Decentralized bank liquidity

What happens when everyone wants their money back?

DeFi brings us new tools to handle a 400-year old problem. In a “financial panic” everyone wants their money back at the same time.

Photo by Jeremy Bishop on Unsplash

Summary

DeFi handles surges in money demand with three tools:

• Variable interest rates
• Flexible pricing. Not fighting too hard to hold a $1.00 redemption value
• Transparency, with a real time view of balance sheets

The government-supported bank market offers stabilized rates, no-loss bank accounts, and opaque balance sheets with approximately quarterly reporting. Holding this system together under stress requires a mass of regulations, capital requirements, FX operations, implied and explicit insurance, plus a “lender of last resort”. A private market will do the same job with different tools.

The problem: Productive investments are not liquid investments

DeFi protocols typically use assets that can be sold very quickly on 24 hour markets. For example, DAI from MakerDAO can be redeemed at any time for ETH or USDC. However, MakerDAO has recently approved investment into “real world assets” which can capture money for up to 5 years. This frees the money up for productive uses, such as building physical infrastructure. But, it creates a complicated problem. What happens when people want their money back sooner?

More productive investments tie up money. They leave lenders with more risk, and more challenges managing liquidity.

This is a core problem of banking, perhaps THE core problem. Depositors accept a low rate of interest for on-demand redemption. Then, the bank puts deposit money into loans. The loans pay a higher rate of interest, but the money is stuck. This is a complicated balancing act. Banks want to lower their cost of funds by offering rapid redemption. But, they also want to raise their interest income by lending for long “durations”. Banks earn their profits (if any) by managing to provide liquidity to depositors in this situation.

Here are three steps to pay back depositors.

1) Keep cash on hand

Anyone who is offering a “demand deposit” that can be redeemed into dollars will need to keep some money in liquid assets that are available for redemption.

Some lawmakers have proposed that stablecoin issuers keep 100% of their deposits in immediately liquid reserves. Even economists at the Federal Reserve have argued that this is stupid. The money held in these highly liquid reserves is not available for more productive investment. High reserves are the banking equivalent of a stablecoin lending pool with very low utilization and very low earnings.

Regulators have traditionally asked banks to hold 10% of deposits as liquid assets available for withdrawal. 10% is appropriate for a banking system that has an insurance fund and a lender of last resort. It makes 90% of assets available for more impactful loans and investments.

The “Palmer rule” recommended that banks keep 1/3 of their deposits in immediately accessible funds. This rule was used in the 19th century when banks had less support from networks and central banks. It provides enough cash for any demand short of a full-blown financial panic.

The Aave interest rate curve is designed to keep 20% in cash — approximately half way between these two approaches.

2) Adjust interest rates

Aave pools gain liquidity from rapidly change interest rates. If enough people withdraw money, then there is less unused money, and the utilization rate goes up, and the interest rates go up. This improves liquidity from both sides. Lenders are more motivated to stay in, and borrowers are more motivated to repay.

A DeFi banking system will need to use variable rates in this way. When there is a demand to withdraw from the system, the price of deposits will go down, and less money will be available for loans. The banking system will need to increase rates to increase demand for deposits, and reduce demand for loans.

In theory, there is a neutral rate that balances the supply of money (deposits) with the demand for money (into the low-risk tranche of loans and investments). DeFi banking depends on 24 hour markets for prices and rates to find this neutral rate.

Real central bank systems use short-term rates this way

Real central banks use interest rates to adjust the value of their currencies. When currency value goes up/down, they can decrease/increase interest rates to adjust demand. After a sudden change in the value of their currency, they sometimes react with overnight changes in interest rates.

Deposit demand can go up. When people pull their money out of risky assets, they want to put that money into low-risk assets like cash and cash-like accounts. Then there is no place to invest those low risk assets, and interest rates go down. Rates can go negative. In DeFi, we frequently see negative rates when there is a high demand for dollars. It appears in the form of dollar coins that sell for more than $1.00, or low-quality undercollateralized coins that sell for a full $1.00. The most likely result of a rush to liquidity is that low-risk assets like bank currency go up, and interest rates go down.

DeFi has few fixed rate instruments. Nobody has succeeded in developing a high volume “term” market in DeFi that prices money for 3 months, 6 months, 1 year, 2 years, 5 years. I interpret this as a signal that DeFi needs variable rates. It’s difficult to stick to a fixed rate without the financial mass of a central bank to support it.

3) Handle financial panics

There will always come a day when everyone wants their money back. People lose confidence in the value of their investments, and the value of their bank’s investments, and they want to cash out. This happened in 2008 during the “great financial crisis”. We have seen this behavior recently in DeFi. Similar events happened about every 10 years during the 19th century, when they were known as “panics”.

Panics are bad. They cause cascading defaults, where Peter cannot pay Paul, and then Paul cannot pay his depositors. They cause a damaging reduction in real investment.

During the 19th century, the Bank of England developed a practice as the “lender of last resort.” They would step in to buy assets and provide cash when nobody else would provide cash. Just knowing that there is a lender of last resort reduces the frequency of panics. The actions of a lender of last resort prevent some of the cascading defaults and loss of investment. Central banks around the world have adopted this practice. Central banks are designed with the ability to mint new cash in order to “lend freely against good collateral at a penalty rate.”

DeFi does not have a lender of last resort. A decentralized banking system is also a privatized banking system. It needs a private mechanism to handle financial panics.

DeFi gives us some tools to handle this situation.

1. Efficient conversion of deposits to bonds and equity. When banks experience difficulties, they will often offer to convert demand deposits to bonds and equity that will take much longer to redeem. DeFi protocols will sometimes program this as an automated process. “Stakers” can earn extra rewards, if they offer an option to convert their money to other types of tokens.
2. Tokenization. Banks that need liquidity will try to securitize and sell their loans and longer duration assets. DeFi gives us a native format for doing this.
3. Transparency. Panics occur when people don’t know if they can get their money back. DeFi works on the theory that you can see in real time where your money is, and when you are going to get it back.
4. Synthetics

Discounts

What happens when depositors are asking for redemptions, and we use up the reserves of liquid assets? Then redemption requests will go into a queue, where they wait for more money to become available. A deposit token will naturally discount when people are waiting for redemptions. They will instead turn to selling the token on a secondary market.

I have a strong opinion about this. Under panic conditions, deposits should sell at a discount. $1 of deposits should sell for less than one dollar. If you want your money back RIGHT NOW, then you should take a loss and sell to someone with a lower “time preference.”

Trying to hold a peg under these conditions just causes losses (through forced asset sales) and increases the pain when the peg fails. In 2008, money market funds dumped assets and caused a huge crisis because they did not want to “break the buck” (become worth less than $1) by holding slightly depreciated assets. Our decentralized deposits are money market funds. George Soros “broke” the Bank of England (remember them, the smart guys of the 19th century?) when they tried to hold a peg. That was bad for the Bank of England.

Plus transparency

It’s important to minimize the size of the discount. We want small discounts, the smallest possible discounts. Transparency minimizes discounts. If I can see where the money is and when the money is coming back, I’ll be ready to buy that cash flow.

A private mechanism is driven by opportunities for profit. Do lenders of last resort make a profit? They are making a “penalty rate.” They have a chance to buy cheap assets when everyone else is facing forced liquidation. A lot of central banks have claimed to make a profit in this role, and the Federal Reserve reported record profits following the great financial crisis.

High transparency will allow private parties to fill the role of a lender of last resort, and fill it profitably.

DeFi lenders need to push for maximum transparency from their borrowers and investment strategies. We should not get dragged into the problems that afflict non-transparent CeFi balance sheets. Instead, we should drag off-chain lending toward the transparency, sweetness, and light of DeFi.

Plus synthetics

But, where will these private parties get the money to lend? They can mint new money. They can take assets that they are HODLing, and the new assets that they are buying, and use them as collateral to mint synthetic coins like DAI. This should be inexpensive, because liquidity crunches and panics increase the demand for these synthetic dollars, and lower the interest rate.

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Related articles:

• Decentralized bank architecture — A unified view of moves from protocols like MakerDAO, Frax, Aave, Circle
• Stabilizers — a standard structure for composable assets
• Compliance — How do we fit this global system into national regulations?
• Money supply — How does DeFi contribute to macro investment?

Maxos is building decentralized banking with standardized assets, real world lending and investment, and reliable dollar interest. Please consider following us on Medium or on Twitter, or chatting with me on the Maxos discord.