In recent weeks, there have been systemic failures in the global financial system, particularly in the banking sector, causing people to question the legitimacy of information provided by regulators. Despite repeated assurances of robustness and security, people continued to withdraw their money from banks and invest in assets they could hold.
Many of our community are familiar with the idea of “not your keys, not your crypto” after the failure of several protocols and investment funds. Just as these failures caused people to withdraw their crypto from exchanges and opt for self-custody, a similar situation is happening with the current banking crisis.
Although no major banks have catastrophically failed in the past two weeks, the aftershocks of recent collapses are still affecting the markets. It is widely known that more banks will fail, and the central banks’ determination to continue with monetary tightening makes this even more likely.
The central banks’ challenge is that they claim to tighten policy, but they are also printing vast amounts of cash to backstop every troubled bank to reassure the markets. They are taking liquidity away with one hand and giving it back with the other.
The failure of regulators, banks, and politicians to realize that 20th-century approaches are outdated in the digital age is becoming evident. While they demonize crypto as a threat to financial markets, they have not accounted for the sudden movement of liquidity from banks through digital rails.
News spreads at a lightning pace through social media platforms, creating contagion. Combined with the speed of mobile banking this creates a recipe for disaster when banks have reinvested depositor funds in underperforming assets.
To support regulated banks, central banks have given them credit lifelines to borrow funds based on the assets they hold without having to liquidate them. While this resolves the short-term liquidity issue, it merely postpones the losses.
As long as interest rates remain high, government bonds held by banks remain unrealized losses. Investors are continuing to withdraw their funds from banks until there are clear signs of rate reductions or a guarantee from governments to protect their deposits in full.
Therefore, central banks will be forced to consider reducing interest rates much sooner than they want to or print the money needed to bail out banks one by one as they continue to fail. The present situation is clearly unsustainable, and there are no easy solutions in sight.
Because the current banking crisis is due to banks reinvesting depositors’ money to earn yield, making them overleveraged to some extent, whatever solution is implemented, banks will remain overleveraged. We have witnessed similar failures in crypto in the past 12–18 months, which is why the regulators’ aggressive approach toward the industry seems so unreasonable.
Decentralized finance (DeFi) provides a solution with over-collateralization. For instance, in our mainnet V1, when users deposit crypto into a liquidity pool, they earn yield on their deposit. When someone wants to borrow from the protocol, they have to deposit crypto as collateral and can only borrow a proportion of the amount they’ve deposited.
Both parties’ assets are locked into smart contracts that protect the collateral at every step of the process. It cannot be reused by the protocol to earn additional yield, and the protocol cannot create assets from thin air as banks do. Over-collateralization is the key to making DeFi a safe haven for assets.