MakerDAO on Collision Course With Banking Regulators

It's a shots-fired moment for decentralized finance, or DeFi. MakerDAO, a decentralized bank and one of the cornerstones of DeFi, made its first "real world" loan last month. It is lending to Americans who want to fix and flip residential real estate.

If old-school bankers weren't aware of decentralized banks before, Maker's new foray changes that. Maker is now treading the same hunting grounds as not only banking behemoths such as Wells Fargo, but also A+ Federal Credit Union of Austin and thousands of other credit unions.

J.P. Koning, a CoinDesk columnist, worked as an equity researcher at a Canadian brokerage firm and a financial writer at a large Canadian bank. He runs the popular Moneyness blog.

No business is more regulated than banking. As long as MakerDAO confined itself to the blockchain sector, bank regulators such as the Federal Reserve could stay unaware. They can't now.

Decentralized banking = centralized banking

Wells Fargo, A+ Federal Credit Union and MakerDAO are all engaged in the magical business of banking. That is, they each create deposits out of nothing and lend them out.

In Wells Fargo and A+'s case, dollar-denominated deposits are instantiated on centralized ledgers and then lent out to customers. MakerDAO does things a bit differently. It spins up dollar-denominated deposits, known as dai, on a decentralized ledger, the Ethereum blockchain, and then lends them using smart contracts.

But apart from the little details of how the deposits get stored and managed, all three institutions are in the exact same basic business – banking. Create a dollar, lend it, repeat.

Since its inception, Maker has provided banking services to a particular set of clients: pseudonymous cryptocurrency speculators. A typical MakerDAO borrower is a gung-ho crypto fan who, already heavily invested in ether, wants even more exposure. No credit checks or personal references required by Maker. The borrower need only submit their ether tokens to the Maker protocol as collateral, upon which a loan of fresh dai is automatically issued. The speculator uses borrowed dai to buy additional ether.

Like any bank, MakerDAO manages credit risk by controlling the amount of collateral that clients must submit. If a loan is about to go bad, Maker can protect itself by seizing the collateral, whether that be ether or wrapped bitcoin, or any other crypto asset on its permissible list.

Neither Wells Fargo nor A+FCU would ever dream of lending to pseudonymous coin speculators. And so Maker has never landed on those traditional banks’ competitive radar screens. U.S. banking regulators have been mostly oblivious, too. No need to supervise some strange blockchain-y thing that lends to an invisible and amorphous online client base.

But shots have been fired. And now traditional banking is going to have to devote some brain-power to figuring out what decentralized banks such as MakerDAO are up to. Here’s a quick explanation.

Anatomy of decentralized loan to meatspace

Last month, MakerDAO created and lent around $500,000 dai to fund “fix and flip” U.S. residential properties. A homeowner applies for a mortgage, uses the borrowed funds to improve the house, sells it and pays the loan back.

New Silver, an originator of real estate loans, set up a special purpose vehicle, or SPV, which holds title to the fix and flip loans. Technology from Centrifuge, a fintech, dices the loans into senior and junior tranches and encodes the securities as non-fungible tokens (NFTs) on Ethereum. New Silver keeps the junior, riskier tranche for itself and submits the senior tranche to Maker as collateral in return for fresh dai financing. (The fix and flip loans can be monitored here.)

Shorter story: We made some loans to house-flippers and our banker, MakerDAO, is financing them.

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It's hard to miss the irony. Cryptocurrencies such as bitcoin and ethereum emerged in response to the 2008 residential mortgage implosion. Mortgages had been sliced and diced into conduits, SPVs, collateralized debt obligations (CDOs) and CDO-squareds, graded by credit rating agencies, and sold to witless buyers. And now, 13 years later, MakerDAO is tinkering with the senior tranche of an SPV-securitized residential mortgage portfolio.

Wells Fargo, A+FCU and other traditional banks will be furious (when they find out). They have invested significant amounts of money into chartering and compliance. With no regulatory costs, MakerDAO can probably undercut them by offering fix-and-flip financing at a lower interest rate.

MakerDAO isn't standing still. It is targeting $300 million in real-world loans by the end of this year. There is talk of freight invoice lending, financing of U.S. farm properties and loans to solar facilities. Expect more blockchain-based banks to start copying Maker.

With all this growth, decentralized banks are destined to collide with real-world bank regulators. What will this collision look like?

DeFi, not-so-censorship resistant

The U.S. has a bewildering system of banking regulation. The Federal Reserve, Federal Deposit Insurance Corp. (FDIC) and Office of the Comptroller of the Currency (OCC) are all involved in regulating banks, as are more than 50 state financial departments. Credit unions are regulated by the National Credit Union Administration.

One of these, perhaps a state financial department like the New York State Department of Financial Services, is likely to send a notification to blockchain-based banks. If they want to provide banking services in U.S. meatspace, the notice will say, they must get bank charters and submit to regulatory supervision.

America's bank regulation probably won’t fit MakerDAO very well – it's designed for 20th-century banks with physical locations and loan officers, not banks that are built on a layer of automated smart contracts. Perhaps lawmakers will devise a special blockchain bank charter. But that will take time, engagement and patience.

DeFi enthusiasts often laugh at the talk of regulation. Any bank regulator that attempts to exercise authority over the collection of smart contracts and stakeholders that calls itself MakerDAO will inevitably fail, they say. The whole point of being on a decentralized protocol, after all, is to avoid being controlled.

And there is certainly some truth to that. But even if a bank is decentralized enough to ignore a government order to get a bank charter, there’s a good chance it would comply anyway. Refuse and MakerDAO would be operating illegally. No more fix and flips. It would have to retreat back to the censorship-resistant safety of the blockchain and its relatively small clientele of pseudonymous cryptocurrency speculators. Submitting to regulation means a ticket to the biggest market in the world: Main Street America.

Other big DeFi applications such as decentralized exchange Uniswap or lending market Compound may soon face the same sort of difficult choice as MakerDAO. They can either stay safely rooted in their rules-free financial zone or get more real-world relevance, but at the price of regulation.

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Financial regulation is often criticized. It adds costs. It forces financial institutions to cut off unprofitable customers. It favors incumbents. It reduces innovation. Much of that is true.

On the other hand, regulation emerges through a democratic process. We impose onerous capital requirements and leverage ratios on banks, because burnt by the credit crisis, we are hoping to avoid another crisis. Banks that use decentralization as a means for evading rules are acting undemocratically.

Significant amounts of electricity are being used to secure the Ethereum blockchain. That ensures that Ethereum, and everything built on it, remains open and censorship resistant. But if DeFi tools like MakerDAO choose to become regulated, censorship-resistance is pretty much cancelled. Is there a point to being a regulated bank on an expensive and open blockchain?

For now, MakerDAO will keep on pushing into real-world loans. But expect many of these complicated issues to bubble up in the next few years.