In March 2023, we saw Silicon Valley Bank (SVB), Signature Bank, and Silvergate all collapsing following the bank runs, fanning fears of a banking-sector meltdown. As we saw over the past two weeks, these bank runs can have significant implications for modern finance as well as the broader economy.
These far-reaching implications include liquidity risk as banks get forced to sell assets quickly at a loss to meet the demand for withdrawals, contagion risk, where depositors in other banks start to worry about their own bank’s solvency and rush to withdraw their deposits which is exactly what took Signature bank down, undermining public confidence in the banking system, and changes in regulation.
But this is where crypto comes into the picture. Unlike traditional currencies, such as the US dollar or Euro, cryptocurrencies are decentralised, meaning they are not controlled by any central authority, such as a government or a bank, and use cryptography for security.
While crypto and bank runs may seem unrelated, they are connected in the sense that crypto offers an alternative to traditional banking systems. And in the event of a bank run, depositors may turn to cryptocurrencies as a way to safeguard their funds and avoid potential losses. Crypto can also provide a means of transferring funds quickly and securely without the need for traditional banking systems.
During these past two weeks, as several banks folded, crypto assets recorded increased interest that saw BTC/USD surging over 26% while the total crypto market cap jumped 25% to surpass the $1.2 trillion mark.
The Failures of Centralised Finance
Centralised finance, or CeFi, refers to traditional financial (TradFi) systems that rely on central authorities such as banks, governments, or other financial institutions to manage and control the flow of funds. While this system has been around for centuries and has provided stability and security for many, it has several inherent problems.
One of the most significant issues with CeFi is its susceptibility to bank runs. Bank runs occur when a large number of customers simultaneously withdraw their funds from a bank, causing a liquidity crisis that can ultimately lead to the bank’s failure. Bank runs can be triggered by various factors, such as economic uncertainty, negative rumours, or a lack of confidence in the bank’s solvency.
We have seen several instances of bank runs in various parts of the world. Just this month, SVB — the largest US bank to collapse since 2008 — experienced a bank run after revealing a financial shortfall resulting from the sale of its bond portfolio, which was affected by inflation.
Now the demise of Switzerland’s second-largest bank, Credit Suisse, is sending shockwaves through financial markets and impacting the country’s reputation. Switzerland’s largest bank, UBS, is purchasing the embattled rival for $3.2 billion as part of a government-backed, cut-price deal, which comes after years of scandals at Credit Suisse, as it eroded its reputation, leading to a sharp loss of confidence among investors last week.
Another issue with CeFi is its lack of transparency and accountability. In a traditional financial system, the central authorities have complete control over the flow of funds, and customers have to rely on these authorities to ensure that their funds are safe and secure. However, this lack of transparency and accountability can lead to corruption, fraud, and mismanagement of funds, which can ultimately harm the customers and the economy as a whole.
Moreover, CeFi often creates barriers to accessing financial services for those who are unbanked or underbanked, particularly in developing countries. Banks and other financial institutions require customers to meet specific eligibility criteria, which often exclude those living in poverty or having limited access to formal financial services.
In contrast, decentralised finance, or DeFi, provides a more transparent, accessible, and democratic alternative to TradFi. DeFi is a blockchain-based financial system built on decentralised protocols and smart contracts, allowing users to access financial services directly without intermediaries or central authorities. This system provides greater transparency, security, and accessibility, ultimately leading to financial inclusion for those currently underserved by the TradFi system.
Crypto as a Solution
Centralised finance systems, such as banks, have long been the go-to choice for managing money and conducting transactions. However, they have several shortcomings, such as a lack of transparency, high fees, slow transaction times, and potential for fraud and abuse.
That’s where crypto comes into the picture as a potential solution to these problems. As a decentralised system, it is not controlled by a single entity or organisation. Transactions are validated and recorded on a public blockchain, providing transparency and accountability.
Meanwhile, being programmable means, it can be programmed to execute financial transactions automatically without the need for intermediaries. This enables the creation of smart contracts, which can be used to automate financial agreements and eliminate the need for intermediaries.
Moreover, crypto is secured by cryptography, making it difficult to hack or manipulate. Transactions are verified by a network of computers, ensuring the integrity of the transaction.
Crypto is also accessible to anyone with an internet connection, regardless of location or financial status. This makes it possible for people without access to traditional banking services to participate in the financial system.
But most importantly, crypto gives individuals full control over their financial assets, eliminating the need for third-party intermediaries to hold and manage their assets.
These benefits of crypto have led to the emergence of a new sector, DeFi, within the industry. DeFi refers to a set of financial applications and services built on top of blockchain technology, which allows for peer-to-peer transactions.
In this new financial system, applications are open-source, meaning anyone can review and verify their code. DeFi transactions are also often cheaper than TradFi transactions because they don’t require intermediaries like banks or payment processors. This makes it possible for people to send money, invest, or borrow at a lower cost.
Given that it is in its early stages, there is much room for innovation and experimentation. This could lead to new financial products and services that are more tailored to the needs of individuals and communities.
This way, DeFi has the potential to democratise finance and make it more inclusive, transparent, and accessible to everyone. However, it is still a new and rapidly evolving field, and its challenges and risks still need to be addressed.
The Potential of Crypto in Modern Finance
Crypto has the potential to significantly impact modern finance in a variety of ways. One of the most notable impacts of crypto is the growth of DeFi, which has emerged as a major force in the financial industry in recent years.
With DeFi, users can earn interest on their assets, borrow and lend funds, and trade assets without needing to go through TradFi intermediaries. Additionally, DeFi platforms can facilitate cross-border transactions, providing greater access to financial services for individuals in underbanked or underserved regions.
The increasing adoption of cryptocurrencies is another potential impact of crypto on modern finance. Cryptocurrencies such as Bitcoin, Ethereum, and others are becoming more widely accepted as a form of payment. This increased crypto adoption can potentially disrupt traditional payment systems and reduce the reliance on banks.
Furthermore, the use of cryptocurrencies can potentially provide greater financial privacy and security for individuals, as transactions are recorded on an immutable public ledger rather than being stored in centralised databases that are vulnerable to hacks and cyber attacks.
The integration of crypto into traditional finance, however, presents both challenges and opportunities.
One of the biggest challenges facing the integration of crypto into traditional finance is regulation. Crypto assets exist in a regulatory grey area, and there is no consensus on regulating them. This creates uncertainty for TradFi institutions that are used to operating within well-defined regulatory frameworks.
Cryptocurrencies are also vulnerable to theft and hacking, and traditional financial institutions may not have the expertise to manage the risks associated with crypto assets. This could lead to an increased risk of fraud and financial loss.
But while cryptocurrencies are also highly volatile, they have the potential to provide new sources of liquidity to markets, which can increase the efficiency of financial markets and potentially reduce transaction costs. Crypto could further drive innovation in the financial sector leading to the development of new financial products and services that could benefit consumers and investors.
Moreover, by integrating crypto into their portfolios, TradFi institutions and investors can diversify their holdings to potentially reduce risk and increase returns.
While currently limited, the integration of crypto into traditional finance will continue in the years to come as institutions seek to take advantage of the opportunities presented by this emerging asset class.
The future of modern finance is likely to be characterised by increasing digitisation, automation, and decentralisation. The rise of technologies like blockchain, artificial intelligence, and machine learning will continue transforming how we conduct financial transactions, manage risk, and make investment decisions.
In this context, crypto is likely to play an increasingly important role in the future of modern finance. Cryptocurrencies like Bitcoin and Ethereum have already demonstrated the potential to disrupt traditional financial systems by enabling peer-to-peer transactions without the need for intermediaries like banks.
As the technology underlying cryptocurrencies continue to evolve, we can expect to see new use cases for crypto emerge. However, it is important to note that the future of crypto is not without its challenges.
Concerns around security, scalability, and regulatory oversight will need to be addressed for crypto to become a mainstream financial asset. Additionally, the volatility and lack of stability of many cryptocurrencies may make them less appealing to some investors.
Overall, crypto’s role in modern finance’s future is likely to be significant, but it remains to be seen just how this will play out over time.