Preparing for the Network State
….Why grassroots credit creation matters
Having listened to The Creature from Jekyll Island over the weekend (a book about the creation of the Federal Reserve Bank) and attending Balaji’s “The Network State” conference on how decentralized communities can provide a viable organizational alternative to nation-states, several topics that I have written about previously (the Bloodletting & Freedom From Regulatory Capture) have come sharper into focus.
I think a key starting point for this discussion is Balaji’s observation that the existing system (political & financial) is too “sick” to be incrementally changed from within by supporting blue or red candidates and their respective policy measures.
The realization that national, personal, and corporate debt levels across the globe (China, Japan, Europe, EM & the United States) are collectively at levels that most will agree can never be repaid. Leaving only three options 1) hard default (unlikely as long as the printing presses remain available), 2) soft default through negative real rates (inflation > nominal yields) and financial repression, or 3) restructuring which is the most likely ultimate answer but can only happen in a globally co-ordinated way.
Financial repression therefore is the most likely near-term solution and it only works if people have high barriers to exiting the existing system and/or existing arrangements such as those administered through banks, brokers, pensions & indeed the state itself. It is therefore highly dependent on regulatory capture and control.
As we have discussed before the regulatory capture has been, and continues to be progressed to the extent that ordinary banks (non-systemically important financial institutions or SIFIs) can barely make a return on equity that is more than their cost of capital. This is why most of them trade at a discount to book value even though they pay depositors only a fraction of prevailing interest rates and get preferred access to fixed-income markets on the back of their implicit government guarantee. Not to mention that they run at between 10–25x leverage through what is affectionately called “fractional reserve” banking. Even the sharkiest of sharks at Goldman Sachs (my alma mater) only managed to clock a 10% return on equity last year and are currently running at <7% on an LTM basis (according to TradingView)… Something is very wrong with TradFi!
So what gives? Probably nothing. As long as they can continue to create more debt/leverage to pay the interest on the existing pile of fractionally reserved debt (aka “assets” to banks), they can keep the ball rolling. But surely there is a natural limit to all of this? I have spent an inordinate amount of time pondering this exact question, and I think the answer is there isn’t. That is, as long as we are asking those who are incentivized to push that boundary indefinitely. I think it was Upton Sinclair who said, “It is difficult to get a man to understand something when his salary depends on him not understanding it.”
So, instead of trying to convince those who have no incentive to listen, there is but one option. To opt-out and build better alternatives from the ground up — Grass Roots Credit Creation!
A lot of current RWA tokenization (especially of existing securities) doesn’t contribute to the stated goal of decentralizing credit creation. They may serve a purpose in bringing liquid collateral with attractive yield on-chain, thus providing an easy-to-implement driver of on-chain adoption, but it does nothing to opt out of and “defund” the existing system. Quite the opposite!
What we need, is localized and regional credit assessment and provision without the dependence on fractional reserves and/or hard limits to such fractions, in the order magnitude of 1–2x leverage or 30–50% reserve requirement. For this to work, we need a drastic reduction of the cost of credit creation through the simplification of processes related to the selection, creation & administration of credit whilst creating a liquid and transparent market for the pricing and trading of credit units so that they may trade freely and be priced efficiently.
Instead of when rates go down you have to pay a prepayment penalty if you would like to pay down your mortgage early, you should be allowed to pay off (buy-back) the mortgage at the prevailing reduced face value of the mortgage bond at any point in time. This ends the perverse growth incentive of the current fiat banking system and provides an elegant solution to resolve excesses, i.e. the market is allowed to find the clearing price for excess/bad debt. To my knowledge, only Denmark has implemented something similar for private mortgage bonds, and it seems a complete no-brainer. This should be easy to create, administer, and trade even without digital ledger technology (DLT), as Denmark has demonstrated. Add in DLT and it becomes a complete no-brainer. In fact, the more you think about it, DLT and free markets are just infinitely superior to banks for the maturity transformation of credit even before you consider the cost, waste, and regulatory capture. So that leaves only the credit appraisal and selection, which can also be co-operatively solved using DLT.
If a community collaborates on credit appraisal and selection through delegation to appropriately incentivized and aligned bona fide credit experts and then administers such credits through DLT, making them freely tradable and composable, it should be possible to organize credit allocation and pricing collectively more efficiently and equitably than our current banking system. In doing so, it will provide a viable alternative for putting money to work and, over time, attract more and more deposits, which in turn will enable it to provide increasing amounts of credit to those that require it to do value-accretive stuff even after we take the losses of those that fail to realize their ambitions. If so, this will slowly capture TradFi deposits while funding the beating small and medium-sized entrepreneurial (SME) heart of the economy without needing fractional reserve or leverage.
It is my best guess that however far-fetched the above might sound to you today, it is precisely what will happen. Caitlin Long’s initiative to create a fully reserved bank (Custodia), Balaji’s Network State conference, and most of the on-chain lending activity that is 100% or more collateralized (i.e. not fractionally reserved) are the tell-tale signs that people are thinking about an alternative future. And, more importantly, they are willing to forego the Faustian fruits of leverage to achieve such. This type of lending activity is and will remain healthy, and slowly but surely, as it gains traction and appreciation for what it stands for (the moral high ground), it will attract more capital, causing the old overleveraged system to slowly be starved of the liquidity it requires to keep re-financing and re-hypothecating its assets until the point that whatever is left gets put on the FED’s balance sheet, written-off or marked to actual market and refinanced/restructured by the new system.
I have discussed the scenarios for that transition in “The Bloodletting”, and whilst it is interesting to ponder how & when that will happen and how one might profit from it, it is ultimately a lot more essential to contribute to building the financial ARK of the future. At Florence Finance, we are doing our little part to further this cause, and where it felt idealistic when we started building, it is becoming clearer by the day that we are on the right track. Now that we are live on Arbitrum and you can deposit and withdraw capital in and out of our lending vaults for mere cents in gas fees we think we have built the elemental building block for cooperative, community-led decentralized credit creation. We look forward to growing and harnessing it for a brighter future, as envisaged by Balaji in his Network State thesis.
The non-fractionally reserved Renaissance is here.
