Regulation
Regulators should embrace decentralized finance
Disclosure: The views and opinions expressed herein are solely those of the author and do not represent the views and opinions of the crypto.news editorial.
Right now, the global financial system operates under a veil of secrecy. Global banks are currently undergoing stress tests to see if they can withstand significant 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.
Only 16 years have passed since then Lehman Brothers spectacularly declared bankruptcy in what was the world’s largest business collapse. Millions of high-risk mortgages had led to an unstable financial system and a deep, punishing recession when the bubble burst.
Some lessons were learned then. Scrutiny of major banks has increased and more aggressive controls have been imposed on the affordability of home loans. Yet despite tougher laws, tighter controls and more rigorous stress tests, history continues to repeat itself.
Just last year another crisis occurred, one involving the Bank for International Settlements describing has been called “the most significant system-wide banking stress” since 2008. Silicon Valley Bank, Signature and First Republic have all suffered high-profile bankruptcies, while Credit Suisse has suffered a humiliating bailout and takeover by of rival UBS.
In the space of 11 days, four banks with an astonishing $900 billion in assets were closed, creating a contagion effect and a crisis of confidence among consumers. Aggressive rate hikes by the Federal Reserve have exposed inadequate risk management procedures within these companies, with losses on government bonds leading to large deposit outflows that have dealt a fatal blow to their liquidity .
The fact that all of this can happen so quickly painfully highlights the flaws in the stress tests. Regulators only get glimpses of the financial health of the banks that billions of people rely on every day, and when things go wrong, they are forced to play catch-up.
To make matters worse, inadequate levels of transparency coincide with an increasingly uncertain economic picture. Federal Reserve Chair Jerome Powell has done so once again admitted that inflation in the United States is taking longer than expected to cool and that interest rate cuts may not come as soon as hoped. The increase in the cost of the loan is causing the mortgage tends to tick upwards. There have also been widespread problems in the Chinese real estate market launch a dark shadow over the world’s second largest economy, with effects that could be felt elsewhere. Meanwhile, the International Monetary Fund has done so warned the ongoing conflicts in Ukraine and the Middle East could jeopardize growth prospects in the coming years.
All in all, one thing becomes clear: it has never been more important to undergo regular, thorough stress testing to highlight 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 embraced by regulators urgently.
Lift the veil of secrecy
When compared to the smoke and mirrors of the world of centralized finance, which means that considerable risks to the health of an economy are only detected when it is too late, defi offers full transparency and in real time.
Defi protocols are autonomous ecosystems governed by smart contracts visible to all. They are powered by lines of code that dictate the rules for transactions, eliminating the prospect of human error and greed. An open source environment means anyone can access and examine these smart contracts, allowing potential issues to be quickly identified and resolved. This is in the interests of all stakeholders: regulators racing to achieve stability, businesses wanting to avoid costly and reputation-damaging incidents, and consumers wanting iron-clad guarantees that their savings are safe.
So… what does this mean in practice? Well, it ensures that the protocols can be continuously 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 immediate feedback on potential weaknesses, meaning preventative safeguards can be put in place. Never before have regulators been able to access such a wealth of data so quickly and ascertain the financial fragility or resilience of an entire ecosystem with every transaction that occurs.
Promote innovation and competition
This goes beyond helping regulators maintain high standards. Defi also inaugurates 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 old-style companies have proprietary algorithms and complex structures that create barriers to entry, open protocols foster competition and prevent the formation of powerful incumbents.
This already has real-world consequences: banks are quick to increase the cost of borrowing when interest rates rise, but slow to reward savers. In Australia, banks have been accused of prices “driven to profit” because there are few rivals on the market. In Belgium, regulators have done so respect the financial sector to an “oligopoly” in which competition is suppressed by the major banks. And in a recent survey, two-thirds of Irish adults She said they believe that there is a lack of competition in the banking sector and it is difficult to switch to other suppliers.
It’s time for a change. By embracing the transparency and open architecture of Defi, 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 work seamlessly together, further fosters innovation and paves the way for a vibrant ecosystem.
The time of opaque financial institutions and inadequate stress tests is over. Defi represents an opportunity for a more transparent, secure and dynamic financial future, and many existing protocols are eager to collaborate with regulators. PwC recently She said“There is no investment without trust,” and achieving compliance can actually add value to a project, as well as encourage adoption.
Defi’s potential to revolutionize financial systems is undeniable. Its fundamental principle – radical transparency – offers a powerful tool for preventing future financial crises. By openly recording all transactions on a public ledger, defi eliminates the opaque practices that have fueled past collapses. Regulators, instead of fearing disruption, should recognize DeFi’s potential as an early warning system, allowing them to identify and address risks before they become exponential growth.
Edward Mehrez
Edward Mehrez is a 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 trading. Prior to Arrow, Edward honed his quantitative finance expertise at MKP. He has a solid academic foundation with a bachelor’s degree in Mathematics and Economics from UCLA and a Ph.D. in Economics from Cornell University.