Opinion – Nelson Barbosa: Waiting for the blockchain and DeFi sheriff

The Putin shock and rising interest rates in the US are promoting losses in various financial assets, including cryptocurrencies.

I don’t think the ongoing correction will end “cryptofinance”, because the technology involved in the bitcoin and similar market goes beyond the creation of private currencies.

Specifically, on the computational side, cryptofinance is based on continuous block processing (blockchain), where every transaction is recorded in an electronic ledger, available to all users, using cryptography techniques, in order to prevent someone change the system history.

Blockchain technology has many other applications besides creating and trading cryptocurrencies (Bitcoin, Ether, Tether… I would create “Friedman” and “Maynard”, but that’s a topic for another column).

It is also possible to use the blockchain processing system or environment to create smart contracts in cryptocurrencies, state currency or any other unit of account.

And what are smart contracts? These are financial commitments created on demand by users and processed directly in the blockchain system, that is, without the need for intermediation by financial institutions or the government.

Cryptofinance advocates argue that blockchain enables decentralized finance (DeFi), cutting financial intermediation costs as has happened in retail (Amazon), hospitality (AirBnB), urban transport (Uber), pay TV (Netflix) and other activities now dominated. by application companies.

Imagine a large “open banking” system, but without regulation by the Central Bank and with high transaction processing costs. Today the DeFi system is that. Big dog thing, for people or companies that want to avoid financial regulation and have the capacity to take big risks.

Five thousand years of monetary history indicate that financial innovations like blockchain and DeFi start by generating bubbles, which may or may not end up in financial crisis. In this process, at some point, the users of the innovation themselves ask for a sheriff, to organize the market.

Translating from economics, the key to DeFi’s success is not only in computing. It is also necessary to efficiently manage the risks inherent to any financial transaction: liquidity, solvency and exposure to sudden fluctuations in key market prices.

To manage liquidity risk, this thing called a society developed compulsory reserves, lender of last resort (known as the “Central Bank”) and deposit insurance. Calls to reinvent this in blockchain language have already started.

In the case of solvency, in a long process of trial and error, humanity has also developed minimum capital requirements for an institution to carry out financial intermediation. Provisions for losses, indebtedness limits and limits on creditor exposure to an agent or sector were also created.

In the case of market risk, the 2008 international financial crisis made it common to carry out financial stress tests, in which regulated institutions inform the authorities of their potential for loss in the event of sudden changes in some prices, such as exchange rates, interest rates and oil.

Is there already someone rewriting the Basel criteria as “smart regulation” on blockchain? I think so, but before that becomes common, we’re likely to have some turmoil in DeFi. Only after the crisis comes the sheriff.