Decentralizing A Broken Financial System.
How Blockchain can help prevent a repeat of the Great Recession and create a more inclusive, prosperous global economy.
The cyclical nature of financial markets seems inevitable.
Booms are followed by busts when the economy struggles to keep pace with skyrocketing asset valuations and investors are forced to readjust their expectations. Busts are followed by booms as the quality companies which survived the downturn and continued to add value begin to flourish in economic climates more conducive to consumer spending.
And so the sequences continue — expansion followed by recession followed by yet another expansion.
However, the story of the 2008 financial crisis is not one of nature taking its course. Rather, it is a tale of broken trust and lurking catastrophe revealed only once it was too late, all enabled by a system that places total control in the hands of a select few bankers.
It was during these trying times that Satoshi Nakamoto released the code for the Bitcoin blockchain ushering in a more transparent, inclusive global economy. He took a look around at the financial destruction wrought by legacy institutions and saw a critical flaw in the system that his new currency sought to address.
That flaw was the need for trust.
Who Is To Blame For The Great Recession?
Not since the Depression of the 1930s had the global economy experienced a downturn of such length and severity as the Great Recession. The recession, which lasted from December 2007 to June 2009, contracted the GDP in the USA by as much as 6%, and over 30 million Americans lost their jobs. Not all sectors of the population were affected equally. Minorities and the less-educated were hit especially hard, while those most responsible for causing the catastrophe escaped any form of serious disciplinary action.
What makes the Great Recession that much more tragic is the way in which the opacity of the financial system made it easy to veil the human greed that eventually brought the entire global economy to its knees.
A booming housing market in the early 2000s led many individuals to take out mortgages in pursuit of The American Dream of becoming homeowners. Banks bundled together these mortgages and sold them to investors as bonds, granting them the right to receive the stream of payments made by the new homeowners. However, different players across the system made a series of grave errors when handling this new investment class, leading to the biggest financial disaster since the Depression.
Commercial banks were guilty of issuing complex mortgages to homeowners with low credit scores in a bid to increase their asset base. These mortgages, known as subprime loans, were often offered with an adjustable interest rate that started off deceptively low before rocketing up to unsustainable levels. As a result of a booming housing market, many individuals with questionable creditworthiness were taking out large mortgages to buy real estate. When the market began to cool off and the higher interest rates kicked in, these subprime lenders defaulted on their loans in large numbers.
While destructive on its own, the damage caused by subprime mortgages could possibly have been contained were it not for securitization.
Investment banks were guilty of packaging these toxic mortgages into tradable assets and selling them to investors. With the bull market raging on and risk appetite growing, investment banks such as Goldman Sachs, Morgan Stanley and Bear Stearns began bundling mortgages together to form a new type of yield-bearing financial instrument — the mortgage-backed security(MBS). As the underlying mortgages began turning bad, investors holding MBS saw their income streams freeze, causing widespread panic in the markets. Lehman Brothers, the fourth-largest investment bank with $275 billion in assets under management at the time, was so badly damaged by their irresponsible foray into the mortgage-backed securities market that the 158-year old company had to file for bankruptcy after losing $3.9 billion in a single quarter.
However, the titans of finance would not have been able to create such a lucrative market for MBS had it not been for the support of the rating agencies.
Rating agencies, those ostensibly responsible for protecting investors from financial malpractice, were guilty of giving unreliable mortgage-backed securities their stamp of approval. Standard and Poors, Moody’s and Fitch, the agencies responsible for quality control in financial markets, all blessed these mortgage-backed securities with AAA ratings despite the poor quality of the mortgages that were included within them. According to the logic the agencies presented, since each security contained many different mortgages, they were considered sufficiently diversified to warrant a high rating. For whatever reason, they forgot to factor in a systematic risk: if the entire housing market collapsed entire populations would default on their mortgages, causing mortgage-backed securities to turn sour. When this exact scenario played out, many fingers were pointed at the rating agencies, accusing them of accommodating their investment banking clients by rating their debt AAA in exchange for higher fees.
Further piling on the risk where the insurance companies, whose ‘too big to fail’ status ensured that it would be the American taxpayer who would bear the brunt of their dangerous gambits.
Insurance companies were guilty of adding an extra layer of risk onto an already-shaky system by selling insurance contracts on these risky securities, known as credit default swaps (CDS), that would compel them to pay large sums of money in the event that these bonds went bad. CDS contracts went as follows: in exchange for receiving a fixed premium from the insured party, insurance companies obligated themselves to cover their debts in the event a mortgage-backed went into default. When the MBS began to go south, insurance companies suddenly found themselves with mountains of liabilities and not enough assets to cover their obligations. In one of the pivotal episodes of the financial crisis, insurance giant AIG lost $30 billion from its CDS business, leading the failing company to require an $85 billion bailout from the government to keep it from going under.
“Long Bitcoin, short the Bankers” has become the rallying cry for a blockchain industry seeking to replace the breaches of trust and self-interested behavior of the banking system with a decentralized financial system built on trustless, transparent protocols.
How Does Decentralized Finance (DeFi) Improve on The Current System?
DeFi’s core value proposition over the traditional financial system can be broken down into three major categories: Transparency, Trustlessness and Incentive Alignment.
Transparency
While traditional institutions are required by law to make their financial data public, they have been known to employ suspect accounting practices to skirt the edges of financial reporting requirements, if not breaking them completely. In a notable case of financial malpractice, the Enron Corporation was able to hide billions of dollars in debt by means of accounting loopholes and special purpose entities, all later exposed in their 2001 bankruptcy scandal.
With blockchain technology, every single action involved in fulfilling the main functions of a financial system — whether it’s issuing loans, trading derivatives and drafting insurance contracts — can be done on-chain for all to verify.
The common man no longer needs to trust the veracity of data provided by traditional institutions. Instead, anyone can query the blockchain directly when making financial decisions. For instance, mortgage-backed securities based on blockchain would contain a record of every mortgage within them, allowing investors to evaluate the health of these assets directly instead of blindly trusting the rating agencies to make the assessment for them.
Trustlessness
In the world of financial risk management, counterparty risk refers to the likelihood that one of those involved in a transaction might default on its contractual obligation. Trusting one's counterparty to deliver forms the foundation of the traditional financial system. For example, an investor buying a 10-year bond issued by Deutsche Bank must trust the bank to remain solvent long enough to pay both his interest and capital. However, if the 2008 crisis proved anything, it is the fact that we should not take the immortality of financial heavyweights for granted. Bear Stearns and Lehmann brothers were around for 85 and 158 years respectively before the Great Recession brought them down.
Instead of requiring trust, financial products built on blockchain make use of distributed consensus and smart contracts to eliminate counterparty risk by enabling self-executing contracts to clear immediately upon the fulfillment of certain pre-set conditions.
Miners and validators with a financial incentive to remain honest, not the banks, are the ones updating the state of the ledger. Moreover, smart contract technology allows conditions for a transaction to be set ahead of time in a smart contract recorded on the blockchain. Once these conditions have been met, this self-executing piece of software automatically carries out the terms of the agreement without the risk that one of the parties will backtrack on their commitment.
Let’s say Bob and Mike enter a simple futures contract. Mike has a car company while Bob supplies him with steel during manufacturing. Disturbed by the economic climate around him and the prospect of his steel costs increasing, Mike wants to lock in next month’s supply of steel at today’s prices. To do so, he enters into a contract with Bob which stipulates that Mike has the right to buy 1,000 tons of steel at $1 million when he places his order next month.
Instead of trusting each other to deliver, Mike and Bob can lock up their respective assets in a smart contract which will automatically execute the agreement at the predetermined time while still allowing them full ownership during the duration of the contract.
Incentive Alignment
If those individuals making risky bets on complex financial products would have been the ones to feel the economic ramifications of their actions, 2008 may have turned out differently. Instead, the big banks and insurance companies took on excessive risk and were able to, and through sophisticated financial engineering pass that risk on to their investors and clients. When the times are good, bankers reap the rewards in the form of sizeable commissions and bonuses, when the economy took a turn for the worse, it was those at the bottom of the socioeconomic ladder, not the bankers responsible for causing the crisis, who bore the brunt of the economic crisis.
A decentralized financial system realigns risk and reward by taking power out of the hands of major institutions and putting it in the hands of the people.
Individuals with ‘skin in the game’, whose livelihoods depend on the system, are given a say in how the system operates. For example, MakerDAO, a decentralized platform used to issue loans, allows all holders of their native MKR token to vote on the interest rate at which users lend money from the system. Since the MKR tokenholders directly experience the result of their decisions, they are incentivized to reduce any unnecessary risk and act in the best interest of the network as a whole.
Decentralized finance creates a new vision — a financial system that is more inclusive, transparent and resilient, and relies on cryptography and consensus instead of fallible human beings. It could be the breakwater to prevent the next financial tsunami from causing untold destruction.
