Keynote address by Gordon Liao given on April 1st, 2023 at the Annual Harvard Blockchain Conference, Cambridge, MA
Good morning everyone! It's my distinct pleasure to be back here at Harvard, a place that holds so many memories for me. I spent more than a decade here, first as a student at the College, then as an employee at the endowment, and finally as an academic at GSAS and HBS. I want to thank the organizers for welcoming me back and giving me this opportunity to speak today. It's truly an honor to be here with all of you.
As I look back to the fall of 2007, when I first stepped on this esteemed campus, I can't help but recall the atmosphere that surrounded the finance industry at that time. It was a period of great exuberance, marked by an allure that drew in many young minds like myself. Even as freshmen, my classmates and I were well acquainted with the most well-trodden paths of careers in finance. If one had a knack for numbers, the trading desks were the destination of choice. For those who were less quantitatively inclined, investment banking was the typical route. I can still remember how packed the undergraduate Econ10 class was, with close to a thousand students enrolled. And as for CS50, it was still a small class. How times have changed!
Little did I know at the time, a tremor was underway that would shake the foundation of finance and put the global economy into a tailspin. As more of an idealist than my peers, I did not lean towards finance initially. Rather, I opted for summer internships in sustainability and global health in Geneva and East Africa, respectively. When the opportunity to work in quantitative finance with a mission to serve the University showed up, I was thrilled and jumped on the chance. Thus, I embarked upon the realm of traditional finance, or "TradFi”.
TradFi is about the usage of balance sheets to intermediate financial services, such as credit provision, market-making, and payments. These intermediation activities are usually done by banks and affiliated broker-dealers but also can involve hedge funds and more nimble institutional capital, such as the Harvard Management Company.
The financial innovations that led up to the 2008 Global Financial Crisis involved tranching and recombining of risks. At the heart of the crisis was the complexity and opacity of balance sheets, which had grown increasingly convoluted due to the proliferation of complex financial instruments, such as collateralized debt obligations and credit default swaps.
In response to this crisis, regulatory authorities around the world implemented a series of sweeping reforms aimed at reducing the risk of future financial crises. These included measures such as higher capital requirements for banks, tighter regulation of derivatives markets, and enhanced supervision of systemically important financial institutions. The goal was to create a more robust and transparent financial system that could better withstand shocks and protect the global economy from future crises.
The unintended consequences of the post-crisis regulatory reforms, however, were market distortions that arose due to the balance sheet constraints of large financial intermediaries. While increased capital requirements and tighter regulations were designed to enhance the resilience of the financial system, they also led to reduced risk-taking by banks and a decline in principal market-making activities. This, in turn, resulted in lower market liquidity and a dispersion of spreads in the pricing of assets with similar fundamentals.
As a trader on the fixed income desk at the Harvard Management Company, it was one of the most exhilarating experiences that a recent graduate could wish for. Over-the-counter relative value trading, or risk arbitrage, demanded a combination of quantitative agility, mental stamina, and some nerves. The experience also gave me a direct view into various types of market frictions because of balance sheet strains. Out the window is the classic economics text-book notion of the law-of-one-price, as I observed and traded directly on peculiar price discrepancies such as the spread between forward and spot prices of exchange rates adjusted for interest rate differentials, or otherwise known as deviations from covered interest rate parity.
My interest in these types of market segmentation and balance sheet constraints eventually led me to return to campus to pursue a Ph.D. in financial economics. During my doctoral program, I explored various limits to arbitrage, such as slow-moving capital allocation, funding constraints, and agency frictions. It became clear that addressing these frictions was crucial for financial market efficiency and stability.
One solution to overcome these frictions is through CeFi, or centralized finance, with entities like the Federal Reserve at its core. As the lender of last resort, the Fed has an unparalleled ability to flood markets with liquidity. In the words of Prof. Jeremy Stein, a former Federal Reserve Governor, monetary policy “gets into all the cracks” of the financial system.
Curious and excited by being at the center of finance, I joined the Federal Reserve Board in D.C. after my Harvard years. As an economist at the Central Bank, one's role entailed conducting rigorous research and providing data-driven and model-based policy recommendations. The combination of deep intellectual thinking interspersed with bouts of crisis response offered a stimulating environment for a financial economist to engage in both the science and art of monetary policy.
In the aftermath of the global financial crisis (GFC), central banks worldwide adopted a range of unconventional monetary policies to stabilize the financial system and support economic growth. These measures included large-scale asset purchases, known as quantitative easing, and the provision of liquidity to banks through various lending facilities.
As a result, central banks' balance sheets expanded dramatically, providing much-needed liquidity to the financial system and helping to restore confidence in the markets. The balance sheet of the Federal Reserve expanded from less than a trillion in 2007, representing around 5% of the U.S. GDP to around $4.5 trillion in 2017, or around 13% of the GDP. Today, the Fed’s balance sheet is at $8.5 trillion, or 34% of the GDP.1 While these unconventional measures were necessary in the short term to avert a deeper crisis, they also raised concerns about the long-term implications of such policies, including the potential for asset bubbles, inflationary pressures, and the erosion of central banks' independence.
Central banks are “unelected powers”, a term used by Sir Paul Tucker, the former Deputy Governor of the Bank of England for Financial Stability. For a decade after the GFC, these unelected powers were largely unchallenged in their independence. Recognizing the immense power that the Fed had on the economy, the elected officials attempted to coerce central banks for their own political gains. As Trump came to the U.S. presidency, he provocatively questioned the Fed with sayings such as, “who is bigger enemy, Fed Chair Powell or China’s Xi” and equated the Fed Chair as “a golfer who can’t putt”. The internal mood at the Fed among the staff was dim around that time. “Don’t poke the bear” was the mantra at the annual Jackson Hole conference that year.
More worrisome than the disparaging words from the president was the fact that the financial system could not get off its addiction of large balance sheets and the liquidity that was supported. As the Fed attempted quantitative tightening in reducing its balance sheet size from the period of 2017 to 2019, the short-term funding markets, which provides the life blood for intermediation activities, became increasingly dislocated, with funding rates spiking up particularly strongly on quarter-ends dates when regulatory assessments became more binding on these balance sheet reporting days.2
In mid-September of 2019, after a large Treasury auction and the passing of a corporate tax payment period that drained cash from the banking system, liquidity became more scarce and the cracks in CeFi finally broke through. The key short-term collateralized borrowing rate, known as repo rate, spiked to as high as 10% intraday, which then prompted immediate liquidity injection by the Fed and brought the quantitative tightening cycle to an abrupt end much earlier than planned. This happened despite commercial banks holding over $1.4 trillion of excess reserves as liquidity resources at the Fed.3
Today we find ourselves once again confronted with the possibility of reluctantly reversing a monetary tightening cycle while inflation is still running hot. The recent bank collapses and significant unrealized losses that still plague depository institutions pose grave danger to the financial system that requires more immediate responses. The Fed itself is also facing around $1 trillion of unrealized losses on its large balance sheet due to the rapid increase in interest rates.4 Maintaining financial stability while also ensuring price stability and low unemployment has become a challenging trinity for monetary policy.
So, how does DeFi fit in and potentially be a solution? If Tradfi is about balance sheet complexity and opacity, CeFi is centered around balance sheets as a patch to financial stability, then DeFi is about decentralization of balance sheets and distribution of risk sharing that address the challenges of financial intermediation at its core.
This innovation leverages blockchain technology to enable the creation of programmable, transparent, and secure financial instruments and services. DeFi has the potential to address some of the shortcomings of both TradFi and CeFi by decentralizing balance sheets and reducing the reliance on large, systemically important financial institutions.
In the realm of payments, blockchain-based transactions that occur near-instantly and atomically reduce the need for intermediaries to hold funds in transit. By enabling direct settlements between end-users through wallet-to-wallet transfers, we can replace a portion of wholesale large value payments that settle through reserve accounts at the Fed. This would lead to a reduction in the demand for excess reserves in the banking system. Since reserves make up over a third of the Fed liabilities, reducing the reliance on bank-centric payment systems would help to right size CeFi. Tokenized cash, also called payment stablecoin, can offer the benefits of a central bank digital currency without the need for a bloated balance sheet or relying on privacy commitments from the elected and the unelected.5
Moreover, DeFi is about the programmability of smart contracts that facilitate better market-based risk sharing. This ensures that the disintermediation of banking doesn’t translate into disintermediation of credit creation. Even before the advent of smart contract, the trend toward syndicated loans, private credit market, and open-banking Application Programming Interfaces (APIs) access has already reduced the reliance of relationship-based lending. Smart contracts are technology solutions that speed up this evolution toward a more market-based approach. Traditional institutions can still play an important role of facilitating human interaction with users, all the while with smaller, less complex balance sheets and less regulatory scrutiny.
DeFi protocols not only facilitate more transparent and automated price discovery, but they also distribute the risk bearing capacity to a greater set of asset owners and market generalists. This distribution of intermediation risks to a larger set of market participants can encourage greater amount of liquidity in markets. For instance, as my research with Dan Robinson at Paradigm had highlighted, automated market makers (AMMs) such as the Uniswap protocol, can draw in greater market depth than traditional limit order books on centralized exchanges.6 The application of these models in traditional asset classes such as foreign exchange can transform TradFi to be more resilient, safe, and efficient.7
The promise of this innovation has also been taken notice by the public sector. Central bank-led projects such as Project Mariana and Project Guardian are taking a page out of the DeFi playbook, utilizing DeFi for new ways of settling cross-border transactions and exchanging values.8 It is in my opinion that collaboration between the public and private sector and encouraging mutual understanding is the only viable path for DeFi to have an enduring impact on finance. It is essential for regulators, policymakers, and industry participants to collaborate in fostering an environment that encourages innovation while maintaining the integrity and stability of the financial system.
In closing, the journey from TradFi to CeFi and now to DeFi highlights the ingenuity of innovations in balance sheets. Finance has progressed from balance sheets that were complex and opaque, to those that are colossal and unelected, and on the way to transition to ones that are distributed and programmable. Each iteration of financial intermediation comes with its own strengths and perils. By understanding the limitations and opportunities presented by each type of finance, we can continue to improve and refine finance to better serve society. With the rapid growth of decentralized finance, we are witnessing an exciting new phase in finance, and I look forward to continuing my contribution to its development. Thank you.
Gordon Y. Liao is the chief economist at Circle Internet Financial, a global financial technology company, and a former senior economist at the Federal Reserve Board. All of the views expressed in this keynote are his own.
2Correa, R., Du, W. and Liao, G.Y., 2020. US banks and global liquidity (No. w27491). National Bureau of Economic Research.
3Copeland, A., Duffie, D. and Yang, Y., 2021. Reserves were not so ample after all (No. w29090). National Bureau of Economic Research.
5Liao, G., 2022. Macroprudential Considerations for Tokenized Cash. Available at SSRN.
7Adams, A., Lader, M.C., Liao, G., Puth, D. and Wan, X., 2023. On-Chain Foreign Exchange and Cross-Border Payments. Available at SSRN 4328948.