Regulators should embrace decentralized finance | Opinion

As a researcher with a background in mathematics, economics, and experience in the financial industry, I strongly believe that the current financial system’s opacity is not only unsustainable but also dangerous. The recent financial crises, including the one caused by Lehman Brothers’ collapse in 2008 and last year’s banking stress, have shown us that even with increased scrutiny and tighter laws, the financial sector remains vulnerable to significant risks.

Currently, the global financial system shrouds its operations in secrecy. Periodic stress tests are conducted on banks to evaluate their resilience during market crashes. However, in certain instances, regulatory bodies mandate these assessments no more than every two years, resulting in outcomes that can be disconcertingly vague.

Sixteen years have passed since Lehman Brothersexperienced a historic bankruptcy filing, marking the largest commercial failure in history. The instability was fueled by millions of high-risk mortgages, ultimately resulting in a fragile financial system that succumbed to a severe and painful recession upon bursting.

Back then, some valuable insights were gained. The scrutiny over major banks intensified, leading me to observe a heightened emphasis on stricter affordability checks for home loans. Despite the implementation of tighter laws, enhanced oversight, and more rigorous stress tests, I have come to notice that history has a tendency to repeat itself.

Last year saw another major crisis unfold, as the Bank for International Settlements labeled it the “most severe systemic banking strain” since the 2008 financial crisis. Notable failures included Silicon Valley Bank, Signature, and First Republic, while Credit Suisse experienced a humbling bailout and takeover by UBS.

Over the past 11-day period, I’ve observed the unexpected closure of four financial institutions, collectively holding an impressive $900 billion in assets. This sudden development created a ripple effect, instilling fear and uncertainty among consumers, which we refer to as a contagion.

As a researcher studying the financial sector, I’ve come to realize how alarming it is that the complexities of stress testing can allow significant issues to surface so unexpectedly. The limited perspective regulators gain into the fiscal wellbeing of institutions serving billions of people daily leaves them vulnerable to being reactive rather than proactive when crises arise.

The economic situation is growing more complex as clarity is lacking and inflation in the U.S. persists longer than anticipated. Jerome Powell, the Federal Reserve Chairman, has acknowledged that American inflation may not subside as quickly as previously believed, possibly delaying anticipated interest rate reductions. This rising borrowing expense contributes to an increase in mortgage defaults. Moreover, concerns over China’s property market instability cast doubt on the world’s second-largest economy and its potential repercussions. The International Monetary Fund has also raised concerns that ongoing conflicts in Ukraine and the Middle East could negatively impact economic growth prospects in the near future.

As an analyst, I have observed that the interconnected nature of today’s financial system necessitates frequent, comprehensive stress tests to uncover hidden vulnerabilities. However, the existing methods leave much to be desired in terms of depth and frequency. Decentralized finance (DeFi) emerges as a promising alternative, with its transparency, decentralization, and automation offering potential solutions to current limitations. It is crucial for regulators to recognize this trend and adapt accordingly.

Lifting the veil of secrecy

In contrast to the opaque nature of traditional finance systems where significant economic risks may surface unexpectedly, Decentralized Finance (Defi) offers complete transparency and up-to-the-minute information.

Defi protocols represent independent digital communities regulated by smart contracts, transparent for all parties. These communities operate based on predefined codes, ensuring error-free and unbiased transactions. The open-source nature enables anyone to examine the underlying smart contracts, enabling early detection and resolution of potential issues. This benefits all stakeholders: regulators seeking stability, businesses aiming to prevent costly mishaps, and consumers desiring secure savings.

In essence, this process enables ongoing surveillance of protocols. Experts can utilize online simulations to assess the effects of various factors on a platform’s liquidity and stability, such as altered interest rates, large-scale withdrawals, or unexpected drops in asset values. This results in immediate identification of vulnerabilities, allowing for proactive measures to be implemented to strengthen the system. Regulators now have unparalleled access to vast amounts of data in real time, enabling them to evaluate the financial robustness or susceptibility of an entire ecosystem with each transaction that occurs.

Fostering innovation and competition

This extends far beyond just assisting regulators in maintaining rigorous standards. Decentralized Finance (Defi) signifies the dawn of a new financial epoch—an era of accessibility for all. The opportunity for engagement and innovation is open to anyone, as they explore the multitude of existing protocols and discover where their creative drive leads them. In contrast, traditional institutions are encumbered by exclusive algorithms and intricate frameworks that create obstacles for entry. Open protocols, however, encourage competition and hinder the formation of dominant players.

In the real world, the consequences of this situation are already apparent. For instance, when interest rates go up, banks swiftly increase borrowing costs but reluctantly enhance savings rates. In Australia, there have been allegations that banks engage in “profit-driven” pricing due to a scarcity of competitors. Meanwhile, Belgian regulators view the financial sector as an “oligopoly,” where competition is stifled by dominant banks. Moreover, according to a recent survey in Ireland, approximately two-thirds of adults believe there’s insufficient competition within the banking industry and find it challenging to switch to alternative providers.

Change is necessary, and defi’s open and transparent architecture provides regulators with a comprehensive perspective on the financial sector. In real time, they can monitor transactions, ensuring a more robust and accessible financial system. Defi’s interoperability feature enables various protocols to work harmoniously, fueling innovation and creating a thriving ecosystem.

Opaque financial institutions and insufficient stress tests no longer have a place in the financial sector. The emergence of Decentralized Finance (Defi) offers a chance for a clearer, safer, and more responsive financial system – an opportunity that many existing protocols are eager to embrace in collaboration with regulators. As PwC rightly stated, “Trust is essential for every investment.” Adhering to regulations not only ensures compliance but also enhances the value of a project and attracts wider adoption.

As a financial analyst, I firmly believe in the transformative power of decentralized finance (DeFi) in reshaping our financial systems. The cornerstone of DeFi—transparency—provides a formidable weapon against potential future crises. By publicly recording all transactions on a distributed ledger, DeFi eradicates the shady dealings that ignited past financial catastrophes. Regulators should embrace DeFi’s potential as an advanced risk detection system, allowing them to identify and mitigate threats before they escalate into major issues.

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2024-05-19 14:22