The Failings of Financial Centralization

Reactions from the NYT article: How a Lone Norwegian Trader Shook the World’s Financial System

“We’re only as secure as our most centralized component.” That’s a line from Keep’s Project Lead, Matt Luongo, who uses it to explain where issues lie within distributed network development. Through this lens, society today is not secure at all. In fact, we are exposed to massive risk. Our everyday actions across financial systems and many digital experiences expose us to inherent vulnerabilities.

Centralization vs. decentralization

Understanding the power of a distributed ledger brought the balance of centralization and decentralization into clearer focus for me. Centralization serves only those at the top, but decision-making is more efficient. It allows for maximum control, which is needed to implement, monitor, and enforce policy and regulation. Decentralization better serves an entire network of participants, but consensus slows progress. It mitigates risk by spreading out responsibility, creating transparency and instilling trust. Implemented exclusively, neither are completely reliable.

Decentralization will have the greatest positive societal impact in finance. Yet, full decentralization without any centralized components likely won’t work. The financial system we have today is based almost exclusively on centralization, and it continues to prove to be an unsuccessful strategy. Pressure builds when power grows in a silo and such pressure results in massive and uncontrollable risk.

Careful, you might break it

The New York Times recently published an article that highlights how vulnerable financial systems are locally and globally. The article features the story of a lone trader based in Norway who single-handedly shook the local financial system with the crisis, nearly inflicting damage upon the global system. How is it possible that one person could have an impact of that magnitude?

After the financial crisis of 2008–09, global financial regulatory authorities moved to better control the opaque derivatives market by processing previously over-the-counter trades through a central counterparty (CCP). In doing this, authorities established CCPs as ill-equipped enforcers of security. They were treated as safeguards for the system, but not enough checks or balances were, or have been, put in place to warrant such responsibility.

The CCP featured in the article, Nasdaq Clearing, had allowed the trader to take on unprecedented risk with large positions in energy futures. Underscoring the consequences of excessive leverage, the article explains that the “short, intense crisis [the trader] created was a precarious moment for the financial industry. It cast doubt on the safety of institutions like Nasdaq Clearing, which were supposed to prevent another meltdown.”

The centralized authority of CCP was never designed to ensure market stability. We are overly dependent on a system without a proper distribution of responsibility. This solution gives trust to an unqualified authority in order to manage system vulnerabilities, but at too great a cost.

The article quotes financial infrastructure writer Peter Norman, pointing out that “by staking so much trust on central counterparties, ‘authorities have stepped into the unknown. These are disasters waiting to happen.”’

Flying blind

The centralization of authority and practice across the financial system has led to an unwieldy level of complexity. As a result, massive markets have functioned in opacity, lacking regulatory oversight of risky market instruments — a driver of the 2008–09 financial crisis. It’s commonly said that hindsight is 20–20, but looking back it’s not clear that controlling authorities would have acted differently because, in the centralized system, they weren’t required to.

Complexity at this magnitude creates unknown risk. Left unchecked, risk increases creating new vulnerabilities, and a lack of transparency exacerbates the problem. When there is a faltering within the financial system, the impact comes in waves, impacting each level of the economy and even influencing fiscal and monetary policy. Deep complexity, the kind that can’t be easily undone, creates a dangerous knock-on effect that becomes too big to fail. At that point, the web can be too vast to effectively regulate.

How decentralization can help

Looking at the example presented by the Times, the financial system would be well served by a decentralized approach to monitoring and assessing systemic risk. Self-regulation, the kind of oversight performed within an organization or by various organizations within an industry doesn’t require participation by formal regulators. Formal regulation often isn’t as effective as self-regulation because it’s reactive, not proactive. A decentralized strategy includes the implementation of security policies and procedures that involve multiple parties, each with the responsibility to review risk status and ensure adherence to policies.

If a wider net of responsibility had been cast within the clearing and settlement sector, Nasdaq Clearing wouldn’t have been so dangerously burdened. Likewise, if responsibility for sustainable behavior was better shared across the financial industry, we’d have less concern over when and how systemic risk may affect us again.

With a focus on the improvements blockchain technology supports, I’m a communication strategist passionate about decentralized power structures. I’ve been writing about cryptography and distributed ledgers since 2016, identifying the many benefits of autonomous data security across industries. This passion for public privacy supports the mission of Keep, a project I’m very excited to be working with. You can find me on Twitter, or reach out to me on Slack.

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