Regulators should embrace decentralized finance

Disclosure: The views and opinions expressed here are solely those of the author and do not necessarily represent the views and opinions of crypto.news editorial.

Currently, the world financial system operates under a veil of secrecy. Global banks are currently undergoing stress tests to examine whether they can withstand significant and sudden market downturns. But in some cases, regulators require these exercises to be conducted only every two years, and the results can be unacceptably uncertain.

It’s only been 16 years since Lehman Brothers spectacularly filed for bankruptcy, the world’s biggest business collapse. Millions of subprime mortgages had led to an unstable financial system and a deep and punishing recession when the bubble burst.

Some lessons were learned then. Supervision of major banks increased and more aggressive affordability checks were implemented for home loans. Despite stricter laws, closer supervision and stricter stress tests, history continues to repeat itself.

Just last year, another crisis emerged, with the Bank for International Settlements describing it as the “most significant system-wide banking stress” since 2008. Silicon Valley Bank, Signature and First Republic all suffered high-profile failures, while Credit Suisse endured a humiliating bailout and was taken over by rival UBS.

In 11 days, four banks with a staggering $900 billion in assets were closed; This created a spillover effect and crisis of confidence among consumers. The Federal Reserve’s aggressive interest rate hikes exposed inadequate risk management procedures at these companies; Losses on government bonds led to massive deposit outflows, dealing a fatal blow to their liquidity.

The fact that all of this can happen so quickly makes the inherent flaws in stress tests painfully clear. Regulators have only a glimpse into the financial health of the banks that billions of people rely on every day, and when things go wrong, they are forced to try to catch up.

Worse, inadequate transparency coincides with an increasingly uncertain economic picture. Federal Reserve Chairman Jerome Powell once again admitted that it is taking longer than expected for inflation to cool in the US and interest rate cuts may not come as quickly as hoped. Rising borrowing costs are causing mortgage defaults to increase. Widespread problems in China’s real estate market have also cast a dark shadow over the world’s second-largest economy; its effects may be felt elsewhere. Meanwhile, the International Monetary Fund has warned that ongoing conflicts in Ukraine and the Middle East could jeopardize growth prospects in coming years.

Put together, one thing becomes clear: Regular, in-depth stress testing has never been more important to uncover potential vulnerabilities in the financial system; but current methods fall far short of what is needed. Decentralized finance offers a compelling alternative and should be urgently embraced by regulators.

We lift the veil of secrecy

Compared to the smoke and mirrors of the world of centralized finance, which means major 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 independent ecosystems governed by publicly visible smart contracts. These are powered by lines of code that set the rules for transactions and eliminate the possibility of human error and greed. An open source environment means anyone can access and examine these smart contracts; This allows potential problems to be quickly identified and action taken. This is in the interest of all parties involved; regulators racing to ensure stability, businesses looking to avoid costly and reputation-damaging incidents, and consumers wanting absolute assurance that their savings are safe.

So… what does this mean in practice? It ensures that protocols can be constantly monitored. Through online simulations, experts can examine how a platform’s liquidity and health are affected by numerous factors, including changes in interest rates, mass withdrawals, or sudden declines in asset prices. This provides immediate feedback on potential vulnerabilities; This means that preventive measures can be put in place. Never before have regulators had access to such a vast wealth of data so quickly and been able to detect the financial fragility or resilience of the entire ecosystem with every transaction that occurs.

Promoting innovation and competition

All of this goes beyond helping regulators maintain high standards. Defi is also pioneering a new financial era: the era of inclusion. Anyone can participate and innovate in the many protocols that exist today and see where their entrepreneurial spirit takes them. While old-school firms have proprietary algorithms and complex structures that create barriers to entry, open protocols encourage competition and prevent powerful incumbents from forming.

This already has real-world consequences; Banks are quick to raise the cost of borrowing when interest rates rise, but slow to reward savers. In Australia, banks have been accused of “profit-oriented” pricing because there are few competitors in the market. In Belgium, regulators compared the financial sector to an “oligopoly” where competition is stifled by big banks. In a recent survey, two-thirds of Irish adults said they believed there was a lack of competition in the banking industry and that it was difficult to switch to other providers.

It’s time for change. By embracing 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 encourages innovation and paves the way for a vibrant ecosystem.

The time of opaque financial institutions and inadequate stress tests is over. Defi offers an opportunity for a more transparent, secure and dynamic financial future, and many existing protocols are willing to cooperate with regulators. “Without trust, there is no investment,” PwC recently said, and ensuring compliance can actually add value to the project as well as encourage adoption.

Defi’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 meltdowns. Rather than fearing disruption, regulators should recognize defi’s potential as an early warning system, allowing them to detect and address risks before they snowball.

Edward Mehrez

Edward Mehrez is the co-founder of Arrow Markets, which is pioneering a new paradigm for options trading on the Avalanche blockchain. Arrow offers the efficiency of centralized exchanges with the transparency and security of on-chain settlements. Prior to Arrow, Edward developed his expertise in quantitative finance at MKP. He has a strong academic foundation, with a bachelor’s degree and a PhD in Mathematics and Economics from UCLA. in Economics from Cornell University.