Wildcat
What happens when one throws in together Knights Templar, Macroeconomics, BoJ, Terra Death Spiral, Tether printing money out of thin air (not in the way you’d think!) and 19th century USA in all its glory?
Well, you obviously get a new take on defi uncollateralized lending and subsequently a love letter to pure Capitalism. Enjoy!
Intro
So, let’s start with some basic disclaimers. I’m not an expert in economic theory. I had a good run studying at HSE in Moscow in the early 2000s (when it was cool). I learned my Smith, Keynes and Friedman (and had a thing for Krugman — his take on Japan’s lost decade is still imprinted in my head). It was very good libertarian brainwashing and I’m genuinely glad I had that part of my life as it formed my way of thinking about how economics works to this day. But I’ve also not been super into catching up on the latest (though I do know Krugman is not my hero anymore), or even refreshing my knowledge. This article has been a nice opportunity to replenish what was lost and learn some stuff that I’m now glad to share with you. I will use the term “capitalist machine” a few times throughout this piece. This is not meant to be a criticism of capitalism, but rather me fully embracing it. I love capitalism, its awesome and I am curious how to make it better not by making it less of itself, but instead making it more of itself. More consistent. More glorious. More free.
Once I got into crypto, I’ve been very curious about one thing — how does a bitcoin denominated economy exactly work? It’s clear that the heart of our beautiful capitalist machine is beating to the drums of continuously expanding money supply. If 21 million BTC is forever unchanged, this means that price of bitcoin would rise as its dominance grows. How would private or corporate credit work? What kind of shocks bitcoin-based economy would have to endure in the absence of central authority. If my local Citibank branch only has 100 BTC to lend (because there is no fractional reserve banking in bitcoin economy (?)) how would that work exactly? So many questions that we are not really discussing instead imagining an economy where people are hoarding bitcoin on their ledgers much like Ron Swanson buries his gold in the backyard. Ethereum based economy doesn’t really fare better with these questions (and I don’t think most people even understand how the ETH supply works exactly, maybe they need to solve the alignment thing first idk).
Parallel to that, I had my own business interests to solve. Being a prop trading firm in crypto comes with all sorts of challenges, but one of the more interesting ones is access to capital. Wintermute (a crypto native prop trading firm I’ve had pleasure of running for the past 6 years) used to be a large borrower from all the centralized lenders (back when more than half of them were not bankrupt) and it was always interesting to me how much the liquidity in the trustless economy is running on trust.
At the same time some supposedly decentralized protocols have been running their own monetary experiments. Looking at UST “deposits” yielding 20% with very unclear business backing these yields, one couldn’t help but wonder — can you run the same kind of protocol with business that consistently makes money (obviously not without risk!).
The final piece of the puzzle came into place when I stumbled upon Wildcat banking. Most likely it has been via George Selgin’s twitter — he’s been heavily into Free Banking, and it suddenly all clicked.
The last thing I’ll say is that I’m rather lazy with my writing when it comes to explaining stuff. Sometimes I’ll say obvious stuff. Sometimes I’ll say something that might require use of your preferred search engine. I apologize for this, and my only defense is I have other things to do besides writing and I had a deadline to make for (today), so let’s just leave it at that.
And now that you have all the background, let’s dive into it!
Bank (what is it good for)
Banks do get a lot of bad rep lately, primarily because of their curious role as gatekeepers into the economy. Without a bank account you are literally nothing. You can’t rent an apartment (and sometimes you can’t open a bank account without having an apartment), you can’t receive salary, you can’t buy expensive stuff (or even stuff in general as more and more businesses are becoming cashless). So, if your bank suddenly sends you an email saying you are not welcome, you are in trouble. Same goes for businesses — crypto entrepreneurs know this quite well, even in our day and age where we have slightly better rep compared to, say, 2016. But ultimately that’s supposed to be the first key “feature” of modern-day banks — store your money and help move it around all while being protected by respective regulators.
The other side is credit. Banks take your deposits and lend them out. Some of it goes to consumers — to buy apartments, cars, vacuum cleaners. Some of it goes to the government to get a slice of risk-free yield. And some of it goes into commercial loans, fueling the growth and maintenance of the market economy.
This fueling and re-fueling is the part that is the most interesting here, and the one concept that is interesting (and would be important for later sections!) is the Money Supply Reserve Multiplier. When you place your honestly earned $10,000 deposit into the bank, it is obliged to keep a certain ratio untouched (to help against an occasional mini-bank run) but is allowed to lend out the rest. Let’s say this reserve requirement is 10% (important to note — this number is controlled by the Federal Reserve (Fed) in the case of USA, or another central authority elsewhere) — this would result in the bank lending out $9,000 to somebody else. What happens here is we had $10,000 in the system that suddenly became $19,000 (since you still can use and spend your dollars electronically). There is more — the recipient of the loan can then take their $9,000 and put it into a bank account and that other bank (or the same one!) can further loan $8,100 to somebody else. And so, it goes on and on until the amount is so small that we don’t really care. It doesn’t matter if at some point the recipient spends it all instead of depositing — whoever receives these dollars would most likely deposit it instead. The result is — the banking system would have suddenly made $100,000 of loans out of your $10,000 in deposits.
Now, it might sound like a scam, but it is literally how our economy works and expands (and, sometimes, contracts). The real economy, not the one funded by venture capitalists, but restaurants and power plants and supermarkets are all running on debt. You might see where I’m going with my initial questions about bitcoin-based economy, but we have more ground to cover.
Daddy, where do interest rates come from?
Reserve requirement is not the only tool available for the government to control the monetary policy. Up until very recently we had almost a generation growing up in a super low interest environment. Credit was cheap, life was good, and people aped into Anchor protocol and Celsius all while making fun of legacy banks paying 0.15% on deposits. Fast forward to now and RWAs are all the rage, and let’s be honest, we are not talking about tokenizing real estate — RWAs are currently all about tokenizing US treasuries.
So now, we are all suddenly aware that interest rates are a thing, and somehow it doesn’t only affect how much we receive on deposits but is somehow connected to all kinds of prices (very much including crypto). Enter the banks (again).
Controlling the interest rates is a key cog in the capitalist machine. Earlier we looked at reserve ratios and the possibility of mini bank runs. Sometimes a bigger run comes. We’ve seen it earlier this year when a few banks tumbled and quite a few more were rescued. Fed steps in when banks need money (and relatively recent development is that you don’t have to be a bank to do this), and when they do, they borrow it from Fed at the rate that it determines. The banks can use this money to give loans to consumers or companies. When the interest rate the Fed lends at is low, banks can fund all kinds of stuff because money is cheap. When interest rates are high, the demand side becomes a bit less exciting. People are not as keen to pay 7%-10% for their mortgage compared to 3%-4%. Your neighborhood pub will be happy to fund a refurbishment at 10%, but not at 20%-25%. And so, let me state the obvious — high interest rates slow things down and low interest rates speed things up. The central bank authorities — the Fed, the ECB, the BoJ are at the center of it and the banking system is the primary conduit of that mechanism.
Eurodollars, Petrodollars and Stabledollars
Another curious part of the dollar economy is it expanded way beyond the home market. It started with Eurodollars (very confusing name that simply describes USD deposits held offshore, initially just in Europe). Then came the petrodollars — a somewhat similar concept related to oil trade financing. I wouldn’t dwell to much on history here, especially because it has been very nicely explained by Josh Younger on Odd Lots. What’s interesting here is further money supply expansion that is truly uncontrollable by the Fed — they can’t influence reserve requirements by non-US banks.
And now enter (dollar backed) stablecoins. Looking at Tether reports:
74 billion out of 83 (tether is $3B overcollateralized according to the attestor) are in liquid instruments, but 9 is not! This is not to point out that Tether is risky (I’d argue this is a healthy self-imposed reserve ratio), but to point that Tether being out there created extra 9 billion in money supply (and probably much more in reality if we take money multiplier into account once these billions hit the banking system).
But that’s where multiplication in crypto seemingly ends. Or does it? The vast majority of defi is running on overcollateralized lending. But this lending is primarily done by supplying tokens. DAI is backed by a large degree by ETH (until Rune’s mad plan kicks into the next gear that is!). UST was backed by LUNA (until it wasn’t). Some stablecoins are backed by nothing but code (AMPL). The result is still, however — USD money supply is increasing using mechanics completely outside Fed control. But can we do more fun ways to expand it on our own?
Fun with banknotes
It wasn’t always like this. In the olden days, gold was all we needed (and earlier people used all kinds of rods, shells, occasional humans, and God knows what as means of exchange and storing value). Governments were not really into lending money, but instead borrowed heavily from private family enterprises (Medici, Fuggers etc) and even earlier from Knights Templar (which did not end well for them very much unfortunately, a rather sad story). One could rather see the state back then as the earliest form of venture capitalists, funding all kinds of crazy things. And so, the expansion of medieval economy was riding on the back of governments and individuals borrowing from private sector with the private sector managing their loan book thoroughly, facing all kinds of challenges — rather low legal protection, significant chance of default, and, let’s not forget, pogroms. Yet somehow credit worked without central banks, reserve ratios and overnight rates. Coinage was still controlled by governments (who occasionally messed it up by scamming the populace with diluted coins), but money expansion was running via public nodes.
As the economy started to be more and more capitalist and less and less medieval, banknotes emerged as a more practical way to store and exchange wealth. A government would issue promissory notes, theoretically backed by gold that was either in the vault or was incoming at some point in future as taxes or spoils of war (a small footnote — great way to accustom oneself on how things evolved over the years is to read Debt: The First 5000 Years by David Graeber). Finally, in the 19th century, the world got to witness the Wildcats, main topic of this “treatise”.
USA in mid 1800s was a place to be — wild enterprises, scams, gold rush, Civil War. One could truly find a thing to do. Among other things, the availability of (printed) money was often limited and so private banks were allowed to issue their own dollar banknotes to facilitate local commerce. The flow went something along these lines — local farmer would need to get cash to buy seeds. He goes into a local bank and borrows $5000 from Adrian in freshly minted Adrian Dollars, putting his farm as collateral. He then proceeds to buy seeds from whoever was selling them back then, grows the crops and, if all goes well, sells them, gets Adrian Dollars, and returns money to Adrian, freeing themselves from risk of collateral liquidation. If you start to see some parallels here with how defi works, you are not wrong.
Some of these experiments in free banking did not end very well. Indeed, if you allow a bank to print its own notes, nothing theoretically stops it from printing a bit more even if nobody really needs them or, for example, accepting all kinds of weird collateral. As a result, these notes traded at a discount and, occasionally, went all the way to zero very like UST. Key issue here was that nobody at any time could really know what collateral or assets were backing these notes and how many notes were there in circulation. After a few spectacular blowups, but also because of the US government wanting to be tad more centralized, Wildcat banks have been outlawed, their name tarnished. When you hear senior government officials saying wildcat banking, they don’t mean it as a neutral fun historical term. They mean it as an insult. Well, this is one of these truly rare cases where I can confidently say — the Blockchain solves this.
Enter Wildcat
Let’s get back all the way to the intro and a lone prop trading firm looking at all the randomly generated yields in defi all while knowing it has a functional business that can justify paying premium over overnight lending rate.
Let’s say I completely replicate Terra-UST-Anchor complex. I can create two tokens: WMT (valueless governance token backed by nothing but good name of Wintermute) and wmtUSD (that one can mint by supplying and burning WMT). The final step would be to create a copy of Anchor protocol with a key difference that once you deploy wmtUSD into a vault, Wintermute can take all of it and use it for prop trading. Wintermute would use the proceeds from its core business to pay the guaranteed yield to the holders of wmtUSD at Anchor.
But this is convoluted and complex. Why do we need valueless governance token that some, less sophisticated market participants, might confuse for a security. I can just create a vault, allow anyone to deposit USDC there and give them wmtUSDC in return. And why bother with paying interest — wmtUSDC can just continuously rebase to reflect the accrued interest instead.
What if somebody wants to get their USDC back or trade back some of the accrued interest? Well, maybe Wintermute can establish a certain reserve ratio, so that 10% of the deposited funds stay in the vault and can be used as (limited) liquidity for lenders.
What if a North Korean hacker wants to get this juicy Wintermute yield. Or even worse, is it a USA based retail person searching for a way to make money ignoring all the educational video warnings from the SEC? We can whitelist lenders much like Tether and Circle currently do and tell all these unwanted people — “your money is not good here!”.
What stops Wintermute from issuing $10B wmtUSDC? Well, it will all be very visible onchain. As you remember, the key issue with Wildcat banking has been not knowing the number of banknotes circulating. With the blockchain, you will know the exact number (as well as how much is backing it in the reserve).
Now, let’s say, the vault is created, there is $10M wmtUSDC sitting in it, guaranteeing (by code) to pay 10% interest, but only $1M is taken wants to send money into it. Well, Wintermute can increase the interest rate to 11%, making it better for both existing lenders, but also more attractive for those considering deploying into the latest L2 multisig instead. Would Wintermute be able to reduce interest rate (in case it doesn’t need as much capital or can find cheaper sources)? Sure, it would, but only as long as it maintains the reserve ratio at 10% (to allow lenders unhappy with the yield to withdraw) and only in small increments (so that it cannot drop the yield from 11% to 1% in one go).
What if Wintermute doesn’t replenish the reserve ratio? Well, sue us. Not in a sense “good luck suing us”, but literally — you should go ahead and sue Wintemute. And win, because there would be actual Master Loan Agreements behind this, signed either at the time of whitelisting or, at some latter point, signed on-chain as part of giving approvals to the protocol. Code is super useful for fun things like creating vaults and rebasing mechanics. The law is here for conflict resolution when the code fails.
Now let’s take it up a notch. Wintermute can create another vault to borrow ETH. And another for (W)BTC. And another for (w)DOGE. Suddenly there is yield bearing wmtBTC and wmtDOGE! Why does Wintermute has all the fun? Other prop trading firms can create their own vaults and compete on yield (and creditworthiness!). Why limit this to prop trading firms? If the business is generating revenue to afford to pay the interest (and the duration mismatch is managed), it should be able to create a vault and whitelist its own set of lenders. It might not make sense for small businesses (like motorcycle rentals for example), but there should be a market for enough trustworthy cash generating businesses out there.
And suddenly you have credit expansion achieved in a decentralized economy with the complete absence of the central bank. We can have metaverse economy running on various xxxDOGE variants. We can have a network state participant issuing its own currency pegged to whatever benchmark they want. Remember the multiplier? We can take the 21M bitcoin cap and multiply it into something functional in a bitcoin-based economy. We can have interest rates varying for different sectors of the economy. If NFTs are going hot, NFT protocols will raise their respective rates to attract more debt. And when there is a slowdown, they will lower these rates as they wouldn’t want to borrow like crazy anymore (those who are not bankrupt). We can change the money supply in our decentralized economy company by company, sector by sector (network state by network state?). In short, we can have economic freedom. Freedom enabled by Wildcat (and Maker, Maple, Clearpool, Goldfinch and many others — I absolutely love the fact that there are multiple teams exploring different directions for pretty much the same idea).
Would there be challenges? Of course. Decades of reliance on regulators and legacy rating agencies would make it initially hard to assess how good the borrowers are. We have seen it in 2022 as a wide range of market participants — from retail to sophisticated venture funds — failed to predict Genesis and FTX. Some even did a comprehensive postmortem and still couldn’t figure out what went wrong in their process, so this must be a complex problem🙃.
Yet, I’m hopeful. It is important to understand that uncollateralized lending is not a niche problem that needs to be solved so that few market makers can roam free. It is a subset of a much bigger challenge — how to enable credit and money expansion in a decentralized system. If we cannot solve it, I don’t think we can really have any ambition for Bitcoin or Ethereum or whatever-other-token-based economy. Full reserve banking is static at best and stagnant at worst. We simply must solve the fractional reserve free banking. It will be worse in many many ways, especially at the beginning, but if it works, it will be better in the way that really matters. Making our beautiful capitalist machine truly glorious.
