DeFi: Shadow Banking 2.0?
28 Pages Posted: 25 Feb 2022 Last revised: 22 Nov 2022
Date Written: February 18, 2022
The growth of so-called “shadow banking” was a significant contributor to the financial crisis of 2008, which had huge social costs that we still grapple with today. Our financial regulatory system still hasn’t fully figured out how to address the risks of the derivatives, securitizations, and money market mutual funds that comprised Shadow Banking 1.0, but we’re already facing the prospect of Shadow Banking 2.0 in the form of decentralized finance, or “DeFi.” DeFi’s proponents speak of a future where sending money is as easy as sending a photograph – but money is not the same as a photograph. The stakes are much higher when money is involved, and if DeFi is permitted to develop without any regulatory intervention, it will magnify the tendencies towards heightened leverage, rigidity, and runs that characterized Shadow Banking 1.0.
Fortunately, though, there is still time to prevent DeFi from becoming Shadow Banking 2.0. This Essay argues for precautionary regulation of DeFi, designed to limit its growth and to cordon off whatever remains from the established financial system and real-world economy. While proponents of DeFi will contend that this will limit innovation, this Essay argues that DeFi innovation has limited benefits for society. DeFi doesn’t aspire to provide new financial products and services – it simply aspires to provide existing financial products and services in a decentralized way (meaning, without intermediaries). This Essay will demonstrate that the DeFi ecosystem is in fact full of intermediaries and explain why full disintermediation of financial services is an entirely unrealistic aspiration. This Essay will then proceed from that finding to argue that if DeFi cannot deliver on decentralization, regulators should feel emboldened to clamp down on DeFi in order to protect the stability of our financial system and broader economy.
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