism is part of what keeps our financial system more stable.
I think something that a lot of people are trying to measure right now is sort of how much leverage is there in the crypto system versus in the traditional financial system. It's hard to get sort of metrics and data on that, but there is a lot of leverage in the crypto ecosystem according to sort of the Bank for International Settlements has done some good work in this space and they've been looking at that.
Now, how exposed is the stability of the traditional existing financial system to problems within DeFi?
This is something that I've spent a lot of time thinking about. I think what we've just seen with the crypto winter has shown us, what I suspected before, which is that the crypto industry or ecosystem writ large is not intertwined enough with the traditional financial system to really cause a problem there. That's sort of the good news, but what I worry about is that people will get complacent. They'll say, "Look what just happened. Celsius failed, Voyager failed, Terra LUNA failed, and there wasn't really a ripple for the broader economy. We're safe from it," whereas that complacency contains the seeds of future destruction. We are seeing interest from banks in this crypto space and the profits that are to be made there. Unless regulators take a hard line on keeping them separate, I don't think that the next crypto winter will necessarily be as contained.
Interesting. Of the DeFi innovations, which do you think poses I guess the biggest risk to the traditional financial system?
This is an interesting question. So much of crypto has been constructed or described as a disruptive force for banking, but really, if you look at what crypto was mostly used for, it's speculating on crypto. That's not necessarily going to be something that really could disrupt banks. They do, some of them have proprietary trading desks, but they're really not necessarily offering their customers speculative services. But I guess the most focus has probably been put on stablecoins because stablecoins do look an awful lot like a deposit.
And so, if you look at where regulatory proposals are focusing, it is on stablecoins, because that's something that potentially, I guess, could be a competitor to deposits, but I'm just very skeptical, I guess, about that line of reasoning because stablecoins are not currently used for payments. Then, there's sort of technological reasons that suggest that they won't ever be particularly good for it, like the blockchain doesn't scale very well. If you look at anything being done on the Ethereum blockchain, for example, during high volume times, you pay a ton in gas charges and it can take a long time to get things executed because of congestion.
When you compare that to sort of the services that you can get in the traditional financial system, I'm not sure that I see an appealing alternative there. All of this, I guess, is a long way of saying, I'm not sure that anything in crypto is really going to disrupt the banks, but I do see things in crypto that look very attractive to the banks as potentially profit-making enterprises through their own proprietary trading, for example, and that it's critical that those be kept separate if we want to keep the banks safe.
Do you think stablecoins could affect monetary policy?
I'm not a monetary policy expert, although, I've been forced to dabble both because we're living through a time of inflation and because it is a relevant part of the stablecoin debate. I come at things typically from the financial regulatory perspective, but the monetary policy concern that I saw was around Libra or Diem or whatever you want to call it, which Facebook or Meta, whichever you want to call it, proposed a few years ago. That to me seemed like a real potential threat to sort of monetary sovereignty, that this was something that could take over from traditional currencies. The current stablecoins that I see now, I see they don't necessarily have the infrastructure that would be needed to process enough transactions I think for them to be a threat to monetary policy, but I could be wrong on that. I don't know.
You mentioned your regulatory background. What regulatory lessons from 2008 crisis are relevant to DeFi?
The thing I think is really important that we didn't take away from 2008 and we should have was that we need to be more precautionary in our financial regulatory approaches. Instead of just sort of humming along and letting things happen and then cleaning up after the problem occurs, after everything explodes, I think we need to have a more proactive approach to new kinds of financial innovations and technologies that are coming down the pipe. And so, this goes back to the point I made earlier about sort of letting the genie out of the bottle.
Once you let the genie out of the bottle, there's no putting it back in. Credit default swaps, repo, we can tinker around the edges with regulation to try and make them a little safer, but there's no putting it back in the bottle. I think we need to be much more intentional about what we let out of the bottle in the first place. My hope is, although, I'm not overly optimistic about this, but that we will recognize the limitations of crypto that it really doesn't have a lot to give in terms of improving financial services, and yet it's coupled with all of these risks and that we should take steps to prevent that from ever being integrated into the traditional financial system.
What could have been done? Do you think more should have been done sooner to get ahead of this innovation?
Are we talking crypto or are we talking 2008?
No, crypto learning from 2008. Should the approach have been different?
I think so. I mean, I think part of it is the way all of this is constructed is very confusing. The financial industry has weaponized complexity for a long time to deflect regulatory scrutiny. They've said, "Oh, you couldn't possibly understand this. You just don't see the benefits. You're too dumb," essentially. Now, with crypto, what we've got is we've overlaid that with technological complexity. You want to say the emperor has no clothes, you have to be able to take that down from both a financial perspective and a tech perspective. I think many of our policy makers have just been nervous about calling it out because the word innovation is shiny.
People love innovation even though there's bad innovation out there, there's plenty of bad innovation, but people don't want to be anti-innovation. When it's so hard to parse both the financial and the tech aspects of this, I think people are too afraid essentially to call out the problems often. What we're getting now is actually exactly what we had. If you look at the rhetoric around the year 2000 about swaps, including credit default swaps, it was, we can't crack down on this innovation. This innovation is going to change things. If we don't have this innovation, it's going to go overseas and we'll lose out. We want the best and brightest, et cetera. You can make a parlor game out of using those speeches and asking people, "Swaps or crypto?" They can't tell the difference because it's the exact same rhetoric.
I think what we need, and this is why podcasts like yours are useful more than anything, is places to demystify this stuff, to explain its limitations and its risks, so that policy makers are more comfortable with going what many people have as a gut instinct, which is like, this doesn't seem right and confirming that for them so that they feel more emboldened to crack down on this as a type of bad innovation or an innovation, if not bad, that it comes with so many costs in terms of environmental and people losing their savings, as well as the financial stability risks I've been talking about today, that it's simply not worth it.
We've talked a lot about crypto and DeFi. People listening might get the impression that we're saying that there's nothing wrong with the existing financial system. Can you talk about some of the problems that the existing regulated financial system does have?
Sure, and they are legion. If there's one thing that crypto and DeFi get right, it's their critique of the existing financial system. Part of the reason why people have been paying attention to stablecoins is that payments processing in the United States is so antiquated and slow, but that's not a technology problem. Other countries around the world have much quicker, better payments systems. And so, it's a solved problem from a technological perspective. What we need is political will and to actually sort of adopt the good technology that's already out there, because yes, the payments system that we have in the United States is too slow for a lot of people, and they suffer as a result. They rely on check-cashing services, et cetera.
Another criticism is that the large mega banks are too big and have incentives to do all kinds of bad things and know that they are too big to fail. All of that is true, but as I mentioned, crypto's not going to disrupt those banks. If anything, it's going to be absorbed into those banks. And so, if you want to solve the too big to bail problem, that is a political issue. It's not something that can be done with technology. I think the critique of the existing financial system is accurate, but the problem is technology's just a tool, and in the hands of the same players, it's going to perpetuate the same kinds of problems. Thinking that you can just avoid the basically very challenging political work of getting things done through that process by waving a shiny technology around it, it's just not going to work.
DeFi does not solve these problems, even though these are the ones that are often highlighted?
Exactly, yes. One thing that if we want to be charitable, we'd say one thing that crypto and DeFi has done well is highlighting the problems with the legacy system with traditional finance, but if anything, it perpetuates and even magnifies those problems.
Interesting. Geez, well, claiming to be a solution, that's kind of scary. You alluded to how decentralized or not the DeFi system is. Can you talk a little bit more about that? How successful has DeFi been at being decentralized?
It hasn't. If you think about how anything crypto has provided, you've got layers. At the bottom layer, you've got the internet itself. We don't like to think about this, but you actually are reliant on ISPs for crypto services. China has managed to shut this stuff down largely. There's that intermediary, but we tend to assume that they are neutral. Then, on the next level, you've got the blockchain itself. This could be Bitcoin blockchain or Ethereum, and then there are new ones like Solana that are being put out there. With each of these blockchains, they say they're decentralized, but in fact, if you look at how they're structured, you're very reliant on a small group of people.
A blockchain is a database. It's run by software. Who maintains that software? Well, ostensibly, it's open source, but if you look at the core developers, it's really a handful of people for each blockchain. You're reliant on them. You're reliant on the transaction validators, which again, is supposed to be sort of any node in the system, but we see that mining pools have concentrated most of the validation for Bitcoin into as few mining pools. Again, there's just a few players there. That's at the blockchain level, which sits on top of the internet.
Then, you've got the things that run on the blockchain. These could be the dApps, for example, that are providing the financial services. DApps are ostensibly decentralized because they are governed by the holders of the governance tokens. The ownership of governance tokens is highly, highly concentrated in the hands of the founders typically of the dApps, and then also, the venture capitalist funds that have funded those founders.
One way I like to explain this is like, okay, you can have a share in Meta, but you don't get to tell Mark Zuckerberg what to do. The same is true if you have a governance token in a DAO. If you've just got one, you're not calling the shots. You're reliant on the founder and the venture capitalists. At every level, you are dependent on quite concentrated groups of people. That's before we even talk about all the centralized providers that don't claim to be anything other than centralized, so stablecoin issuers like Circle or an exchange like Coinbase. Coinbase is a listed company. These are very centralized players that are critical to the ecosystem.
You mentioned innovation is the shiny object. Do you have any concerns about how heavy handed regulation might stifle that innovation in DeFi?
I would like to see it stifle the innovation in DeFi. I think when we look at innovation, we need to look at it with a critical eye. If it's already obvious, which I think it is that the blockchain technology is not fit for purpose in the financial services space, then why would we worry too much about stamping that out? To be clear, if there were no negative externalities, if people could just tinker away forever and not have any environmental costs or people being scammed by fraud or whatever, I'd say go nuts. Have fun. I understand that if you're a computer scientist, the blockchain might be a fun toy to play with.
I do get that, but when you look at the costs that are just so egregious, and when you look at the fact that the technology is just not really fit for purpose. You had, I believe, Bruce Steiner on this show a while back, he, along with many, many other technologists, I think it got up over 1,500 or 1,600 signatories basically called out blockchain is saying like, this technology is not fit for purpose for financial services. When you have that many esteemed technological voices telling you that, and you have so many costs from it, then I think let's stamp out this innovation. That's okay with me.
Does that generalize beyond crypto? We talked with a technology angle there, but is financial innovation always a good thing or a good objective?
I've called for, across the board, a more critical and precautionary approach to evaluating financial innovation. Finance is in a way special. It is something that our economy absolutely needs to be running appropriately in order for the economy to run. There are serious societal harms if we get things wrong. I mean, for example, we don't allow just any innovation in aircraft technology to go ahead. We don't allow them to just tinker with airplanes. We don't allow people to have... with self-driving cars. Our streets are not filled with self-driving cars in the name of innovation.
A point I've made in my book, Driverless Finance, about this is that people seem to think of those as life and death scenarios and then finance as not. And so, therefore, we don't worry as much about innovation in that space, but it's simply not true. Finance can be life and death. When you have huge economic failures, people die. I mean, even in this crypto winter, there've been multiple suicides as a result of people who've lost all their money through Terra LUNA, et cetera.
This is life and death. Finance is a special beast and it has always been regulated in ways that certain other things haven't been. We don't regulate email so much, but we also didn't regulate FedEx that much. We don't regulate the dissemination of photos that much, but we didn't regulate Kodak that much. We've always regulated finance a lot for a reason. For that reason, I think innovation in this space deserves a heightened level of scrutiny that it doesn't necessarily get.
Interesting. What do you think is the best possible regulatory outcome here?
One thing I think should be on the table, which doesn't get talked about is a ban. And so, people don't like to talk about bans in the financial space for all of the reasons that I've just articulated about, wanting to see an innovation, et cetera, et cetera. But another reason that you hear talked about in this space a lot is that a ban would be infeasible, that it wouldn't be possible to ban things because it's decentralized. But as I've just pointed out, it's not decentralized.
For example, if you wanted to ban a decentralized service, you could make it illegal to hold governance tokens in any DAO that provides that service. Now, enforcement of that would probably be a pain in terms of the small players, but you don't really need to go after the small players. Most of the governance tokens are concentrated in the hands of the venture capitalists and the founders, and you simply need to enforce against them and then it's gone.
Then, if you have some services that manage to be really, really decentralized, to live up to the hype, then they're not going to be able to scale big enough to be a problem, so maybe let those go because of enforcement issues. But I think a ban should at least be on the table and it's not part of the conversation, because people don't want to talk about it and don't think they can do it, but it should be on the table. But short of that, if we don't want to do a ban and I suspect that's more likely the case for most policy makers, although if I had my druthers, we would ban it. But for most policy makers who I think don't want to do an outright ban, there's all kinds of equivalents of regulation that you should put in place.
It's critical here that we don't have a lighter touch regulatory regime just because it's crypto. If you are providing security, but you're doing it on the blockchain, the full force of the securities laws should apply. If you are offering a deposit, then banking regulation should apply. I think the difficulty with all of that though, is once you start applying a regulatory regime and this is why I'm more in favor of a ban, once you start applying a regulatory regime, you are giving some implicit legitimacy. That can be misread by people out there who are like, "Oh, okay. I didn't think crypto was okay, but if it's being regulated, surely it must be. I can participate." That's the downside of sort of this sort of functional approach to regulation and it's why I come out more in favor of a ban. But if you're not going to go with a ban, I think, and you're going to accept that this stuff is in your world, then you need to regulate it. It's not special. It's not different from what's already out there.
Did you see the headline right before we started this conversation maybe a couple hours before about Coinbase and the SED?
Yeah. And so, I mean, I think the SEC, I suspect has been working behind the scenes for a long time on these issues, but now it's putting its money where its mouth is. It's saying, "Look, a lot of these things are securities. We have intimated that. Now, we're starting to take enforcement actions to say that where these are securities, simply being on the blockchain will not protect you from enforcement actions."
You mentioned earlier the importance of timing of regulation, where once the cat's out of the bag, it's too late. Have we missed the boat on regulation for crypto?
I don't think so, because I don't think it's integrated into the traditional financial system and I don't think that... It's not integrated into the traditional financial system, not that many people are relying on it for traditional financial services and the ones that were frankly have been wiped out, unfortunately, and this is critical. Crypto is not connected in any way with the real economy. It's not providing funding to real corporations or anything like that. There's sort of no productive capacity behind crypto. This funding isn't needed for real-world economic growth. For all those reasons, I don't think it's too late, but once you bring this into the banks who are critical to real-world economic growth, then it gets a whole lot messier.
I have a politics question for you. Why do you think some politicians are pushing crypto-friendly agendas?
It depends on what the politics of the politicians are. If you're coming from a libertarian perspective where you don't like regulation and you don't like the government, and more the point, you don't care too much about the negative externalities for others, then there's nothing to dislike about crypto, I guess. I just am very concerned about the externalities for others. What's more curious to me on the politics side is the people who typically do care about consumer protection, who typically do care about the environment, who typically do care about protecting our economy from financial stability shocks. There are some of those people who have embraced crypto and I find that really disappointing.
I think what's going on is a couple of things. I think some of them have been frankly hoodwinked by the financial inclusion spiel that we are hearing, which really is it's just the critique of the existing banks. They hear that and they say, "You're right, this is terrible." Then they say, "And we can fix it." That sounds very appealing because if you're a politician right now in the United States in particular, but I think around the world, we've got a lot of political gridlock. It's hard to get anything done. The idea that maybe you could fix things without having to do the hard political work and just have a technology fix it, that sure sounds nice. But as I mentioned, it doesn't work.
But I think there are a lot of policy makers who have been taken in by the rhetoric who just love the idea of a tech fix to all of this. That's what's going on with some of the typically left-leaning politicians. Then. There's the money. I mean, Sam Bankman-Fried is one of the leading donors to the democratic party. Crypto lobbying has, according to a recent Bloomberg report, surpassed the lobbying from the defense industry, which blew my mind. There's a lot of money going on here as well.
Unreal. Now, is there anything that regular people who may be listening to this podcast can do to affect change in the right direction?
First of all, don't buy crypto, but second of all, if you want to reach out to your elected representative about this, I think that would be enormously helpful. What's happening is that the messages that the policy makers are getting are from organized campaigns that are sort of organized by lobbyists in particular, to have people who are crypto proponents reach out to their Congress people to say, "We love this. Let us have this. Why won't you let us have this?" And so, if that's all that the policy makers are hearing, you can understand why they are hesitant to look beneath the hood to think about why this might not actually be so great. Raise your concerns with your elected representatives if you can, because I think that there is a severe imbalance in terms of who political figures are hearing from.
It makes a lot of sense intuitively because when we decided roughly a year ago to start learning about this space, it's not easy to find... Your work took me much too long to find. I was looking harder than, I think, the average person. It did intuitively make sense that politicians would be hearing more of the pro side, because I think that's easier to find.
There's been a real disconnect especially during this crypto winter, where the people who perhaps would've been arguing for crypto before they started losing all their money are clearly unhappy now with what's happened to them, I mean, and unhappy is an understatement. Many are devastated. Yet, the rhetoric at the political level in Washington has not really changed during this crypto winter. The reality on the ground has not filtered up to people who are, I think, only hearing from lobbyists.
Unreal. Well, we appreciate you very much coming on our podcast to share your work on this topic, which I think is very important work.
Well, I appreciate to having the opportunity to speak with you about this and thank you for the series that you are doing.
Great. Thanks, Hilary.
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Driverless Finance: Fintech's Impact on Financial Stability — https://amzn.to/3oRCdnY
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'DeFi: Shadow Banking 2.0?' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4038788
'What Is 'Financial Stability'? The Need for Some Common Language in International Financial Regulation' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2484070
'Driverless Finance' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3366016
'Testimony of Hilary J. Allen, U.S. Senate Committee on Banking, Housing, and Urban Affairs Hearing on 'Stablecoins: How Do They Work, How Are They Used, and What Are Their Risks?' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3989323