Rise of Decentralised Finance (DeFi) when Existing Financial System Fails
In today’s Money Morning…the clogged toilet spills out…the rise of DeFi…you can decide which system you want to support…and more…
The big story from last week was the David and Goliath battle over a video game retailer called GameStop Corp [NYSE:GME].
So, I won’t rehash it all again for you now.
But in my opinion, it wasn’t just the big story from last week; it could actually go onto become one of the biggest stories of the decade.
You see, the fallout from this strange tale has repercussions beyond the immediately obvious.
Suffice to say, it’s now patently clear how corrupted our existing financial system is.
There is no level playing field.
And yet beyond the corruption, the insider access, and the special deals, there’s also a more mundane — yet potentially more important — aspect to this story.
It has shown that the plumbing of the whole financial system is completely ridiculous and will likely be entirely rebuilt in the years ahead.
In fact, this rebuild is already happening.
Let me give you a quick primer on what really happened under the hood with Robinhood and GameStop last week.
Then you’ll see why there’s a huge opportunity out of all this…
The clogged toilet spills out
Late last week, Robinhood restricted trading in GME shares.
At face value, it looked like they were trying to protect the short seller — Melvin Capital — who was bleeding money due to the frenzied buying.
This might have been part of it, after all major shareholder Citadel — who has former Fed Reserve chief Ben Bernanke on their advisory board — was exposed to Melvin Capital.
But it wasn’t the whole story.
You see, it wasn’t just Robinhood who restricted buying on GME shares.
Many other prime brokers did the same.
Why would they restrict trading in GME shares if they weren’t on the hook like Robinhood was?
This is where the financial plumbing comes in…
An analyst I follow on Twitter explained it brilliantly, and you can read that in full here for a detailed description.
But in short, it comes down to the simple fact that the existing financial system is too slow at settling trades.
Changing ownership in a stock transaction takes two days at least (T+2).
Because of this, short-term credit is used to allow trading to happen in real-time.
And when there’s credit, you’ve got two more risks to contend with: interest rate risk and default (counterparty) risk.
So, I can buy a share today and sell it tomorrow, even though technically I’ve never actually owned the share.
In fact, that process can happen on one set of shares many times over, before even the first trade is settled.
This creates a chain of ownership that isn’t certain because each trade is based to an extent on a short-term loan being honoured. If someone in your chain defaults before you’ve taken ownership, you could be in trouble.
Now, in the old world, such a slow system worked OK. After all, a short-term loan for just two days is unlikely to go wrong.
But in a modern, fast-paced digital world, this two-day delay can seem like a lifetime. Especially when things go wrong like they did with GME.
The entity responsible for settling trades (the DTCC) starts to worry about the credit of their counterparties. After all, they need the chain of trades to match out.
So, they request more collateral from the brokers they deal with, who in turn pass this onto their clients.
That’s why last week, a lot of brokers — not just Robinhood — increased collateral requirements for ALL clients to deal with the huge risks building with GME.
This action has a knock-on effect of its own.
Panic starts to set in as investors and traders shuffle around their portfolios to meet the new requirements.
Big firms also start to worry about who’s on the other side of their trades.
Are they solvent?
Can they cover their debts?
Will I be able to collect on my trades?
The initial ‘clog’ becomes a systemic issue for the entire network.
As one analyst noted on Twitter:
‘When you flush, a downstream clog causes a mess that backs up into your toilet. Don’t handle that clog well & you end up with a mess on your floor. Handle it *really* poorly & you burst a pipe — wastewater seeps into your walls.’
Which is what started happening last week with Robinhood and their major partner Citadel.
It was clear a number of prime brokers were now at risk in the GME situation. Not because they had placed bad bets, but because they had counterparty risks to those that had.
To be clear it wasn’t the exposure to the GME trade, but the knock-on effect on interest rates, collateral requirements, and liquidity that they were at risk of.
That’s why the regulators stepped in.
I should also stress that letting the system play out without intervention, wouldn’t mean the reddit crowd on WallStreetBets would win and most probably wouldn’t see any money either.
If their brokers — firms like Robinhood — went bust, they’d just be another creditor (remember they didn’t own those shares to start off with) with a claim.
If this all seems very complex and completely f*cked up, that’s because it pretty much is.
And it all stems from the seemingly boring issue of delayed settlement.
Luckily, there’s a new system being built that does settlement very well…
The rise of DeFi or Decentralised Finance
As I said at the start, a new system of financial plumbing is already being created.
Unlike OldFi — old finance — this system is open to all. No insider deals, no special access, no different rules for the elite.
It’s called DeFi — decentralised finance — and it’s all that any honest investor could want: a level playing field.
The one thing it already does really well is the boring old process of settlement.
For example, every transaction on the entire bitcoin network settles roughly every 10 minutes. If you wait an hour, you can virtually guarantee the transaction is settled.
And all this is done on a peer-to-peer network with no central controller.
That one improvement changes the entire financial fabric.
The fact is the tools and technology of blockchain are already re-inventing the plumbing that connects the financial world.
As one leading DeFi developer tweeted:
‘All this unnecessary complexity is replaceable by a few lines of code on Ethereum.’
You can now understand why many on Wall Street hate crypto and are always trying to talk it down!
It’s going to take away their edge. But it’s coming no matter what. And the tentacles of DeFi are long.
Check out this graphic which shows the sheer scope that DeFi is going after:
No area is safe from this DeFi revolution.
If that scares you, think about this for a second…
The original cryptocurrency, Bitcoin [BTC] — which is essentially just a transparent ledger of transactions on a decentralised network that settles every 10 minutes — has been running 24 hours a day, seven days a week, for over 11 years.
With no regulator, no regulations, and no ‘qualified’ middlemen to intervene.
And the system has worked beautifully. It’s been there for whoever needed it, in whatever form they needed it.
It’s also been the best-performing asset for eight of those 11 years.
So, when people say you need regulators, central bankers, and trusted intermediaries for a ‘properly functioning market’ to work, I can only laugh.
Bitcoin has proven you don’t need any of those things.
The truth is regulations are actually just ways to exclude ordinary people from a level playing field.
It’s funny how that same protection doesn’t apply to lotto tickets or casinos, isn’t it?
Anyway, I think the truth is there for all to see now.
And you can decide which system you want to support. The closed world of OldFi or the open world of DeFi?
To me the option is simple, and the eventual winner clear.
As Elon Musk tweeted this week as he changed his bio description to the bitcoin symbol:
‘In retrospect, it was inevitable.’
Editor, Money Morning
Ryan is also editor of Exponential Stock Investor, a stock tipping newsletter that looks for the biggest investment opportunities on the market. For information on how to subscribe and see what Ryan’s telling his subscribers right now, click here.