How to build a crypto banking system?

This post explores the foundations needed to build a financial system on DeFi. Although there are many innovations in the DeFi space, most of them are repeated speculation. Today we discuss the necessary components needed to build an effective financial system that can fund the real economy.

The chart below provides a high-level overview of the cryptocurrency banking system based on Zoltan’s interpretation of the shadow banking system. At the same time, it is also an extension of the content in “Cryptocurrency Banking System 101” and “Comparison of Cryptocurrency Banking System and Shadow Banking System”.

On the right are the lenders of last resort (households with huge savings, financial institutions, independent wealth funds, etc.) that have excess cash (with fees/interest rates) that can be used to finance the lenders of last resort on the left (piggybacking Mortgage households, SMEs, large corporations, governments).

How to build a crypto banking system?

As can be seen in the chart, despite the numerous stories about native crypto assets (such as ETH, BTC, etc.), they do not appear in the table. The chart is not complete, and the position of the cryptocurrency asset will be analyzed later. You can also think of cash as a cryptocurrency, which works the same way, assuming real-world assets use the same unit of account.

The key elements of a cryptocurrency banking system are:

  • Deeply liquid tokenized bonds that represent real-world credit (both private credit and public markets).
  • The cryptocurrency market is the core infrastructure of a market-based economy, including decentralized exchanges and repurchase markets.
  • Crypto banks act as intermediaries for savings and lenders for term conversion.

Demand for new originals

DeFi is built on the basis of no credit, and most borrowings rely on collateral. A key element of good collateral is deep liquidity—the ability to liquidate quickly at scale without dramatically impacting prices.

The most commonly used primary collaterals in the DeFi world are ETH and WBTC. They are all highly volatile (and therefore high valuation wear), limited supply, and speculative. They may be the collateral of the future, but they are not convenient enough at the moment.

So we need to introduce a new collateral. Gold, for example, has been tokenized (PAXG) but has not gained much traction.

If we look at TradFi, people’s choice of collateral has shifted from commercial paper to government bonds.

Tokenization of public credit

The first area of ​​obtaining liquid collateral is on-chain public markets. Companies issue tradable bonds, which are rated by credit rating agencies. The government issues securities with high liquidity and high ratings, which are more stable and can be effectively used as collateral, unlike cryptocurrency assets. In TradFi, these financial instruments are considered safe and sufficiently liquid to be classified as high-quality liquid assets.

Open market tokenization will allow some public securities to be issued on the asset side, and tokens will be issued at the same time (possibly in a 1:1 relationship). To obtain better liquidity, the same type of bonds can be concentrated, or directly introduced into ETFs (at the same time, the underlying assets must also be on the chain, which can be concentrated on the chain).

How to build a crypto banking system?

An example is Backed Finance, which is partnering with MakerDAO to tokenize the iShares USD Treasury 1–3 Year UCITS ETF.

Private Credit Tokenization

If we limit ourselves to the public credit phase, many collaterals could be used in the next few years, but such a system excludes households and SMEs from financing.

The solution is securitization, which utilizes intermediary pools to place illiquid assets (loans or non-tradable assets) and simultaneously issue two types of tokens, divided into priority tiers and inferior tiers. The credit increase of the inferior tier can provide safe and convenient price discovery for the priority tier, while forcing the intermediary to “play the game”. Ideally, the price of the priority tier would need to be assessed by a credit rating agency. The concentration needs to be large enough and the pools transparent enough to encourage the emergence of strong liquid markets in the priority tier.

How to build a crypto banking system?

Examples of such tokenization are New Silver, which does a “fix-and-flip” lending business (not currently strictly for households), and FortunaFi, which offers asset owners in income-based finance Collect loans.

Scale and liquidity trump everything

The key point is that in the public and private fields, a liquid market must be formed for a certain scale to avoid the dispersion of liquidity.

As can be seen from the first data, in March 2022, ETF bonds have more liquidity than their underlying assets. Some studies have also shown that this aggregated investment reduces the impact from asset fire sales. 

How to build a crypto banking system?

One of the problems with the Great Financial Crisis of 2008 was that illiquid securitizations were used as collateral, sometimes with zero haircuts. But in times of crisis, higher haircuts are applied, causing such collateral to be excluded from the repo market.

How to build a crypto banking system?

So it’s important to have very liquid and transparent tools to support the crypto banking system, rather than using a bunch of illiquid, hard-to-understand tools.

Not shown in the crypto banking system are funds issued by on-chain protocols and DAOs, backed or not secured by crypto collateral, pooling these assets requires the creation of other liquid and transparent fund vehicles.

With these deep and liquid originals, we are able to build sound cryptocurrency markets.

cryptocurrency market

At the heart of the crypto banking system is the crypto market, which provides deep liquidity pools (for trading and short-term funding). The crypto market consists of two major sub-markets, the decentralized exchanges (for trading) and the money market (for short-term funds). Both markets should minimize management and maximize the immutability of contracts. It should be credit-free, permission-free, and escrow-free.

How to build a crypto banking system?

There are three types of operators in the cryptocurrency market: value investors, speculators and arbitrageurs.

The stability of the entire system is provided by value investors. These people can be individuals, DeFi institutions (like crypto banks or insurance agreements), or TradFi investors. In short, assuming they have a predetermined allocation of assets (e.g., 50% cash, 50% bonds), they will deposit a portion of these assets on a decentralized exchange, passively letting the market take their position on them Arbitrage is carried out to maintain a constant risk exposure. They will also receive transaction fees (contrary to TradFi, clients are charged for maintaining a constant configuration). They can also deposit unused liquidity and bonds into the money market for other users to borrow for a fee (again increasing returns for value investors, whereas hosting in TradFi is paid).

Arbitrageurs provide more liquidity for tighter spreads to provide an efficient market. If the price of investment-grade bonds fluctuates significantly, they can borrow in the money market in exchange for Treasury bonds of similar maturity (to hedge against interest risk) and bonds with higher credit risk (to hedge against credit risk). These bonds are used as collateral in the money market to fund the borrowed bonds. Arbitrageurs are also able to provide liquidity on options protocols, providing an orderly market for on-chain ETFs (by arbitraging ETF prices with the underlying asset).

Speculators are people who are willing to take more risk than arbitrageurs – speculators go long and short different assets to gain speculative opportunities. Go long treasuries, for example, and when speculators think the yield curve is too steep (or the other way around), take another position in the currency market to gain leverage. Through speculation, they provide price discovery mechanisms in an attempt to achieve efficient markets.

By centralizing liquidity into the cryptocurrency market, rather than sitting idle in wallets, the crypto banking system can achieve higher liquidity than traditional markets at lower cost and less complexity.

Bond originals are designed to be a collection of illiquid instruments (i.e. corporate bonds and mortgages) and thus have high liquidity. Cryptocurrency markets provide the means to be able to use most of the market cap of these originals for liquidity trading or funding facilitation (nothing prevents decentralized exchanges from using currency market liquidity in the background).

To be more effective, we need to have a new player, the crypto bank.

Crypto Banks Towards Fractional Reserve Funding

As currently defined, the crypto banking system consists of bond instruments and cash instruments. We have seen that bonds consist of tokenized private pooled credits and public market instruments. So what is cash?

Defining Cash in the Crypto Banking System

In a simplified version, a fiat-backed stablecoin is a $1 on-demand liability backed by treasuries (or bank deposits). This support allows stablecoins to be redeemed at any time (on demand) without liquidity issues. Currently, the spread between the two (i.e. the Treasury bill rate) goes entirely to the stablecoin issuer (or distributor), not the stablecoin holder. This may change, but structurally, the interest rate that stablecoin holders receive will be capped by the Treasury bill rate.

How to build a crypto banking system?

At scale, such a system could be bad for credit intermediaries. In fact, if stablecoins become the new bank deposits, it will shrink the latter and reduce credit creation by traditional banks. This is where crypto banking comes into play.

Address liquidity preferences and expand money supply

There is a fundamental mismatch between lenders of last resort who need long-term borrowings and lenders of last resort with liquidity preferences. As shown below, most of the ultimate financiers are holding cash, possibly large amounts. While a shortfall in national deficits is unlikely, large amounts of money for economic activity are not allowed and could lead to economic constraints.

How to build a crypto banking system?

To solve this problem, fractional-reserve systems were introduced to expand the cash supply based on long-term loans.

As shown in the figure below, through intermediaries, namely crypto banks, a small amount of stablecoins backed by fiat currencies can be expanded through the fractional reserve system. Crypto banks issue stablecoins that are considered by creditors to be similar to money in that it can be exchanged for fiat-backed stablecoins (reserves). But here’s the problem, there isn’t enough reserves to make a one-time redemption of all stablecoins. History shows that credit declines can lead to bank runs, but the banking system can operate for years without a run, even in a recession.

Currency Creation for Crypto Banking Systems

The crypto banking system is not a traditional banking system (banks hold illiquid loans), a market-based banking system (no maturity conversion), nor shadow banking (the illusion of market-based maturity conversion).

Crypto banks hold highly liquid assets as a means of preventing bank runs.

in conclusion

As we have seen, three components are needed to build a strong cryptocurrency financial system: tokenized real-world credit (bonds), robust cryptocurrency markets, trading and lending (providing deep liquidity and price discovery), and cryptographic Bank’s maturity conversion.

At the time of writing, the cryptocurrency market is imperfect, but still functioning (Uniswap for lending and Aave for money markets). However, the bond part is seriously missing. The system exists, but it is mainly used for speculation.

Crypto banks like MakerDAO are already integrating with money markets using tools like D3M. MakerDAO is also helping to create bond originals, including with Centrifuge on private credit and Backed on public markets, and is proposing to issue up to $1 billion in short-term bonds.

We have never been this close to a robust cryptocurrency banking system.

Posted by:CoinYuppie,Reprinted with attribution to:
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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