DeFi Needs a Safety Net to Make Banking Dinosaurs Extinct

Today’s guest post starts with a great question: Why do we still use banks? If you’re reading this newsletter, it’s likely you agree with me and the author that the current financial system is a relic and you know there’s a better alternative being built. So why aren’t savers taking their money from bank vaults and putting it in smart contracts? Robert Sharratt of CrescoFin, a crypto & fiat savings account, argues the reason has something to do with human psychology: we’re risk-averse creatures. And having money in the bank needs to feel like it’s the safest place to keep it; smart contracts still don’t do the job. To Robert, DeFi needs an additional safety net. It’s the same safety net that makes it easier to trust banks: insurance. Read on, as this might be one of the keys to finally make these dinosaurs extinct.

Why do we still use banks?

By Robert Sharratt, founder and managing director of CrescoFin

“Retail banks are dinosaurs.”

Bill Gates, 1994

Yet, despite this widespread belief, US bank deposits increased from $189 billion in 1994 to $7.8 trillion in 2019.

Technology has been a bit better at making other industries extinct. For example, US newspaper advertising revenue fell from about $50 billion in 1994 to an estimated $15 billion in 2019 and is headed lower. The music, hotel, taxi, etc. industries have been similarly affected by technology.

So, why not banks?

Despite efforts ranging from cypherpunks to Occupy Wall Street protesters to fintech companies, banks not only refuse to die off, but they keep growing. It is a bit irritating.

Two common reasons suggested for banks’ survival are set out below.

Regulation

Few industries are as protected by regulation as the banking industry. The core functions of banks (deposits, loans) are based on a fractional reserve model, which is risky. Interconnections amongst banks spread this risk. So embedded are banks in the economic model that they are substantially shielded from competition, much like guilds in the Middle Ages. Bank enablers (politicians, regulators) typically discourage ideas that would re-imagine the industry.

No alternatives?

Fintechs have done a good job of making some financial processes more efficient, particularly around payments and UX. However, as they share the same (outdated) technology architecture, fintechs can’t really offer an alternative to core banking functions; they mainly nibble around the edges of CeFi. It isn’t easy to access most fintech products without a bank account, let alone rely only on a fintech system.

The best alternative is, of course, crypto. In 2009 Satoshi Nakamoto created a system of money that corresponds to how humanity has exchanged value for most of our history. Technologically, this system is based on mathematical formulae and a straight-forward verification and record system. The implications are spectacular: you can now trust exchanging value with another person or institution directly, even if you don’t know them.

The crypto system means that you don’t need to go through a central authority (like a bank or an exchange). It also means that the costs of the central authority can be cut out, and the savings can be shared with users. Much of this is being built in real-time today, in the form of DeFi on the Ethereum blockchain.

And yet, while there are lots of interesting synthetic derivative products being built on DeFi, few look like a bank account alternative.

Why is that?

Image source: maxpixel.net

Human psychology

One possible answer is that humans are loss-averse by nature. We equate having “money in the bank” with being risk-free, even if it is not quite true.

We didn’t always think this. Throughout history, banks have failed regularly, like other businesses. In the US, from the mid-1800s to the establishment of the Federal Reserve in 1913, there were regular bank failures, often hundreds per year, that led to local contagion. The frequency of bank failure was unchanged after the establishment of the Federal Reserve. From 1929 to 1933, the number of US commercial banks declined by 40%, from 25,000 to 14,000.

Then, since 1934, there has been almost no serious bank failures and none that caused contagion. Almost no bank runs. The same is true in most developed economies.

Why did people all of a sudden trust banks?

The answer is simple: insurance.

In 1934, the US established the Federal Deposit Insurance Corporation. Perhaps quite naturally, we found comfort knowing that our money in the bank was insured.

One of the key reasons why people don’t bank very much with Bill Gates, or Bitcoin, or DeFi liquidity protocols is that they don’t give us enough assurance. They don’t instinctively respond to our loss-averse nature the same way as the “don’t worry, it’s insured” feeling that is associated with retail banks.

So, until DeFi solves this insurance issue, expect the dinosaurs to continue to be around.

As a spoiler: we are working on this and expect banks to be extinct within our lifetime.