DeFi
Regulators should embrace decentralized finance
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Currently, the global financial system operates under a veil of secrecy. Global banks are currently undergoing stress tests to determine whether they can withstand large and sudden market downturns. But in some cases, regulators only require that these exercises take place once every two years – and the results can be unacceptably opaque.
It’s only been 16 years Lehman brothers spectacularly, filed for bankruptcy in what was the world’s largest business collapse. Millions of subprime mortgages had led to an unstable financial system and a deep, punishing recession when the bubble burst.
Some lessons were learned at the time. Supervision of big banks has increased and more aggressive affordability checks for home loans have been imposed. Yet despite stricter laws, closer monitoring and more rigorous stress testing, history continues to repeat itself.
Last year, another crisis occurred: that of the Bank for International Settlements. describing it is the “most significant system-wide banking stress” since 2008. Silicon Valley Bank, Signature and First Republic all experienced high-profile bankruptcies, while Credit Suisse suffered a humiliating bailout and a takeover by its rival UBS.
In the span of 11 days, four banks with a staggering $900 billion in assets were closed, creating a contagion effect and a crisis of confidence among consumers. The Federal Reserve’s aggressive rate hikes exposed inadequate risk management procedures at these companies, as losses on government bonds led to large deposit outflows that dealt a fatal blow to their liquidity.
The fact that all of this can happen so quickly painfully reveals the flaws that exist in stress testing. Regulators only have a glimpse of the financial health of the banks that billions of people rely on every day – and when things go wrong, they have to play catch-up.
Worse still, insufficient levels of transparency coincide with an increasingly uncertain economic context. Federal Reserve Chairman Jerome Powell once again admitted that inflation in the United States is taking longer than expected to subside – and that interest rate cuts may not come as quickly as hoped. The increased cost of borrowing is provoking mortgage defaults will increase. Widespread problems in the Chinese real estate market have also casting a dark shadow over the world’s second largest economy, with effects that could be felt elsewhere. Meanwhile, the International Monetary Fund has warned Ongoing conflicts in Ukraine and the Middle East could compromise growth prospects in the years to come.
Taken together, one thing becomes clear: It has never been more important to conduct regular, thorough stress testing to reveal potential vulnerabilities in the financial system, but current methods fall far short of what is required. Decentralized finance offers an attractive alternative and should be adopted urgently by regulators.
Lifting the veil of secrecy
Compared to the smoke and mirrors of the world of centralized finance, which means that significant risks to the health of an economy are only detected when it is too late, defi offers full, real-time transparency.
Defi protocols are autonomous ecosystems governed by smart contracts visible to everyone. They are powered by lines of code that dictate the rules of transactions, eliminating the risks of human error and greed. An open source environment means that anyone can access and examine these smart contracts, making it possible to identify potential problems and take action quickly. This is in the interest of all parties involved: regulators who struggle to achieve stability, businesses who want to avoid costly and reputation-damaging incidents, and consumers who want absolute guarantees that their savings are safe.
So… what does this mean in practice? Well, this ensures that the protocols can be constantly monitored. Through online simulations, experts can examine how a platform’s liquidity and health are affected by a multitude of factors, including changes in interest rates, mass withdrawals, or a sudden drop in asset prices. This provides instant feedback on potential weak points, meaning preventative measures can be put in place. Never before have regulators been able to access such a wealth of data so quickly and verify the financial fragility or resilience of an entire ecosystem with each transaction.
Promote innovation and competition
All of this goes beyond helping regulators meet high standards. Defi also ushers in a new financial era: that of inclusion. Anyone can participate and innovate in the many protocols that exist today and see where their entrepreneurial spirit takes them. While traditional companies have proprietary algorithms and complex structures that create barriers to entry, open protocols foster competition and prevent the formation of powerful incumbents.
This is already having concrete consequences: banks rush to increase the cost of borrowing when interest rates rise, but are slow to reward savers. In Australia, banks have been accused “profit-driven” pricing because there are few competitors in the market. In Belgium, regulators have compared with of the financial sector to an “oligopoly” where competition is suppressed by the big banks. And according to a recent poll, two-thirds of Irish adults said they believe that there is a lack of competition within the banking sector and that it is difficult to turn to other providers.
It’s time to change. By adopting Defi’s transparency and open architecture, regulators can gain a more holistic view of the financial landscape. Real-time monitoring, combined with a decentralized structure, offers the potential for a more resilient and inclusive financial system. Defi’s promise of interoperability, where different protocols interact seamlessly, further fosters innovation and paves the way for a dynamic ecosystem.
The days of opaque financial institutions and inadequate stress testing are over. Defi presents an opportunity for a more transparent, secure and dynamic financial future, and many existing protocols are keen to cooperate with regulators. PwC recently said“There is no investment without trust,” and compliance can really add value to a project and encourage adoption.
The challenge’s potential to revolutionize financial systems is undeniable. Its core principle – radical transparency – offers a powerful tool to prevent future financial crises.. By openly recording all transactions on a public ledger, Defi eliminates the opaque practices that fueled past collapses. Regulators, instead of fearing disruption, should recognize the challenge’s potential as an early warning system, allowing them to identify and manage risks before they snowball.
Edouard Mehrez
Edouard Mehrez is co-founder of Arrow Markets, pioneering a new paradigm for options trading on the Avalanche blockchain. Arrow offers the efficiency of centralized trading with the transparency and security of on-chain settlements. Before joining Arrow, Edward honed his expertise in quantitative finance at MKP. He has a strong academic foundation with a bachelor’s degree in mathematics and economics from UCLA and a Ph.D. in economics from Cornell University.