Redux, my CWT with SBF

I won’t indent:

COWEN: I have some crypto questions for you. Is there, in fact, any way to coherently regulate stablecoins? I see what the proposals say: It’s all about capital requirements, deposit insurance, treat it as a bank account, like a new kind of money market fund. Can that possibly work? Doesn’t it end up having to be applied to all of crypto, all payments companies, PayPal, whatever else? What’s really there that they can do?

BANKMAN-FRIED: That’s a really interesting question. First of all, I will say, I think there is something that does work compared to the current environment, but I’ll get to your point — it’s actually a good one. If you just said, “Look, all stablecoins have to be fully backed by the dollar and have to have audits to confirm that they are in a bank account,” that would get a pretty safe product that was well understood, well regulated, and frankly would be, from a product perspective, just as good as current stablecoins. That’s what all the stablecoins are doing today.

It’s a mess because there’s no clear regulatory framework for them to fit into and to have oversight of that. So, part of my answer there is, basically, yes, I think that framework would solve the current problems that people have in a pretty clean way. But you have a good point there, which is, how about PayPal? There are all these things that we don’t call stablecoins right now, that we call something else.

COWEN: PayPal promises me a dollar, and they give it to me. I’m happy, right?

BANKMAN-FRIED: Exactly. In fact, a lot of these look a lot like stablecoins when you drill into it. When you really dig into it, what is the difference between PayPal and USDC? I guess there’s some differences, but I think there are more similarities than there are differences, to be honest. What does that imply for PayPal? You can just say, whatever it implies, stablecoin is not PayPal — it’s how it is.

I think there would be a big improvement over the current world, where it’s the same thing but without regulatory oversight and with a lot of random drama because of this. But I do think that it gets to this question of, “Wait, but banks are allowed to rehypothecate dollars. Banks are allowed to do all manner of wacky things with their deposits.” Are stablecoin companies allowed to? If not, is it obvious they shouldn’t be allowed to? And how should that be governed and regulated?

Maybe the answer is, whatever: The banks will do that on their behalf, the banks where they hold their assets, and then pay them interest for the right to do that — although, of course, right now banks aren’t actually paying interest, really . . .

COWEN: Not to me. Also, how stable does a stablecoin have to be to be regulated as such? If there’s any regulatory definition, won’t a lot of people just camp their crypto assets to be just slightly more volatile than wherever the line is drawn, or you’d just end up regulating all of crypto? How does that work?

BANKMAN-FRIED: This could go in a few ways. Is your thought that people will attempt to get just barely into the regulatory system or just barely out of it?

COWEN: Maybe both, but a lot of people will go out of it. So I’ll issue something. I’ll call it a “not stablecoin,” but de facto, it will be very stable. But also, “Oh, it’s just sort of an accident. Oh, who knows what the markets going to do today?” It’s just stable for decades. How do you regulate that?

BANKMAN-FRIED: Oh, that’s a really good question. Of course, what it gets you is this question of, what if a stablecoin didn’t promise to be a stablecoin? Is it bad that it’s backed by the dollar? Does it somehow make it worse from a regulatory perspective? Why is it being held to a higher standard?

COWEN: Exactly.

BANKMAN-FRIED: I do think there’s a little bit of an answer here, although I also think that this is getting at another point, which is, you could reasonably say, “Look, are consumers doing what they’re doing with their eyes wide open?” If there’s sufficient disclosures and transparency, shouldn’t people be allowed to use stablecoins with some risk in them?

I think that’d be a reasonable thing to think, but if you put that aside for a second, you say, “No, absolutely not.” Here’s one difference between that and the stablecoin, which I think is relevant, is that a stablecoin is not just stable in one direction. It’s stable in both directions. In particular, if you’re an investor, and you buy a stablecoin, you have downside risk but not upside. If somehow the stablecoin company makes money, you’re probably not going to get any of that, but if it loses money, somehow, you’re probably on the hook for that.

So, there is something a little asymmetric going on here for the consumer. I think it wouldn’t be crazy from that perspective to think that there should be some protection here and that maybe there should be regulation if consumers are only given one side of exposure, but I don’t think that’s obviously true. I think you’re making a decent point.

COWEN: Now, if we look at DeFi, there are some forms of obvious, explicit leverage, like people borrow money to participate in the system. But those aside, I’ve learned over my life, if you look at any system, any institution, typically there are forms of hidden implicit leverage in those institutions. Might be good, might be bad, but it’s there, and in a sense, you don’t understand the institution until you understand where’s the implicit leverage in this game. In DeFi, where is the implicit leverage? Is it rehypothecation, or where is it? What is it?

BANKMAN-FRIED: Ignoring the explicit leverage of borrow-lending protocols —

COWEN: Yes, which is easy to see, right?

BANKMAN-FRIED: Which is easy to see, yes. So, what happened in 2008? What caused the collapse in a lot of things? That’s sort of a dumb question, but one of the things that led to this is that no one knew how much leverage there was, really, in the system. As you said, there’s always implicit leverage, and in this case, it was all of these bespoke OTC swaps between banks that basically didn’t get reported anywhere. In fact, those got rehypothecated again and again and again. No one was keeping track of the total notional fees. It was impossible to — they weren’t public.

One thing you could do is look for a similar thing in crypto. You could look for OTC transactions. You could look for OTC swaps that live on. You could look at OTC borrow-lending. Those are in crypto. Are they in DeFi? It’s sort of ambiguous — they touch all areas of the crypto ecosystem.

But that’s an area where I think there’s some dubiously accounted-for leverage. I think that’s one answer to that question. Where else is there leverage that sort of is implicit? Rehypothecation sometimes, although in DeFi, because it’s all on-chain, it has to be pretty explicit if it’s going to be rehypothecated, but you’re not . . .

COWEN: But it’s hard to see, right? If you traced everything, you could find it, but no one’s actually watching it. Or are they?

BANKMAN-FRIED: Well, they’re halfheartedly watching it maybe, is how I’d put it, which is not great. Maybe full-heartedly watching it. I could imagine arguing for people full-heartedly watching it, and that would be a reasonable thing for them to be arguing for. In particular, if someone releases a protocol, there’s a question of, well, is that protocol rehypothecating? You just look at the code and see if it can rehypothecate, right?

In general, people actually often do know whether each protocol individually can rehypothecate, which is a separate question from whether they, as a group, can or whether they are or something. But in fact, most of these aren’t. Most DeFi protocols are not doing things beyond what they literally say they’re doing, and so the amount of leverage they introduce into the system mostly is what they say they are.

But here are some hidden things. First of all, you take one leverage thing, you put in another leverage thing, so DAI. DAI is an algorithmic stablecoin. Like other algorithmic stablecoins, it is not perfectly stable. It’s not perfectly stable because it’s not backed by the US dollar. It’s backed by crypto assets that could have price movements. It’s very overcollateralized. DAI can then be used as collateral on some borrow-lending protocols in crypto. That’s one form of rehypothecation in DeFi markets that you can trace through. It is, in theory, public, but it’s not super easy, necessarily, to trace through.

COWEN: Now, for mathematical finance, as you know, we at least pretend we can rationally price equities and bonds. People started with CAPM. It’s much more complicated than that now. But based on similar kinds of ideas — ultimately arbitrage, right? — if you think of crypto assets, do we even have a pretense that we have a rational theory of how they’re priced?

BANKMAN-FRIED: With a few of them, not with most. In particular, let’s talk about Dogecoin for a second, which I think is the purest of a type of coin, of the meme coin. I think the whole thing with Dogecoin is that it does away with that pretense. There is no sense in which any reasonable person could look at Dogecoin and be like, “Yes, discounted cash flow.” I think that there’s something bizarre and wacky and dangerous, but also powerful about that, about getting rid of the pretense.

I think that’s one example of a place where there is no pretense anymore that there is any real sense of how do you price this thing other than supply and demand, like memes versus — I don’t know — anti-memes? I think that more generally, though, that’s happened to a lot of assets. It’s just less explicit in a lot of them.

What is Elon Musk’s greatest product ever, or what’s his most successful product ever? I don’t think it’s an electric car. I don’t think it’s a rocket ship. I think one product of his has outperformed all of his other products in demand, and that’s TSLA, the ticker. That is his masterpiece. How is that priced? I don’t know, it’s worth Tesla. It’s a product people want, Tesla stock.

COWEN: But the prevalence of memes, Dogecoin, your point about Musk — which I would all accept — does that then make you go back and revisit how everything else is priced? The stuff that was supposed to be more rational in the first place — is that actually now quite general, and you’ve seen it through crypto? Or not?

BANKMAN-FRIED: Absolutely. It absolutely forces you to go back and say, “Well, okay, that’s how cryptocurrencies are priced. Is it really just crypto that’s priced that way?” Or maybe, are there other asset classes that may claim to have some pricing, or purport to, or people may often assume it does, but which in practice is not exactly that? I think the answer to that is a pretty straightforward yes.

It’s a pretty straightforward answer that you look at Tesla, you look at a lot of stocks right now, you think about what determines their market cap — the discounted cash flow? Yeah, sort of, that plays a role in it. That’s 30 percent of the answer. It’s when we look at the meme stocks and the meme coins that we feel like we can see the answer for ourselves for the first time, but it was always there in the other stocks as well, and social media has been amplifying this all over the place.

COWEN: Is this a new account of how your background as a gamer with memes has made you the appropriate person for pricing and arbitrage in crypto?

BANKMAN-FRIED: Yeah, there’s probably some truth to that. [laughs]

Here is the full dialogue.