Issue #31: How Decentralized Finance (DeFi) Can Improve Wholesale Clearing and Settlement
A proper comparison and contrast of decentralized finance (DeFi) and traditional finance (TradFi) necessitates some basic working definitions of both, definitions that I will outline below, so that we can form some sort of a common ground on which further discussion and debate can be built. In this issue of Monetary Mechanics, I argue that the development of decentralized finance is a phenomenon that is similar to the development of the post-WWII financial system. Specifically, I argue that it is similar to the development of “wholesale banking,” which is the practice of borrowing and lending between banks themselves or between banks and their large institutional customers, such as governments, pension funds, and large corporations.
However, there are still some important differences between decentralized finance and wholesale finance. Notably, while DeFi is able to create liquidity that can be used within the cryptocurrency ecosystem, no DeFi protocol is able to create additional fiat currency (i.e. create additional US Dollars). The closest thing that can happen is the creation of additional “stable coins,” which are digital assets designed to maintain a peg to various fiat currencies, such as the US Dollar, the Euro, or the Japanese Yen.
In some sense, DeFi protocols can create additional purchasing power that mimics fiat currency through the creation of additional stable coins. However, until stable coins are a widely acknowledged and accepted medium of payment, DeFi protocols cannot create “dollars” that could leak out into the real economy and the traditional financial system. Nonetheless, attempting to measure and quantify “money” is much less simple and straightforward than taking the aggregate of M2, which (in a broad sense) measures and quantifies various types of paper currency and commercial bank deposits, what we usually think and talk about as “money” today.1
There are various types of assets that live in a sort of a “gray area” – they are not “money” proper, but they appear to have one or more of the important defining properties that “money” is supposed to have (i.e. as a medium of exchange, as a unit of account, or as a store of value). Alan Greenspan himself stated in June 2000 that “we cannot extract from our statistical database what is true money conceptually, either in the transactions mode or in the store-of-value mode.”2 A main reason cited was that the rampant proliferation of financial products was remarkable, which caused the underlying mix of money and near-money data to be constantly changing.
An example is that, in the traditional financial system, accounts are often settled with collateral in the form of high-quality liquid assets (HQLA), as opposed to with commercial bank deposits, as one would expect. In this example, financial securities (i.e. US Treasuries) are more money-like than actual “money,” as financial securities are preferred as a medium of exchange over commercial bank deposits.
Another example is the fact that individuals have generally preferred various real and financial assets (e.g. real estate, bonds, equities, precious metals/stones, fine art, etc.) as a store of value over commercial bank deposits. The US Dollar and other fiat currencies have historically been a relatively poor store of value because they have significantly depreciated relative to virtually all other assets over the past century.
What is Traditional Finance (TradFi)?
Understanding the Wholesale Payments Systems
A proper explanation of the utility of fiat currencies, as well as why fiat currencies are so popular and have persisted for so long, requires an explanation of their “moat.” As fiat currencies are a relatively poor store of value, which we have already determined above, their “moat” relies primarily on their function as a medium of exchange.
The “moat” that fiat currencies, especially the US Dollar, enjoy is that they are extraordinarily liquid and flexible. In particular, the global payments system primarily operates through a few large interbank settlement systems, the largest of them being Fedwire and the Clearing House Interbank Payments System (CHIPS). All payments made using US Dollars, domestically or internationally, must eventually settle on one of these systems using US Federal Reserve balances as an “ultimate settlement.”
Now, I am going to elaborate on the difference between “gross settlement” and “net settlement” and attempt to explain why “ultimate” (i.e. “final”) settlement is an important distinction from both. While this will seem a bit pedantic and boring to most people, understanding this important distinction is rather crucial to understanding why digital assets are so fundamentally different from traditional forms of money.