4 min read

The price of money for airlines is 0% and for Cyprus -100%

What is the fundamental innovation of decentralized finance? For bonus points, answer the question without relying on anarcholibertarian soundbites about how taxation is theft or about censorship resistance. For decentralized finance to represent a meaningful innovation on top of regular centralized finance, it has to do something better. The big promise is that it can work better because it’s a better discovery mechanism for the price of money than regular centralized finance. That it works without the moral hazard of government interventions is a higher order need. If you can improve price discovery without worrying about the ECB forcing 48% of all deposits into a bail-in, it’s even better. Is the savings rate in Cyprus really -100% while the savings rate in Germany 0%?

Any model for the price of a financial asset has to start with the assumption of a risk-free rate at its core. Nailing down this risk-free rate is a matter of sleight of hand, as it is easily manipulable by monetary policy. Most textbooks live under the presumption that the risk-free cost of money more or less approximates the borrowing cost of, say, the US government over a 10-year period. This could have been accurate-to-quaint at best during the second half of the 20th century. Rapidly, people will recognize that this model will no longer be true in the near future, if it hasn’t detached already.

What is the cost of capital of a country that:

  1. borrows money over a range of horizons
  2. uses the proceeds to invade another country to protect its security interests, whether a credible threat exists or not
  3. wages a grotesque multi-decade campaign of attrition
  4. declares defeat
  5. abandons all of its economic interests in the region
  6. leaves behind a worse security situation for itself than before it started?

Over and over and over and over and over and over again? It’s probably at least a little risky.
Over time, these geopolitical shifts trickle into the real economy through monetary mechanisms such as inflation. The process gets worse when governments misappropriate monetary policy for short-term political objectives instead of for solving for broad-based consumer welfare and price stability.

These distortions also face significant friction to permeate the real economy with any meaningful efficiency. Presumed risk-free assets earn a convenience yield lower than the natural risk-free rate (Krishnamurthy 2012, van Binsbergen 2021). Market participants put faith in state actors to backstop the financial system, particularly during the last few periods of crisis. This has the effect of compressing risk-free rates below the natural arbitrage prediction based on put-call parity for risky assets (unaffected by convenience yield). Early announcements of quantitative easing reduced this convenience yield on safe assets and pushed capital back into other sectors of the economy briefly, but the effect disappears for further rounds almost completely. Charitably, you could hypothesize that market participants price in the effect of new announcements. Uncharitably, you could argue that investors have faith in institutions that announce they will backstop the economy the first time, but lose faith in institutions that have to announce it a second or third time.

Financial intermediaries are all too happy to rent-seek the spread between an artificially reduced cost of capital for themselves and higher rates for feeding credit into the productive economy. As long as the broader economy grows enough to offset default rates, the rentier extraction can continue. But the net effect is that savings rates, the price of deposits, sit at 0% while unsecured loans to consumers and small businesses, the price of credit, can range anywhere between 5-15%.

In 2020, governments imposed unprecedented authoritarian capital controls and property confiscations on the economy in the name of preventing the spread of a deadly virus. Airline operators around the world beached their planes in empty airports and hangars. The experiment was quickly coopted by political interests, leading to some of these airlines to be bailed out by governments. We were taught in school that the cost of equity capital to a business approximately equalled the risk-free rate, whatever it was, plus an equity risk premium. An airline business, for example, could expect to pay the risk-free rate, plus a risk-premium for being a certain size, being a company of a certain maturity or being in a sector with specific risks. Some of these risks include the wildcard chance that a democratic government decides to impose mandatory confinement on the population, thus preventing them from traveling.

Ostensibly, these are the sort of unexpected risks equity holders should be rewarded for in return for their capital and participation. They are also the sort of unexpected risks you could expect equity holders to get slashed for if they materialize. In this specific instance, although travel restrictions significantly chopped the short-term value to equity, the business could have continued functioning perfectly well under new ownership with enough time. The airplanes themselves were totally intact, sitting in hangars, waiting to fly again. But by getting bailed out, we learn that the cost of equity to this business is essentially 0%. This suggests that airline stocks, with market beta, exposed to the vagaries of demand creation and destruction, nevertheless earned a convenience yield that pushed their equity risk premium all the way down to 0% with government intervention. Is 0% really the price of money for an airline business, particularly during a period when airline businesses are literally forbidden from functioning by world governments?

This is the logical conclusion to the moral hazard of limitless QE as base financial and monetary policy. Clearly, it is not a process of price discovery between two unencumbered market participants.

The promise of decentralized finance is the emergence of a new market interaction that can help discover the true risk-free interest rate over time. An intriguing possibility is that Ethereum staking rewards will provide a benchmark for future risk-free rates. Today, they are over 4% but over time can be expected to compress as the network becomes more secure and platform-specific risk starts to bleed out entirely. This is what makes it all the more important to integrate decentralized financial infrastructure with the real-world and introduce feedback mechanisms with no assumed convenience yield or single-sided policy decisions to distort the market rate of money.

Between a world where special interests can destroy the price of money and one where equity holders face the risk of simply getting rugged with no recourse, the alternative with the biggest promise for broad improvements in welfare has to be the latter.

“The Aggregate Demand for Treasury Debt”, Arvind Krishnamurthy and Annette Vissing-Jorgensen (2012)
“Risk-free interest rates”, Jules H. van Binsbergen, William F. Diamond, Marco Grotteria (2021)