Minsky and DeFi
Discretion and centrality
I've written a handful of times on topics related to decentralized finance or DeFi. DeFi is a set of financial practices based on the use of programmable "smart" contracts to carry out complex financial exchanges. For example, one can use crypto assets to fund a Uniswap pool that creates the possibility for other users to exchange crypto assets, all according to pre-programmed price-setting and transaction algorithms. Strongly associated with the Ethereum blockchain, DeFi's recent growth from zero to some $80 billion in open interest warrants continued investigation.
The DeFi space is dominated, at present, by lending protocols and decentralized exchanges. Importantly, though, DeFi is not so much a type of financial transaction as a way of conducting the business of financial transactions. It might even be thought of as an ethos or philosophy. This characterization, by Nic Carter and Linda Jeng in their paper, speaks to what the various DeFi projects have in common:
Minsky on discretion and centrality
The objective of eliminating discretion, and that word in particular, jump out at me because of the year that I spent submerged in the publications of Hyman Minsky. The outcome of that work was a book that tries to offer a version of Minsky that can speak to the problems faced by a new generation. Minsky paid close attention to the role of central banks as lenders of last resort, and he traces their ability to serve that function to the connection between centrality and discretion. This idea became a section of my book (chapter 6, second section).
Minsky starts with the survival constraint: "you have to pay your debts." The obligation to pay goes hand-in-hand with liquidity: it divides those who do have cash, and so can make payment, from those who don't, so can't. When a person or business has cash flow available to them, then the survival constraint does not bind, because they can use the cash to make payments as they come due.
Banks are privileged under such arrangements, because their liabilities serve as the money that it is used to pay debts. A bank can loosen the survival constraint for someone else at the bank's own discretion, i.e. by making a loan. Central banks are the most privileged among banks, because even when other banks' liabilities stop serving as money—during a liquidity crisis—central bank money still does the job. Central banks' ability to ease a liquidity constraint, that is, comes precisely from their ability to act at their discretion, on their own initiative:
Minsky warns central banks to defend their ability to act: if everyone knows what the central bank is going to do under any particular set of circumstances, then they can trade against it.
The DeFi vision
DeFi's vision is of a world without a discretionary central bank, indeed without any discretionary intermediaries at all. From a Minskyian point of view, however, this thinking is incomplete. Discretion is important because of the survival constraint. You have to pay your debts, and cash flows are what settle debts, so the presence of an actor who can always create cash flows is important.
DeFi takes no issue with the survival constraint. So, centuries of financial experience tell us, the moment will surely come when everyone scrambles to make payment at the same time. Without a discretionary lender, the only mechanism for adjustment will be prices, which under such circumstances will have to fall until they find a floor, the point at which buyers are willing to return. When this has happened, historically, it has been extremely destructive—that's why discretionary central banks have felt compelled to act during crises.
Carter and Jeng conclude: "Here is where all the chaos in DeFi is really from - systems that are built to be scalable and automated but that are underspecified or not understood by their creators." I would extend this, to say that it is not only individual DeFi projects that are not fully understood, but the spirit of decentralization itself.