CeFi, DeFi, Crypto, and Bank Failures
With the recent demise of Signature, Silvergate and SVB (Silicon Valley Banks), as well as the woes of Credit Suisse, it’s worth taking stock on some of the reasons why these major crashes have taken place.
Without a doubt, the respective business strategies of these banks were major factors, but others are informative about the general landscape of CeFi, DeFi and the future of the greater crypto project.
Poor Risk Management
On the one hand, the mismatched duration of treasury bonds and deposits on the other have resulted in a dangerous liquidity crisis for these banks. When a bank holds long-term assets (ie. treasury bonds) and short-term liabilities (ie. deposits), it creates a maturity mismatch.
This means that if depositors suddenly withdraw their funds en masse, or if interest rates rise, the bank may be unable to meet its obligations because it cannot quickly convert its long-term assets into cash.
This is a classic liquidity crisis, in which a bank typically faces a shortage of funds to meet its obligations, which can lead to a range of problems, including:
- Difficulty in meeting the demands of depositors who want to withdraw their funds
- Forced selling of assets to raise funds quickly, which can result in major losses
- A decline in the bank's credit rating and reputation can make it difficult for the bank to borrow funds in the future, and thus prevent such crises from happening again
- A freeze on lending activity, stifling economic growth
- Potential regulatory intervention or even closure of the bank
The need for banks to responsibly manage their asset and liability durations to avoid maturity mismatches and potential liquidity crises cannot be overstated. This involves matching the duration of their assets and liabilities, or maintaining sufficient liquidity buffers to cover any potential short-term cash shortfalls.
Cost-to-income
In the US, the average cost-to-income ratio increased from 61.7% to 62.73% in 2021, whilst the average net interest margin was 3.1%. Small interest rate and cost changes can have an enormous impact on banks. For context, across most businesses, a cost to income ratio of 50% is considered normal.
Revenue Mix
With deposit interest and service fee incomes making up key revenue sources for banks, the average revenue source was predominantly deposit interest, disclosed at 60% of revenues. Embracing a larger service fee income structure would mitigate the challenge associated with deposit interest.
Technical Debt or Aging Infrastructure restricting reporting and disclosure
Sophisticated financial instruments and/or products are typically difficult to analyse, measure and manage. If Treasury Bonds were frequently marked to market, the reporting would have revealed the liquidity challenges experienced by these banks far earlier.
EGRRECPA Act of 2018
In no small measure, the 2018 decision to relax the 2010 Dodd-Frank Act has contributed to the liquidity and risk situations. The original Dodd-Frank Act required stricter regulatory requirements, such as stress-testing for banks with assets over $50B, whereas the amendments in EGRRCPA 2018 raised the threshold to over $250B. This threshold removed the stricter requirements from these three banks in particular.
Federal Reserve's Interest Rates
The Federal Reserve's attempt to combat inflation in the US through QT (Quantitative Tightening) has directly impacted Treasury Bond values, resulting in significant losses. As a consequence, Tier-1 equity capital has been adversely (and dramatically) impacted.
Did the Audits reveal the Risks?
Current audit practices are being shown to be inadequate as modern systems are very complex and many sophisticated financial instruments are not effectively or frequently reported on. Additionally, traditional accounting solutions lack transparency, especially if compared to blockchain solutions, in the current financial and risk reporting of banks.
Insufficient FDIC cover
The FDIC deposit insurance was manifestly insufficient to protect depositors, capping reimbursement at only $250 000 per depositor. This painful shortfall has prompted subsequent revising to cover the full extent of depositor exposure.
Aggressive Short Selling
Aggressive short selling has certainly influenced the overall market and depositors' sentiment, which has impacted their equity markets and tier-1 capital.
Conclusion:
Despite the noise across the market, the actual impact of crypto on the failure of these banks continues without any real justification. The impact of exposure to individual client risks, such as the downfall of FTX and the popularity of these banks with crypto business clients has become overstated to say the least.
However, the upshot is that the rapid collapse of Silvergate, Silicon Valley Bank (SVB) and Signature Bank has highlighted the true fragility of the traditional banking sector, while depriving crypto of its primary fiat on-ramps in the United States.
Many observers agree that, like Silvergate, the collapse of SVB was largely the result of unfavourable market conditions and poor risk management.
At the same time, the dramatic shutdown of Signature Bank has been more controversial. According to multiple sources, the bank was not facing insolvency and had largely stabilised its capital outflow when U.S. regulators decided to intervene. Many in the crypto industry saw it as a political decision aimed at relegating crypto out of the United States.
Where does this leave DeFi?
DeFi (decentralised finance) aims to create a more open and accessible financial system using blockchain technology and the Internet.
Some of the key advantages of DeFi include:
- Decentralisation - no control by a single entity or intermediary, which enables the system to be far more fraud and censorship resistant
- Accessibility - regardless of location, social standing or background, DeFi services are accessible to anyone with an internet connection
- Transparency - DeFi transactions are recorded on public blockchain networks, which makes them easy to audit and verify, making DeFi more trustworthy than traditional financial systems
Particularly in the US, the major risk associated with DeFi is a regulatory one. Given the nature of DeFi’s systems, in that transactions are irreversible, any security breach can cause a permanent loss of funds.
Existing CeFi organisations can benefit from migrating their systems to DeFi in several ways. These can include considerable cost savings, access to new markets, increased transparency, faster settlement times and tremendous competitive advantage.
Utility
Irrespective of the advantages presented by blockchain systems, their utility remains elusive. Here are some persistent challenges that stand in the way of broad market adoption:
Hacks, frauds and theft
According to the Chain Analysis, crypto crime in 2022 totalled to $3.8B, of which 82% (or $3.1B) was from DeFi. So far in 2023, there has been the Euler Finance hack, where $196M was stolen. It’s worth mentioning that nearly all of these hacks are a result of bridging vulnerabilities.
Regulatory uncertainty
The current political and economic situation has increased the crypto and blockchain regulatory uncertainty, particularly in the US.
Complexity
Available Smart Contract implementations are complex and require a special programming language, resulting in a number of security and other flaws, which are difficult to identify and resolve.
Evolving and developing technology
Web3 is still largely an emerging technology, so careful assessment is needed prior to adopting a solution. The usual approach of choosing a rational market leader cannot be applied if the technology is relatively immature as is the case with available solutions.
Key differences between solutions involve questions about how consensus or validation is handled, transaction performance and capability, security and risks management, and the ease of implementation, to name a few.
The Art of the Possible and the Future
Zenotta’s ITTP-based Digital System (Internet Transaction & Trade Protocol) comprehensively addresses these aspects.
By implementing a fully-featured blockchain-based Web3 solution, it is possible to achieve a secure, reliable, transparent DeFi solution that does not require trust.
Each customer financial instrument or contract can be reliably and transparently recorded, whilst at the same time being based on algorithmic standards (metadata).
This provides what’s referred to as strong typing, thereby mitigating the typical smart contract vulnerability associated with external data. Also by resolving global program behaviour, major risks can be addressed by avoiding the unnecessary complexity imposed by most if not all current smart contract implementations.
By adopting the Zenotta solution or an equivalent and combining it with available analytics tools, critical reporting aspects, such as being able to mark-to-market, are readily achievable.
Overall, the future of DeFi remains bright, as it has the potential to transform the traditional financial system by greatly improving user access, transparency and efficiency. However, it will still require ongoing innovation and collaboration between the crypto and blockchain communities to overcome the challenges that lie ahead.
About the Author
Authored by Pieter Bouwer, COO of Zenotta
