Why Should Traditional Finance Adopt Decentralised Technology?

Why Should Traditional Finance Adopt Decentralised Technology?

By Jesper Kristensen

On 21 April 2023, the European Central Bank (ECB) released a report urging banks to be more transparent with information on climate change that they publish.

“We acknowledge that banks have been making progress, but further improvements are urgently needed. Stricter disclosure rules are taking effect this year. If necessary, we will take the appropriate supervisory actions to ensure that banks comply,” the Vice-Chair of the ECB’s Supervisory Board, Frank Elderson, said in a statement.

But why is this important?

In March 2023, the ECB published a different paper on how climate change affects the four largest eurozone economies – Germany, France, Italy, and Spain.

According to the report’s main findings, “weather shocks” have “heterogeneous and asymmetric effects across countries” on inflation, therefore indicating that climate change could lead to its nonlinear responses.

“In particular, we find that an increase in monthly mean temperatures increases inflation in summer and partly in autumn, significantly more than in other seasons of the year, with a stronger response in warmer euro area countries (Spain and Italy in summer, Spain in autumn),” the report stated.

However, information on climate change is not the only thing that banks fail to be transparent about.

The lack of transparency and the creation of a so-called “gated community” approach in traditional finance can limit access to financial opportunities and exclude certain groups of people from participating in the financial system.

Meanwhile, regulations require banks to not just inform their customers of most (if not all) of their inner workings but also act more honest, impartial, transparent and professional. However, when there is no way to check if a bank is being their most transparent self, how can consumers be sure they are not being played?

This is where decentralised finance (Defi) can play a critical role.

Essentially, DeFi has the potential to disrupt traditional finance by offering more accessible and transparent services. This is one of the main reasons why a number of DeFi applications have been hit by more strict regulations in recent months. 

While traditional finance has been slow to adapt to modern technology and commerce, the increasing speed of regulation topics in the blockchain space is highlighting the need for more transparency and accountability in the more traditional parts of the economy.

This is further highlighted by the outbreak of a number of cases in the last decade, including the Archegos Capital scandal that occurred in March 2021 and the Wells Fargo fake accounts scandal that first came to light in 2016.

The Archegos Capital scandal involved a complex web of derivative trades that allowed Archegos to take on massive leveraged positions in a handful of companies, including ViacomCBS and Discovery. When the value of these positions plummeted, the banks that had provided the margin loans suffered significant losses. The situation essentially highlighted the risks associated with unregulated, opaque, and highly leveraged trading practices and also raised questions about the adequacy of risk management practices and regulatory oversight in the traditional finance industry.

Meanwhile, the Wells Fargo fake accounts scandal involved the creation of millions of unauthorized bank and credit accounts by the bank’s employees without the customers’ knowledge or consent.

Blockchain technology is known for its ability to provide an immutable and public ledger that can establish trust in transactions with practically no overhead. Using blockchain technology, regulators and consumers can track trades and transactions in real-time, reducing the risk of fraudulent activities and providing an auditable trail of transactions.

This means that within DeFi, a Wells Fargo or Archegos Capital scandal is very unlikely to take place, since all actions on the blockchain are available to the public. 

The conventional finance sector often faces challenges related to transparency, however, if it integrates blockchain technology, it will have the potential to alleviate this issue significantly. Because DeFi operates in a decentralised manner, there is no central point of control or failure, making it more resilient to systemic risks and shocks. 

In addition, its open-source protocols can be audited by anyone, therefore increasing trust in the system and making it easier for regulators to monitor DeFi platforms’ activities and ensure compliance with relevant regulations. 

Also, decentralised finance has the potential to introduce innovative financial products that are currently unavailable in traditional finance markets, such as peer-to-peer lending, prediction markets, and yield farming. Such products will therefore provide broader access to financial services and generate higher returns for investors. The same goes for a wider range of financial products, including futures and options. 

Overall, the implementation of DeFi technology could greatly benefit the traditional financial industry, granting it more transparency and thus raising its trustability. A number of users are starting to lose trust in traditional finance systems, but greater transparency could turn everything around.

About the Author

JesperJesper Kristensen holds a Ph.D in Applied Physics and Computer Science from Cornell University and has previously led a large Web3 Research Organisation. Jesper also co-authored a book on Automated Market Makers: A Practical Guide to Decentralized Exchanges and Cryptocurrency Trading.

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