Compiled edited by TechFlow
Guests:
Haseeb Qureshi, Managing Partner, Dragonfly
Robert Leshner, CEO Co-founder of Superstate
Tarun Chitra, Managing Partner, Robot Ventures
Tom Schmidt, General Partner, Dragonfly
Podcast source: Unchained
Original title: Exchange War Erupts: Hyperliquid vs. Binance OKX - The Chopping Block
Highlights of this issue
Hyperliquid’s JELLYJELLY Crisis – How a high-profile DeFi project used fake oracle prices to bail out its own treasury, ultimately losing the trust of the market.
Exchange competition escalates – Binance and OKX’s listing of JELLYJELLY perpetual contracts was interpreted as a precise strike against Hyperliquid.
Are decentralized exchanges really decentralized? – The Hyperliquid incident reveals the problems caused by the concentration of power among validators behind the so-called “decentralized” performance.
DNA on the chain: 23andMe on the blockchain – Say Foundation proposes to protect genetic data through token thresholds; is this an innovation in privacy protection or a dystopian vision?
The Decentralized Science (DeSci) Scam – Tarun once again criticized the DeSci concept and explained why the risks of putting genetic data on the chain are more serious than meme coins.
The battle over stablecoin regulation – The Stability Act and the Genius Act face off in Washington, which one will prevail?
The possibility of stablecoins as narrow banks – The rise of cryptocurrencies may force the Federal Reserve to accept a financial idea they have resisted for 20 years.
HLP deposit future bet – The host is betting real money whether Hyperliquid deposits will recover or continue to decline after the crash.
New Movements with Memecoin and Olympus – Are those former “looters” quietly earning profits from the broken vaults?
Taruns Failure Rankings – Why JELLYJELLYs failure was worse than MobileCoin, but at least it fits Hyperliquids brand positioning.
Hyperliquid Events Expand
Haseeb:
One of the biggest stories of the week has been the drama around Hyperliquid. For those unfamiliar, Hyperliquid is a new hot DEX that is now the #1 DEX by overall trading volume. They did a massive airdrop and are loved by retail crypto investors for the size of the airdrop and the way they launched it fairly.
In recent days, Hyperliquid has suffered a large-scale attack around a memecoin, JellyJelly, which is a memecoin with very low liquidity and has passed its peak, but is listed as a contract trading product by Hyperliquid. A trader opened a short position worth $8 million on JellyJelly, which was equivalent to 50% of Jellys circulating market value at the time, a very large short position. Next, the trader raised the spot price of Jelly, resulting in his own forced liquidation.
So why would a trader do this? Why would they force themselves to get liquidated?
On Hyperliquid, when a position cannot be closed in a normal way, HLP (Hyperliquids crowdfunded market maker) will take over the position and try to close it in an orderly manner. The existence of HLP is crucial to the liquidity of Hyperliquid, and it always provides liquidity to traders. However, due to the huge size of the position this time, HLP was forced to short Jelly, but no one in the market was willing to take over this short position, which eventually led to the so-called short squeeze.
This short squeeze was not just a prank by retail investors. In fact, two major exchanges, OKX and Binance, were also indirectly involved. When the market realized that Hyperliquid or its HLP was shorting Jelly on a large scale, OKX and Binance announced that they would launch JellyJelly contract trading within 24 hours.
Almost everyone thought, “This is a war between exchanges.” CZ and the boss of OKX had already pointed their guns at Hyperliquid, and this was an opportunity to strike them down.
Hyperliquid’s validators voted to delist JellyJelly and forced liquidation of the position at a level below the market price by artificially adjusting the oracle price.
Haseeb:
Hyperliquids decision sparked widespread controversy. They believed that instead of letting the platform or HLP holders bear losses, it would be better to lock the price at a false low price through artificial intervention to ensure that the interests of HLP users are not harmed. However, this move caused the price of Hyperliquids token to drop sharply, from about $21 to $15, a single-day drop of nearly 25%.
This incident raises two core questions: First, is Hyperliquids response in this situation reasonable? Are there fundamental flaws in their mechanism design? Second, does this expose that Hyperliquids degree of decentralization is not as high as it claims? These questions have sparked heated discussions in the industry, and some centralized exchanges (such as Bitget) have publicly criticized Hyperliquids practices as unfair. Competition among decentralized exchanges has therefore become increasingly fierce, and the DeFi field seems to be experiencing an important watershed moment.
So, what do you think of this HLP incident?
Tarun:
I think this incident did expose some flaws in the protocol design. Like AMMs, the mechanism of AMMs does not allow orders to be rejected. For example, the initial Unicorn v2 and v3 had no flexibility in this regard, and you could not choose to accept or reject specific orders. This problem also exists in Hyperliquids liquidity pool.
Hyperliquids HLP mechanism is different from other platforms (such as GMXs GOP and Jupiters JLP). The operating logic of HLP is that users deposit ether (ETH), and the platform will allocate these ETH to multiple assets for market making. For example, 1% of ETH may be used to make JellyJelly, 90% for Ethereum, and the rest for Bitcoin. These asset allocations are determined by off-chain algorithms, and users need to trust the asset allocation capabilities of the Hyperliquid team.
Apparently, they made some mistakes in the mechanism design, such as not setting position limits, open interest caps, etc. If these limits were in place, the problem could have been alleviated without the need for emergency intervention. Hyperliquid has stated that it will fix these mechanisms, including adding open interest limits and concentration limits.
This is exactly why I mentioned when describing this problem that liquidity pools that do not distinguish between order types have certain limitations. Under the current mechanism, HLP cannot process orders selectively, that is, it cannot reject certain orders and only accept specific types of orders. If HLP can distinguish positions that are forced to be liquidated by third parties, the market can price them according to the actual value of these positions, and HLP will not have to bear unnecessary losses. However, the current design makes HLP automatically trade with these positions, a model similar to how the Unicorn pool operates. Therefore, they lack sufficient restrictions in strategy design. These strategies are actually run off-chain by the Hyperliquid team, rather than being executed openly and transparently on the chain.
I dont know exactly what their code looks like because most of it is not open source. I can run a node, but I only get the binary and cant view the source code. Also, many of the settings of the system are not clear and transparent. This incident clearly shows that they have obvious shortcomings in their policy restrictions. I think this is something they admit to being a priority to fix. But from a market perspective, it also shows the value of having a more open policy, rather than being completely closed like it is now. Because at present, there is almost no transparency to the outside world about how HLP works.
As a depositor of HLP, you don’t actually know whether HLP has clear risk limits, such as whether it will automatically assume the position risk of the entire liquidity pool. You also cannot be sure whether they will intervene in the market by artificially adjusting the oracle price as in this incident. Although some relevant content is mentioned in the document, users cannot verify the actual operation of these mechanisms because the code is not open source. Even if the code is not open source, there is a lack of other verifiable proofs to confirm its behavior.
I think the mechanism provided by Hyperliquid is different from the transparency that users expect in other protocols. In other protocols, users can clearly understand the operating logic of the strategy, although this transparency may require certain compromises in efficiency and flexibility. Hyperliquids strategy is not public, which does improve the efficiency of capital use, but also weakens users trust. This trade-off is not completely wrong, but it is clear that they have made less than ideal choices in some decisions. However, these problems are understandable and can be fixed.
Controversy over the bailout decision
Haseeb:
Is it reasonable to rescue HLP depositors? Obviously, HLP may face huge losses in this incident. Do you think this is a wrong decision?
Robert:
I think this is a mistake, frankly. It is one thing to try to fix the market after the platforms risk parameters get out of control, but it is inappropriate to close positions in a way that makes the HLP pool profitable through human intervention. Because in the contract market, one partys profit usually means another partys loss. In this case, the Hyperliquid team and validators seem to have made a mistake in choosing who the winners and losers are.
HLP liquidity providers are supposed to bear the risk. If the liquidation is successful, they will make a profit; if it fails, they have to accept the loss. However, this liquidation operation made HLP profit, which also means that other market participants suffered losses. I think this violates the principle of fairness in the market. If they must intervene in the price, at least they should not choose a price that is favorable to them. What is even more confusing is that the price they chose is even lower than the market price at the beginning of the event, obviously in order to make themselves the winner.
Tom:
I agree. This behavior also leads to a delicate relationship between HLP as a product and the entire Hyperliquid platform. HLP is just one of the pools, and users can also choose other pools and run different off-chain strategies. HLP is positioned as Hyperliquids official pool, but in theory anyone can create a pool. Therefore, most people will not assume that HLP will enjoy any special treatment. However, this incident makes people feel that HLP has received some kind of preferential treatment.
Some people compare this incident to the socialization of losses or automatic deleveraging mechanism of traditional contract exchanges, but the two are not the same. In the traditional mechanism, when the market as a whole is below the margin level, the exchange will freeze the position and spread the losses to the insurance fund. In this incident, HLPs loss status was only compensated by human intervention, and Hyperliquid itself was not at risk of default. This makes people question why HLP can be the preferred liquidity provider of the exchange? If the HLP operation fails, why is it rescued?
Robert:
And it is actually rescued in a profitable way, which is crazy.
Tarun:
Indeed, it is. And what is even more ironic is that HLP holders decided the price of this bailout through governance voting, which indirectly brought them profits.
Robert:
Could you elaborate on this? How do HLP holders participate in the Hyperliquid validation process?
Tom:
HLP holders can delegate voting rights to a validator, but some validators need to go through KYC, so the mechanism is a bit complicated.
Tarun:
Validators control the price of the oracle, and therefore determine the price adjustment of the oracle through governance voting. In other words, HLP holders actually participate in voting indirectly through governance.
Haseeb:
Yes, this has been criticized a lot. Because the Hyperliquid Foundation holds the absolute majority of voting rights for HYPE tokens, in this case, HYPE holders quickly completed the vote through delegation. However, the entire process took only two minutes, and the so-called voters had almost no real say from the beginning to the end of the vote.
Robert:
I am still a little confused about whether the launch of contracts on other exchanges will have an impact on Hyperliquid. The contract market and the spot market are relatively independent trading venues. Even if the demand for JellyJelly contracts on Binance increases, it may not directly change the price of Hyperliquid or the spot market, because the spot price is controlled by the index, which also determines the funding rate of Hyperliquid. So, what is the specific mechanism of this impact?
Haseeb:
First, if Binance wants to launch a spot market, they need to procure actual spot inventory, which takes longer to complete. But launching a contract market is faster than a spot market because the contract market does not require actual spot inventory. As long as there is enough demand, users can start trading contracts without the spot price adjusting immediately.
Robert:
For every long there is a short, and for every long there is a short.
Haseeb:
Thats right. But structurally, its easier to launch a futures market. If you say, Hey, I want to hit these guys as quickly as possible, and I dont have much time, then the fastest way is obviously futures, not spot.
The purpose of launching a futures market is to allow more people to participate in the short squeeze. If Hyperliquid is experiencing a short squeeze, then the opening of the futures market will exacerbate this trend.
Tarun:
This mainly depends on the dynamic changes of the funding rate. In this incident, the funding rate soared by 300% in a short period of time, causing extreme market instability.
OKX and Binance join
Haseeb:
Funding rates have spiked by hundreds of percentage points. This was a very intense short squeeze, so the market expects this to blow over quickly. My guess is that Binance and OKX will probably delist JellyJelly contracts within a week or two, as there is clearly no real demand for this product.
Tarun:
No one really needs JellyJelly.
Haseeb:
What I find interesting, though, is that the mechanics of this incident can be difficult to understand, especially if you’re not familiar with the workings of contract markets, liquidity providers, and HLPs. Let’s simplify it. The essence of the matter is that Hyperliquid was in a risky position, and Binance and OKX attempted to further weaken Hyperliquid’s position through market manipulation. More specifically, their goal was to force HLPs, rather than Hyperliquid itself, into insolvency.
This is pretty aggressive behavior, right? Some people compare this to what CZ did to FTX, but I dont think they are similar. Because CZ had no reason to believe that selling FTT would directly lead to FTXs bankruptcy. If we look back at the Bitcoin hack, Binance and Bitget actually lent out Ethereum to help Bybit make up for the shortfall and keep it running. So their behavior in that incident is completely different from how they are treating Hyperliquid now. I dont have a good theory at the moment to explain why Binance and OKX would adopt such a strategy.
Hyperliquids behavior implicitly sends a signal that HLP has some kind of protection mechanism. If HLPs losses are too large, Hyperliquid will actively intervene to protect it. Judging from the market reaction, Hyperliquids price is very sensitive to changes in HLPs situation, which confuses me. I am curious about what the connection is between HLP and Hyperliquids value. Maybe I am missing some key points about HLPs economic model.
Tarun:
In fact, HLP does not have a clear economic model. It is more like a pure liquidity provider and is not closely related to the core mechanism of Hyperliquid. But I find it strange that I prefer to think of the HLP pool as a debt instrument because it operates by raising funds from depositors.
Haseeb:
I think of it more like equity than debt.
Tarun:
No, HYPE is equity. That’s where it gets confusing.
Haseeb:
I mean, from a market-operating perspective, the investors in the HLP actually get all the profits. So its more like equity than debt.
Robert:
To some extent, this is true. Market makers use the USDC deposited by users to trade in different markets.
Haseeb:
And users ultimately receive all the proceeds, so it’s not like debt in the traditional sense.
Tom:
I think the main reason for the HYPE token price drop is that this incident has created uncertainty about the future of exchanges. After all, if an exchange has privileged liquidity providers, and these providers will never take losses, then why should others trade on this platform? This is actually a question faced by all exchanges with internal market makers: how big are these privileges?
Tarun:
A more pessimistic view is that most of the liquidity of HLP actually comes from the Hyperliquid team themselves, so they are unwilling to bear this part of the loss.
There is another reason to think of HLP as a debt instrument, which is that it takes funds from depositors and uses them for market making activities in various markets. In a sense, it plays the role of a local lender. Similarly, protocols like Jupiter and GLP are explicitly lending protocols, and they charge fees for this. HLP makes its profit through fees and spreads. If HLP defaults, such as in this case, then depositors have priority claims.
So I think HLP is more like a debt holder, and HYPE is the real equity instrument. Because HYPE is the core asset that can control key mechanisms such as oracles, and this control is the essence of equity.
FTX moment?
Haseeb:
Hyperliquid is more like an exchange, and HLP is a tool used by the exchange for market operations. HLP can be thought of as equity for market operations, while HYPE is equity in the exchange itself.
Robert:
I actually think we should learn a lesson from the FTX incident that exchanges and hedge fund-like entities (such as the teams that do proprietary market making inside exchanges) should be completely separated. This is to avoid conflicts of interest, right?
Tarun:
It is worth mentioning that Hyperliquids mechanism is very different from FTX. On Hyperliquid, I can view every transaction of HYPE and HLP at any time and withdraw funds at any time. This transparency makes it easier to supervise. I agree with this, and I dont think Hyperliquids approach is wrong in principle.
Haseeb:
If an exchange provides protection to a market maker and explicitly states that the market maker will not lose money, then the exchange and the market maker are effectively tied together. It is like the exchange team itself is operating the market maker. If you do not trust the team to run the market maker well, then do not invest in the equity of the market maker.
Tom:
But the question is, how does this situation present itself? For example, We have a pool of funds that can be launched, and here is another market maker that can invest. On the surface, this seems to be an open choice, but in fact, it is just a unique market maker.
Tarun:
This is a unique situation indeed. If you look at other market makers, like Seafood, he is always losing money. I dont understand why people are willing to give him money. His past record shows very serious losses.
His pools are certainly interesting. But my point is that there is already a problem of adverse selection in these pools. Until this incident, people didnt really realize that HLP and Hyperliquid were closely linked, and now that connection has become more obvious.
Robert:
I think before this incident, they were not separated. The Hyperliquid team was operating a major market maker, and this market maker was the core market maker on the platform. Although the economic benefits belonged to the users, the owners of the exchange actually operated this major market maker and also controlled the liquidation mechanism.
Haseeb:
Yes, Hyperliquid’s connection to the liquidation mechanism does put them in a somewhat privileged position. But on the other hand, it also forces them to take risky positions that other market makers may not be willing to take.
Robert:
In a similar situation to Alameda, whether they wanted to or not, they had to take on all the bad positions on FTX, including some high-risk assets. This eventually led to the collapse of the exchange. Although they were forced to take these risks, it was also a responsibility to some extent.
Haseeb:
Theoretically, the rationale of this arrangement is that even if the HLP funds are liquidated to zero, Hyperliquid can still continue to operate. This is the ideal design. If all the mechanisms are mixed together, the design of the entire system becomes unreasonable.
Tarun:
I think getting crushed by MobileCoin was better than getting crushed by JellyJelly, in a sensual sense. MobileCoin at least tried to be a real project, while JellyJelly was more like a joke to VCs.
Haseeb:
After this incident, people may think that HLP and Hyperliquid are closely linked. This may cause third-party market makers or liquidity providers to reduce their activities on Hyperliquid as they realize that they are not on the same competitive level as HLP.
Tarun:
To be fair, I have observed a reduction in participation from many market makers. This phenomenon is not new, but now they have clearer reasons to reduce their activities.
Haseeb:
On the other hand, you may see more capital flowing into HLPs as people now realize that the protocol may protect their investments.
Tarun:
We can use the DeFi AMA as a benchmark.
Haseeb:
Will it go up or down? So far, it has gone down.
Tarun:
Yesterdays deposits were $1.85 million, three days ago it was $2.96 million, and on March 24th it was $3 million. I think thats a good benchmark time. Now its down to $1.85 million. I think there are two possibilities. One is that money will flow in because its seen as an insurance-like product, as Haseeb said, and the other is that fees on exchanges may decrease due to a drop in confidence. Im not sure which one will dominate.
Robert:
I think the risk has increased. If the incident is severe enough, the platform may step in and close the market, setting a settlement price so that HLP does not lose money. We just saw this happen with the JellyJelly incident. This is indeed a protection measure, but it also exposes the vulnerability of Hyperliquids mechanism on small assets. The probability of this attack happening again has increased by at least an order of magnitude.
Haseeb:
I totally disagree. But nobody would try this anymore.
Tom:
Of course, HLP strategies on exchanges are clearly changing as well to reduce risk. So, its not like these events are completely independent.
Robert:
But this is not an isolated incident either. Two weeks ago, a similar attack occurred on the Bitcoin market, which is a very large asset. The exact attack parameters occurred two weeks ago.
2 3a The future of ndMe and SEI
Haseeb:
Let’s talk about DeSci. There has been a big news in the DeSci field recently. SEI Protocol, a high-performance Layer 1 EVM chain, announced that they are making one of the boldest DeFi investments to date.
The SEI Foundation plans to acquire 23andMe, a genetics company that recently filed for bankruptcy. They promise to protect the genetic privacy of 15 million Americans and ensure the safety of this data for future generations. They plan to migrate 23andMes data to the SEI chain and return data ownership to users through blockchain encryption technology, allowing users to decide how to monetize their data and share the benefits. This is not just about saving a company, but about building a future where users still have control over their most private data.
Tarun:
Does anyone on the SEI team actually understand privacy? I doubt it. If you told me there were experts in the field of privacy protection on this team, it would make more sense. But it looks like this is just a team that wants to spend a lot of blockchain money, and their approach is even worse than those companies that are purely for acquisition.
Haseeb:
If they can achieve this goal correctly, will you support them? Maybe you can become their advisor and provide some professional advice.
Tarun:
If this is to be done, most of the other bidders are computational biology companies, such as AI drug development companies. Their goal is to use 23andMes data to train AI models. The reason why this matter has caused controversy is that many users are worried that their data will be abused. For example, eight years ago, I purchased 23andMes services. At that time, their privacy policy promised not to share data with third parties, but now the company has gone bankrupt, and the data may be used to develop drugs, and I did not agree to such use. This concern is understandable. So there are two core issues here: one is privacy protection, and the other is the way to monetize data.
People are concerned mainly about terms of service or privacy aspects, monetization aspects. One of the goals of all the people trying to acquire companies is pure monetization, like these computational bio drug discovery companies. Then there are some people like non-profits trying to bid, and of course the players in the DeFi world.
If blockchain can really bring breakthroughs in data monetization, it may be like the ICO boom in 2017, but I suspect it will fail again. If they can really find a way to both protect privacy and monetize data, it will be worth looking forward to. But at present, it is not enough to just claim let users own their own data because so far I have not seen successful examples. This reminds me of Toms previous complaint that people complained that studios did not monetize content through blockchain, but this is not the core of the problem at all.
Tom:
Indeed. And Im curious how they completed the acquisition, as far as I know, 23andMe still has $200 million in debt. Unless they designed a very complex financing structure or used SEI tokens to attract investors.
Tarun:
The problem is that the other bidders are mostly large companies, and SEIs chances of winning dont seem high. However, emotionally, many people hope that the company can have a better home than being acquired by bidders who monetize data. If SEI can come up with a plan that preserves the original terms of service and protects privacy, then I think they can try. However, this also means that they need to rely on the support of validators because they are actually borrowing the future earnings of validators.
Robert:
From a macro point of view, this data is currently stored in the database of a bankrupt company. Generally speaking, migrating data to the blockchain will not be more secure than the current method. In fact, it may increase the risk of data leakage. Of course, this depends on the security measures adopted, such as encryption technology, zero-knowledge proof (ZK), etc. But overall, I don’t think this will significantly improve privacy or security.
Haseeb:
Suppose, as Tarun said, the current situation is that a company acquires this database and then does whatever it wants with the data. This is obviously not what we want to see, but in theory there is such a risk. I have always been skeptical about the concept of data ownership. For example, some people have proposed to encrypt the data and put it on the blockchain, and authorize others to use the data through the decryption key. But I have never seen this method really solve the problem.
Tarun:
This is exactly what I am worried about. If blockchain practitioners lack understanding of privacy protection technology and try to deal with such issues, it will often backfire. For example, they may spend all their funds, but leak data due to operational errors. Even worse, this data may be used by some countries to develop biological weapons.
I prefer teams that focus on underlying cryptographic technologies to do this, such as those that study zero-knowledge proofs or homomorphic encryption. But even these teams may not be good at commercializing the technology on a large scale.
Haseeb:
It’s been three months since you declared war on DeSci, how is it going?
Tarun:
To be honest, I have given up. For example, Bio Protocol has almost disappeared now. I think everyone realizes that most of these projects are scams.
My view is that the DeSci craze is essentially a better-packaged meme coin. Its a different brand that appeals to people who are turned off by traditional meme coins. These people are still speculators chasing trends. DeSci operates more like donating to a nonprofit, but lacks the mechanism to verify its public benefit.
Stablecoin legislation: Genius Act and Stable Act
Haseeb:
Now Congress is moving forward with a new stablecoin bill. Previously, we mentioned the Genius Act proposed by Kirsten Gillibrand, and now there is another bill proposed in the House of Representatives, called the Stable Act, proposed by French Hill.
Robert:
The names sound like a combination of stable and genius, a bit like stable genius, dont you think? Maybe thats where the inspiration came from, like a reference to Trumps stable genius speech.
Haseeb:
The new bill is called the Stable Act. To make a clearer comparison between the Genius Act and the Stable Act, the main difference between them is that the Genius Act is more friendly to industry development. It allows banks and non-bank institutions to issue stablecoins, and state regulators can also participate in supervision, not just federal agencies. It also supports interoperability and allows the payment of benefits in certain circumstances, which overall encourages innovation and growth of stablecoins.
In contrast, the Stable Act is stricter. It stipulates that only banks or approved bank subsidiaries can issue stablecoins and must be subject to direct supervision by the Federal Reserve. In addition, it has more restrictions on the types of reserve assets, does not allow the payment of returns, and imposes a two-year ban on algorithmic stablecoins, although existing stablecoins will have a transition period.
Robert, you’ve recently been involved in some lobbying for stablecoin legislation in Washington, D.C. How do you think the bill has been received?
Robert:
I happened to be in Washington, DC on Tuesday and Wednesday, meeting with about 15 members of the House of Representatives, and obviously the topic of most concern was stablecoin legislation.
Robert:
I feel like both sides have shown great interest in developing legislation that is beneficial to the crypto industry, and there is not much controversy. Stablecoin legislation is the most pressing issue at the moment, as both sides recognize the need to establish a legal framework for the operation of stablecoins. This legislation is relatively simple, so it may become the first major crypto legislation. Although there are still some differences between the House and the Senate that need to be resolved, overall I dont think these differences will become obstacles. There may be more discussions about market structure after the stablecoin legislation, but the current focus is still on the stablecoins themselves.
At the same time, there are also many discussions about the market changes that may be triggered by the passage of stablecoin legislation. Overall, the industry generally believes that this legislation will lay the foundation for the future market structure. Although this goal may take some time, the current discussion and attention are almost entirely focused on the stablecoin legislation itself.
I need to add that when I communicated with some members who tend to support cryptocurrencies, I felt that they highly recognized the stablecoin legislation. Although this may have a certain perspective bias, overall, the differences between the House of Representatives and the Senate are expected to be smoothly reconciled, and the prospects for the advancement of legislation are very optimistic.
Will Stablecoins Become a Trojan Horse in the Crypto World?
Tarun:
I first heard about the concept of a narrow bank in 2009. At the time, a lot of people were talking about narrow bank legislation. This makes me a little old-fashioned, but at the time, everyone was talking about this model: should you have a very restricted bank that can only provide a very basic type of income.
Haseeb:
Can you explain what narrow banking is?
Tarun:
The definition of narrow banks has evolved over time, but the core idea is to make banks simpler. Especially after the financial crisis, some people have raised the question of whether banks should be subject to stricter regulation, such as restricting them from participating in transactions or other complex activities? Or is it possible to create a bank that only provides basic services, such as deposits and loans, without involving other complex businesses? Interestingly, many early fintech applications are like pseudo narrow banks in some ways. They allow users to deposit money, but have almost no income products. Users may indirectly purchase treasury bonds through these platforms, or provide Bitcoin services like Square, but these platforms themselves do not engage in complex investment activities, such as proprietary trading or bond portfolio investment.
In a way, many of the bills about stablecoins remind me of the concept of narrow banks. Stablecoins themselves have no yield, but the way the banking licenses are used behind them is very interesting to me. This idea of narrow banks has been proposed for almost 20 years, and now it is finally being realized through blockchain technology. I feel like history is repeating itself, but at a very slow pace. After all, there was a decade-long period in the United States where no new banks were established and no new banking licenses were issued.
Robert:
My understanding is that the core of narrow banking is to keep all deposits at the discount window of the Federal Reserve and maintain 100% liquidity. In this way, the bank does not need investment analysts or loan officers, all deposits are given to the Federal Reserve to earn interest, and then paid to depositors after deducting certain fees. In a sense, this is basically a branch of the Federal Reserve.
This model is a full-reserve bank with 100% liquidity and no liquidity risk to worry about. In theory, only a dozen employees are needed to manage a large banking system. But the reason people oppose narrow banks is that they will compete with existing commercial banks. Commercial banks expand the money supply through loans, while narrow banks just keep their funds at the Fed, which will reduce the liquidity of high-quality assets such as mortgages.
Haseeb:
I believe the reason the Fed rejects narrow banks is that it reduces the Feds ability to intervene directly in the money supply. While mortgages can still be made by private lenders, once the market shifts completely to private lending, the Fed will lose direct control over the expansion of the money supply.
Robert:
From another perspective, the Federal Reserve may have gained more intervention capabilities because adjustments to overnight interest rates will affect all market players.
Haseeb:
If there is a reserve ratio, yes. The reserve ratio is the second lever, and it is a very powerful lever that can change the money supply in an instant. Raising interest rates or lowering interest rates obviously has a zero lower bound, although, technically you can break through, but the United States will not go into negative interest rates. But it is just a slower mechanism to enter the market, and now as a bank, you can use everything in the reserves to invest, and this change will be faster.
Robert:
This reminds me of the Genius Act. Tarun said stablecoins are like narrow banks, but I don’t think they are exactly the same.
Haseeb:
I think he was talking about the Stable Act, specifically because it doesnt allow yields. Why arent yields allowed in the Stable Act? Probably because they dont want it to compete with commercial banks.
Robert:
Tarun may mean that this limitation makes stablecoins more like narrow banks. But the core of narrow banks is that they allow for fully liquid interest payments.
Haseeb:
So you could create a narrow bank with a stablecoin if the yield was not prohibited. So under the Stable Act, you couldnt really create a narrow bank that competed with commercial banks. But under the Genius Act, you could essentially have a stablecoin that just held Treasuries and returned all of the Treasuries yield minus 20 basis points or something, and that would end up being a very simple business model.
You could say thats the model of Tether, obviously they dont pay out yields, but if they did, it would be an incredible business model. Its very labor efficient, they have about 90 employees and over $100 billion in assets under management. So its a pretty good business.
Haseeb:
I think this point makes sense. Stablecoins may be a way to reintroduce the concept of narrow banks in a more acceptable way, while also bringing geopolitical advantages. In contrast, narrow banks will only impact commercial banks, but will not help the internationalization of the US dollar. The advantage of stablecoins is that even if it competes with commercial banks, it can expand the overall market size of the US dollar through internationalization. Narrow banks cannot do this because they are a zero-sum game between commercial banks and narrow banks. From a policy perspective, this is why stablecoins may be more popular. But I also agree with you, Tarun, that when central bankers or bank executives look at this issue, they may be inclined to let banking license holders monopolize the issuance of stablecoins. This is actually a manifestation of regulatory capture, that is, protecting existing interests by restricting market participants.
Robert:
What do you think of the final bill? Do you think it will be more like the Genius Act or more like the Stable Act, less restrictive or more restrictive?
Robert:
I think it will be less stringent in terms of other than yield, I think the commercial banking sector right now doesnt want to see yield on stablecoins.
Haseeb:
This reminds me of some strange phenomena in the banking industry. For example, my Chase bank account, why cant my cash be automatically transferred to a money market account to earn interest, but I have to take the initiative to operate it? It would be great if the bank could complete these operations automatically. But in fact, many people dont take the initiative to operate, resulting in idle cash there. This phenomenon is actually very common. Although users can transfer funds to money market accounts with a button, many people just dont click it. Therefore, brokers make a lot of money through this laziness.
Robert:
One of the main sources of income for securities firms is the interest rate spread.
Tom:
I heard that the FTC investigated Citibank because they launched two almost identical savings products, but one of them had a lower interest rate. This shows that banks profit from information asymmetry, and stablecoins circumvent this problem in some ways.
Robert:
You can’t easily lower the rate for new customers, but you can launch a second product and all the old customers remain on a rate that has not increased.
Haseeb:
But the irony is that if you think of this as a cash account, a stablecoin, even if you dont get a yield, like on Tether or USDC, just lending in the market can give you a pretty high yield.
Tom:
The current yield on market lending is between 5% and 6%. The advantage of narrow banks is that users can freely choose their own risk profile, rather than having the bank make decisions for you. For example, you can choose to invest in private credit or tokenized treasury bonds instead of being tied to the bank. If users want, they can do it themselves.
Haseeb:
This does make sense. If stablecoins do drain deposits from the banking system, my guess is that it’s because they allow users to earn a yield on their cash no matter how lazy they are.
