Banks handle $100T in assets worldwide. They fill an important role in every modern economy. Banking connects savers and builders.
Savers want to earn some interest, without having to think about placing an investment. They also want to get their money back quickly, whenever they want it. Builders want money for investments that require a lot of attention and lock up money for some time. A bank converts term loans and investments with intermittent payoffs (on the builder side) to safe and liquid demand deposits (on the saver side).
A centralized bank combines three components under unified management
- Deposits or "liabilities"
- Assets - investments and loans. Bank managers are responsible for placing deposits into assets that pay a higher rate of interest
- Capital. Bank shareholders put in money to protect depositors from losses. A bank is overcollateralized by this capital. Technically, a bank is a "waterfall" where the shareholders get the profits and losses that don't go to depositors.
A move from local markets to global markets is changing banking. It separates liabilities from assets.
Depositors have an incentive to put their money into large pools. Those pools give them a product with more diversification, more features, and more fungibility. JP Morgan acquired $3T in liabilities while smaller banks get merged out of business. Buyers will go to a small number of stablecoin issuers, not thousands of less-fungible deposit coins.
The organizations receiving those deposit pools are not qualified to place all of that money, and to bet their capital on how they place it. Instead, they outsource that to experts that have local or industry knowledge.
For example, the $18T US mortgage market started with local banks funding mortgages from their local deposits. Now it supplies funding to local lenders through huge national pools.
In this structure, the capital is provided by many different wholesale lenders. It appears in the junior tranche of their waterfall.
- Pooling deposits is a good role for a global DAO, which we call a "savings protocol"
- Placing assets and providing capital is a good role for a group of expert wholesale borrowers
These observations inform the design of architectures from MakerDAO, Aave, Frax, and Sweep.
Centralized banks have an advantage in management focus and agility.
A decentralized structure should be more scalable. It can expand by tapping into capital and risk management from a growing pool of wholesale borrowers.
A decentralized structure may have advantages in efficiency with automation and lower fixed costs.
An automated structure should be more shrinkable. This reduces systemic risks during hard times. A protocol does not need to take on risks to preserve jobs and cover fixed costs and other commitments. It can just let its pools shrink. Wholesale borrowers can move to other funding sources, perhaps with the same structure but improved risk management.
DeFi adds useful packaging to a savings account. You can’t do much with a bank account number. You can do more with a token.
- You can automate. Your software can acquire the token through an API. You can program your own software for front ends, smart sweeps, payments, structured investments, and other services.
- You can use it as collateral for other investments. You can stack yield by borrowing against it. You can use it as collateral for a derivatives contract, or as the deposit on an apartment.
A demand for tokenized deposits will have an impact on the traditional banking system. Nations provide deposit insurance to boost local economies by subsidizing deposits and lending at local banks. Tokenizing insured deposits can destabilize this system by motivating savers to buy the largest and most fungible deposits, concentrating assets and risk in a few institutions, and forcing their regulation as de-facto CBDCs. Alternatively, regulators are proposing that stablecoin reserves should go into central bank cash accounts- the safest and most liquid storage. However, this makes the money unavailable in the real economy and is economically destructive. These scenarios create a need to "sweep" money into more productive uses.
The banking industry experiences "panics" where everyone wants their money back at the same time. These can be damaging if they cause cascading defaults, or a loss of credit to the real economy. Central banks have developed tactics to supply money and smooth over these events.
A global, private, and decentralized system will have less support from central banks. However, it will have improved tools that include 24/7 flexibility of rates and pricing, and conversion between deposits and equity, and most importantly, transparency.