Welcome to Galaxy Brain—a newsletter from Charlie Warzel about technology, media, culture, and big ideas. You can read what this is all about here. If you like what you see, consider forwarding it to a friend or two. This is a free edition of the newsletter, but you can subscribe to The Atlantic to get access to all posts. Past editions I’m proud of include: A 10-Year-Old Nuclear-Blast Simulator Is Popular Again, The Bad Ideas Our Brains Can’t Shake, How to Spend 432,870 Minutes on Spotify in a Year, and Confessions of an Information Hoarder.
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What I find most concerning about crypto/Web3 is that a great deal of the projects I’ve seen add unnecessarily complex financial elements to areas of our lives that didn’t have them before. Crypto critic Dan Olson recently described this ethos as the construction of an internet where “everything that can be conceptualized as valuable can be numeralized.” “Play to win” games like Axie Infinity, for example, are a dystopian vision of leisure that replicate exploitation we’re used to seeing in real life. I find myself more alarmed about the crypto’s hyper-financialized vision of the world each day but I also lack some of the historical knowledge necessary to offer a strong financial critique of the space. Which is why I was deeply fascinated when I came across an essay by American University law professor Hilary J. Allen titled “DeFi: Shadow Banking 2.0?”
Allen studies financial crises—specifically, threats to financial stability and the ways in which financial fallout affects regular people, not just institutions—and she has testified before the House Financial Services Committee. Her recent essay focuses on the financial innovations (money market mutual funds, credit default swaps, mortgage-backed securities) that ultimately led to the 2008 crisis and draws parallels between those and some of the tools and dynamics in the world of crypto and decentralized finance (DeFi). DeFi, she argues, is repeating many of the mistakes of the past.
What follows is one of the most fascinating and eye-opening conversations I’ve had about crypto. We cover America’s casino mindset, the echoes of the financial crisis she’s sensing right now, how to regulate crypto, and how to innovate without exploiting others. Allen offers a lacerating but level-headed criticism of the space that is well worth your time.
Charlie Warzel: Your essay is about DeFi, or decentralized finance. Like a lot of terminology in the crypto space, DeFi is pretty broad and vague but also very much accepted in the lexicon. How do you define it?
Hilary J. Allen: Like any evolving space, the terminology is hard to pin down. People inside the crypto world have different definitions for DeFi and would probably argue with mine. But the way I think of DeFi is as a way to describe any analogue of traditional financial-service transactions—loans, deposits, etc.—that are provided using technological tools like the blockchain or facilitated through smart contracts or stablecoins. The technology is what is different, but the financial transactions are very much similar to traditional finance.
Warzel: And the idea—at least in theory—is that DeFi tools eliminate the need for the centralized authority, which is usually regulated banks and other intermediaries that do all kinds of things: from holding and transferring money to charging transaction fees, etc.?
Allen: Right.
Warzel: Of course, your essay argues that DeFi doesn’t really deliver on this promise. You write that, “DeFi doesn’t so much disintermediate finance as replace trust in regulated banks with trust in new intermediaries who are often unidentified and unregulated.” This is a growing critique of much of the Web3 movement—the idea that a lot of blockchain-based apps and tools are not actually decentralized. And that, for Web3 applications to scale, they’ll have to rely on the same types of platform structures that exist now. An example of this outside of the DeFi space is that, for NFTs to work, you need a centralized marketplace like OpenSea.
But what I found interesting is that your critique goes a step further. You argue that part of the decentralized finance ecosystem looks to you like it “mirrors and magnifies the fragilities of shadow banking innovations that resulted in the crisis of 2008.” Can you walk me through your argument here a bit? [For readers interested in a synopsis of Allen’s essay, Cory Doctorow has a truncated recap here.]
Allen: Sure. As somebody who studied the 2008 crisis in great detail, I’m always looking for parallels. So when I’m looking at the building blocks of the 2008 crisis, I’m thinking of things like mortgage-backed securities and credit default swaps. These financialized tools created additional complexity and rigidity and leverage into the financial system that ultimately led to collapse. And I see similarities with what’s being built in DeFi spaces—what unites them is their opacity and complexity and the way that it is potentially destabilizing.
Warzel: Right. The idea is that these financial innovations were essentially workarounds that allowed banks and stakeholders to skirt limits or some regulatory aspects. Or that they were such an abstraction that they were difficult for even bankers to follow — that the complexity of these instruments obscured exactly what people were buying and if it was garbage or not. In the essay, the three financial innovations you see parallels to are money market mutual funds, credit default swaps, and mortgage-backed securities. Can you go through them at a high level?
Allen: Money market mutual funds were created to be a functional equivalent of deposit accounts but in fact are an abstraction: a special accounting treatment that allows a share in a fund to be consistently valued at one dollar. But a share in an MMF is actually a share in a pool of assets with fluctuating prices, and so its value changes constantly. If the value of an MMF share deviates too far from one dollar, shareholders will find their shares revalued below one dollar. When this happened in 2008 and investors pulled out of MMFs, it was analogous to the traditional bank runs. Basically, the financial crisis was made worse by runs on money market mutual funds.
There are—and I’m far from the only person to note this—striking similarities between MMFs and stablecoins, like Tether, which is pegged to the dollar and supposedly backed by the dollar. But there are a lot of allegations that Tether is not backed as it claims and is fraudulent. Other stablecoins offer their own complexities. I’m maybe less convinced in those parallels than some. But if something were to shake confidence in stablecoins and holders rushed to exchange them back to fiat currency, there could be a similar kind of run dynamic. And, if stablecoin issuers become interwoven in the real economy, it could introduce risk into the broader system.
Now, with credit default swaps, the parallel is leverage. CDSs created a new, initially unlimited way to create leverage, which is another way of saying they used debt to acquire financial assets. In DeFi, you see similar dynamics, especially that tokens can be created out of thin air. Those tokens could then be used as collateral for loans that can then be used to acquire yet more assets. It’s somewhat striking, the parallel.
Warzel: How about the mortgage-backed-security parallel?
Allen: Here, I focus on the rigidity. The idea is that when you have these financial products, they’re designed to be very hard to alter. That’s great most of the time, but things begin to fall apart if something unexpected happens. This was a real problem in the financial crisis. The obvious parallel here is with DeFi’s smart contracts. The whole selling point is that with smart contracts, you set the parameters up at the outset. Things happen quickly and are automated. There’s no opportunity for human intervention, though I’d argue that is overstated to some degree. I’m concerned about that.
Warzel: I understand in theory—but could you give me a real-world example of this happening?
Allen: See, so this is a great question. And, if I’m being very honest, I don’t have a great example of this happening. A lot of times in traditional finance and DeFi, these things work okay. Now, there’s all kinds of potential problems with smart contracts, like vulnerabilities and hacks. But—assuming we don’t have those problems, and assuming the contracts execute as intended—this system only becomes undesirable in the “1 percent of the time” case.
This is sometimes a challenge to illustrate. So in my book I explain what would happen if the credit default swaps that AIG issued to Goldman Sachs had taken the form of smart contracts. AIG overextended—it issued too many CDSs, thinking it’d never have to pay out. And because it was so deluded into thinking it wouldn’t have to pay out, it didn’t look at the margin requirements, which are the contracts AIG and Goldman signed. The contracts they used basically gave Goldman carte blanche to dictate what the margin requirements would be, should the underlying bonds be downgraded. Now, what actually happened when the time came is that Goldman came to AIG and said, “We want X terms.” AIG said, “We’re not paying that much; we can’t.” See, AIG negotiated it down. That was in 2007. And, when 2008 came and there were all these margin calls for AIG, it had time to wait on the contracts—because they weren’t smart contracts that automatically executed. They were facilitated by human beings. This gave time for the government to intervene and to avoid a complete financial meltdown.
Now, what if all those contracts had been totally automated? If the margin calls were automated via a smart contract, it would have spun them into insolvency well before any possibility of government bailout.
Warzel: That makes a lot of sense to me, and that rigidity and taking humanity out of the system sounds like a huge potential risk. But, playing devil’s advocate, I’m sure the crypto contingent would say that your story is proof that a smart contract system is superior because it doesn’t give time for intervention and, specifically, bailouts to overleveraged, irresponsible banks. What would you say to people who hear that story and say that smart contracts “sound like a feature, not a bug”?
Allen: I’ve definitely heard that a selling point of DeFi is that it gets rid of the need for bailouts. And yes: I’ve had people accuse me on this point of shilling for big banks, and it’s just not true. If you’re asking me to choose, I’d absolutely rather see a bailout that prevents broader, sustained economic chaos than not. And the reason for that isn’t because I care about protecting executives at banks. In all my work, I’m speaking for the people downwind of all of this. The already vulnerable people who end up being hurt the most by financial collapse. In the case of DeFi being interwoven with our greater economy, these would be the people who are not investing in crypto but could still be hurt by a collapse. That’s the viewpoint I represent. And for those people, bailouts are the best outcome, even if they’re unpopular.
Warzel: One thing that Web3 and crypto proponents like to tout is that it democratizes finance—that a broader scope of people (usually framed as either unbanked or those without outsized means) who’ve been shut out of more traditional financialized elements of the economy can just plug in, get a wallet, and play like others do. What you’re arguing though is that, if you’re looking to protect the most financially vulnerable, then these regulatory frameworks are more important than access. Is that how you’d describe it?
Allen: The rhetoric around crypto and access reminds me of something similar to the rhetoric around mortgages in the lead-up to 2008. Again, there are striking similarities. With subprime mortgages, the line was that it increased the opportunity for more people to own homes. But that rhetoric is sometimes used to hide predatory practices.
Let’s go back to credit default swaps and this idea of multiplying the amount of risk in the system by allowing essentially unlimited bets on the performance of a single bond. I worry in DeFi what’s being constructed is essentially the unlimited ability to create financial products and borrow against them. We are increasing the amount of risk—because the assets are essentially anything that somebody with programming knowledge who can mint a new coin can make up. You don’t necessarily have to tie these assets to something physical: like, say, a house somewhere in the world.
Warzel: I want to go back to the bit about complexity. I find almost all the decentralized applications I encounter just largely inaccessible, especially to the layperson. Specifically when it comes to decentralized finance, I find that it’s often extremely hard to figure out what a given project does. Before our talk I was searching around for interesting projects in the space, and here’s the definition I got from a website about one particular project:
Simply put, Colony is an entourage of smart contracts that provide the framework for an organization’s essential functions. Apart from funding, this project caters to online organizations’ ownership, structure, and authority.
That is extremely, comically vague. I’m wondering if you could talk some more about the use of complexity as a shield.
Allen: Complexity is weaponized in some of these instances to deflect scrutiny. This is an old trick from the financial industry: Make things more complex. In DeFi, you have financial complexity overlaid with technical complexity, too—so there is, really, just the thinnest subset of people who can do both. And those people will be paid a LOT of money to participate and build these tools. And when the slice of people is so small and they’re so handsomely rewarded, there’s not going to be many savvy watchdogs—there’s less incentive to be a policeman on the beat. It’s much easier to just go work on a project.
And even if the complexity is not purposely weaponized, I think there’s a reason for pause. The literature on complexity science and the interactions in complex systems is something we should all be paying more attention to. There’s this idea of “normal accidents”—that once you have a complex system, things are bound to go wrong in ways we can’t anticipate. Partly for those reasons, and partly for the fact that regular consumers and regulators aren’t going to understand this, I vote for simplicity.
Warzel: There’s this frustrating interplay here for critics, I think. You can say, “I don’t think this thing makes a whole lot of sense” or “It seems to me like this doesn’t really do…anything new?” And it is met by proponents with a sneering “You just don’t get it.” When in reality, I think maybe the bigger problem is that there’s not a lot to “get.”
Allen: This is what I find so frustrating about the financial-inclusion narrative. Let’s start with a problem and solve it. If the problem is that people need money quicker and need payments more cheaply and more return on savings, who would move from that problem and build stablecoin-backed sets of volatile, highly leveraged assets that are themselves complex systems, managed by a decentralized autonomous organization [DAO]? You wouldn’t do that. You’d say: Okay, let’s look at Brazil’s real-time payments system, or Australia’s. That’s part of my frustration with the crypto complexity—it is complexity that ends up making a system more fragile. Complexity may be worth it sometimes. But if it doesn’t solve the problems we actually need to solve, then I don’t know why we go with all of this.
Because the complexity of the crypto world is only justified by the idea of decentralization. That was the intellectual power of the Satoshi Nakamoto white paper. [Nakamoto is the apparent pseudonym of Bitcoin’s creator.] It was this idea for how to transfer value without a trusted intermediary. That was the appeal. But everything that’s been built on the back of the blockchain since seems to be trying to deal with the idea that this decentralization is purposefully wasteful, slow, and complicated. Now, in order to get rid of intermediaries, they’re using intermediaries. They’re losing the decentralization, but they’re keeping the complexity.
Warzel: I think that’s a powerful way to frame it. In a way, it’s almost like using the initial founding vision as marketing material for new products that undermine the initial vision.
Now, I consider myself a crypto skeptic, but I do want to continue playing devil’s advocate. One argument you hear from crypto proponents occasionally is that yes, the system that they’re building might have its own flaws, but that the new rules are being dictated by different players. I’ve also heard a lot of true believers argue that, with different DeFi projects, people are able to invest but also get a say in the governance, which is better than an old model of a bank or company setting all the rules. How do you respond to that governance argument?
Allen: A lot of the power of DeFi and crypto comes from a lot of real and powerful critiques of our system. Banks performed abysmally in 2008 and haven’t changed that much as a result. I understand the distrust, I understand the need and want for solutions. I just don’t think DeFi will get us there. If you own one share in JP Morgan, you don’t own them. You can’t actually control how they operate. Similarly, if you have one governance token in a DAO, you won’t control or meaningfully influence how the DAO operates. Because this is a system where, already, you see founders are keeping tokens. The concentration of wealth in crypto is already totally lopsided. So the idea of the little people having a say is really marketing at best and deceptive at worst. It’s just…not how it’s going to work.
One of the points I’m trying to make in that essay is that, where there’s money to be made from intermediaries establishing themselves, intermediaries will appear. If there’s money to be made by controlling a DAO and the DeFi protocols it administers, then somebody will be in there making a majority of that money. And those will be the people who’ve been in the ecosystem from the beginning. That means those in the venture-capital firms. They’ll make a ton off this. To suggest that what I’m describing is democratizing the ability to control how our financial system works is totally disingenuous. Because we haven’t changed the underlying incentives of the financial system. We haven’t changed any of the structural or political issues…
Warzel: We’ve just put them on the blockchain!
Allen: …and it could be worse in this new iteration if we don’t have the regulatory mechanisms.
Warzel: Yes, I wanted to get to this. You argue it’s time now to bake in regulatory processes rather than wait until crypto gets more interwoven into the financial system. I know the Biden administration issued an executive order on crypto, but it was very vague—a sort of “We have our best people on this” type of thing. But, say you are king of the world for a day. What would you do, regulations-wise?
Allen: The first order of business is to create a Glass-Steagall system for crypto. Glass-Steagall is the legislation put in place after the Great Depression to separate banking and securities. What I’m suggesting is that banking and crypto be kept separate—so that if there’s an implosion of the crypto world (for me it’s a when, not if), the consequences stay largely in the crypto system, but wouldn’t have spillover effects to the broader economy. In the early 2000s, when the dot-com bubble burst, we didn’t have a broad-based, 2008-style recession. That is, in part, because banks didn’t have huge exposures to internet companies like they did to the mortgage sector. It contains the potential fallout.
In some ways, I think there could be a lot of political support for something like this. Because people who have support for crypto see it as an alternative to the banking system. If you truly believe that, then you should not integrate it with our current banks. You should keep them separate, so that if crypto succeeds, then it could maybe live up to its promise. And if it doesn’t, the banks won’t be taken down by it. And it makes the economy as a whole more robust.
Warzel: You argue in your essay that, essentially, we need to slow down DeFi, and that critics are going to see this as an attack on innovation. I find this is a huge tension right now, especially between, say, Silicon Valley and people who are critics of new technology. There’s an argument that building new things is a universal good and that critics are jeopardizing progress. The builders argue that, yes, there may be problems that arise, but the most important virtue is to keep pushing forward. I should be clear I think this is a pretty facile premise, but it puts critics in a difficult position. For example, I’m not anti-progress or anti-innovation. But I’ve also spent enough time in the “move fast and break things” world to understand what happens when we build without an eye toward what our tools might do if they succeed. As a very clear critic of crypto, how do you hold all this in your head?
Allen: For me, it’s about incentives and negative externalities. What are the incentives for innovation? What are the social problems? We won’t solve any of it if the only motive for building is profitability and shareholder value.
What the broader public is looking for are win-win situations. We don’t mind rewarding people for building great things. That’s how this works. But win-win outcomes require a bit of guidance, regulation, and oversight to make sure that the tech is providing social outcomes as well as profits.
In the absence of any constraint, innovation will be profit-mining and seek to maximize those profits. When I push back on crypto people, some say: “Don’t tell me how to invest my money. I will take on the risk if I want to.” And I’m tempted to say, “Okay; that’s fine. Or it would be if it was only you we are talking about.” But it’s never only just one person. It’s so much bigger. There are so many consequences for others. There are the environmental externalities, like the energy that comes from mining. There are national-security issues, like the potential for sanctions evasions. My expertise is in the area of financial crises, so that’s where I look. And here, I say that of course you can invest where you want—but if you invest in ways that add great fragility and instability into our systems and it ends up blowing up the economy, it will ultimately hurt people who never invested. Innovation is not an unqualified good.
Warzel: Before I let you go, you mentioned before we began this interview that you’ve been studying crypto’s evolution since 2015, and that each time you’ve written about it, it seems more of the things you were concerned about have come to pass. I am curious about the crypto-hype moment we’re in right now, and the ways that it seems more entrenched than it did during, say, the 2017-2018 run. It’s especially interesting to me because, like I said, beyond buying and selling a coin on an exchange like Coinbase, so much of Web3 is deeply inaccessible to most people. Why do you think so many people have gotten involved? Is it just part of a casino mindset—that it’s easier than ever, and there’s a lot of flashy apps that lead people here? Or is there something deeper?
Allen: The casino mindset is huge. But that is linked to broader structural problems. People think the system is rigged, and they’re not wrong. When people think the system is rigged, they say, “Well then, why not bet?”
I’m on Amtrak a lot these days, and I looked up recently and realized I was surrounded by sports-betting ads and crypto ads. When it feels like you can’t get ahead the normal way, people start gambling more. Just in general, society is gambling more. I think it’s part of that. But financial inclusion is a deep-seated structural problem, and it needs solutions that are structural. There’s a way for technology to assist here. But I don’t think what we’re seeing is the answer.