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Cardano can replace failing banks

Published 22.3.2023

The traditional financial world is in trouble as banks in the US and Europe have begun to fail. Governments and central banks are implementing measures that will have an impact on rising inflation. This is not the first time we have seen a similar scenario. Similar events have been repeated over and over again. Bitcoin was created in response to the 2008 crisis. A decade later, we have other blockchain projects like Cardano, which can replace the banking system in another 5 to 10 years. They say that cryptocurrencies are to blame for the current financial problems. How is that possible? It must be said emphatically that the current problems have other reasons. They are the fractional reserve system, endless money printing, bailing out failing banks, poor risk management, corruption, and other things. The blockchain industry is the solution to many of the current problems of banks./

TLDR

  • Bankers benefit from the fractional reserve system, but depositors bear the risks.
  • Bearing the risk should mean accepting the loss if expectations are not met. If we do not keep this rule, it will lead to a loss of trust in the system.
  • The "fix the money, fix the world" narrative is partly false. Fixing the financial system requires changing the rules.
  • Cardano will allow us to create money with stable purchasing power backed by digital assets.
  • Cardano will allow us to create a bank whose services will always be 100% backed by its own capital. The bank would be transparent and profits would be shared fairly with depositors.

What causes the financial crisis?

If I had to answer in one word, it would be greed. People in positions of power make decisions that benefit themselves and a small group of the rich. By analyzing each crisis, you will find the fault lies in poorly set rules, in the circumvention of the rules, in the abuse of power by intermediaries, or in their failure to make the right critical decisions in time.

The fractional reserve system is irresponsible and benefits only the bankers. Bankers use depositors' money for investments. Bankers are obliged to hold only a small portion of deposits (mostly only 10%) and can use the rest for their own business. This means that if you deposit 100,000 USD in a bank, banks only hold 10,000 USD and can invest 90,000 USD. If they succeed, only they get rich and the depositors get almost nothing. If they get it wrong, the depositors suffer. If the mess is big, the risk is that all citizens will take the hit, because governments and central banks do not want to let irresponsible banks go bankrupt and prefer to bail them out by printing money.

It is unfair that a small group benefits from success and the whole system bear the risks.

In the current economy, bubbles are created and then burst, or unexpected catastrophes occur that we cannot solve except by printing money. The endless printing of money cannot be an automatic cure for all crises, because the increasing volume of money in circulation depreciates the value of money.

Bearing the risk means accepting the loss if expectations are not met. If we do not keep this rule, it will lead to a loss of trust in the system. This is currently happening right before our eyes.

If a bank loses the trust of the people and loses capital because people withdraw deposits, it is supposed to go bankrupt. If the company is not profitable, it should also go bankrupt. The principles of capitalism would work very well if governments and central banks did not need to interfere in everything.

One of the other problems is that the authorities can change the rules very quickly when it suits them. They may have a mandate won in a free election, but they certainly would only get the approval of the majority for some of the decisions they make. We have not had an effective weapon against corruption so far.

People in positions of power can make selfish decisions that benefit them and abuse the system as a bailout if they have misjudged the risks. Low transparency and the possibility of not taking full responsibility for bad decisions are general problems that the whole society suffers from.

People don't have the option of saying they don't want to be part of this system. As citizens of states, they are automatically part of a financial system that they do not control. We all have to trust the authorities and we are expected to be the ones who lose money in the event of a crisis.

States control the banking system. In doing so, they also maintain control over the citizens. The blockchain industry allows people to take some of the control back into their own hands. Specifically, define some rules that even the state cannot change as needed.

What can Cardano change in the financial system?

People sometimes think that better money will solve all the problems we currently face. The "fix the money, fix the world" narrative is partly false. To some extent, the economy does not care whether inflationary or deflationary money is used. What matters more are the rules, how they are followed, and how they are changed.

Fixing the financial system requires changing the rules. An alternative financial system should lead to more accountability, more transparency, less power of individuals, and the opportunity to participate in the success.

An alternative financial world built on decentralized technologies should not use the fractional reserve system. The preferred option should always be to have full reserves.

First and foremost, we need alternative money that maintains stable purchasing power in the short term. Algorithmic overcollateralized stablecoin projects like Djed are ideally suited for this. Money can be created that will be backed by cryptocurrencies like the ADA. The system will be fully transparent and auditable. DJED cannot be inflated out of thin air since Cardano has a capped number of ADA coins. Algorithmic stablecoins are the new gold standard for the digital era.

Peer-to-Peer banking services will have many advantages, as those who lend or invest money will benefit instead of institutions. People will bear the risk, but they do not have to share the profit with the intermediary. I can imagine an alternative bank assisting as a risk assessor or mediator when problems arise. In return, it can get a share of the profit. The loan or investment will be peer-to-peer via a smart contract.

Cardano can be used to create a bank through smart contracts, which will provide services that will be 100% covered by its capital. The bank could only lend money up to the amount of its own capital. If a bank had a capital of 10M DJED, it could only lend 10M DJED. In other words, it would be a full reserve bank.

Let's illustrate this with an example. Alice would put 1000 DJED into the bank. She wants the bank to lend DJED at a profit of 5% a year. The bank could lend this 1000 DJED to Bob and the risk would be covered by 1000 DJED of the bank's capital. The bank and Alice would split the profits fairly. The bank will lend Bob the money at 7% interest. If Bob defaulted on the loan, Alice would be able to get her money back from the bank's capital. Everything would work through smart contracts, so the bank could not prevent Alice from getting her money back.

Such a bank could not fail because all financial activities would be fully covered by its own capital. Theoretically, all people could withdraw all deposits, so that any bank run would not end in bankruptcy. Everyone would get back everything they put into the bank. There would be no need to bail out the bank. The bank would have been motivated to assess the risk very carefully because it would have had its own skin in the game. This would lead to greater accountability and the need to bear the consequences of poor risk assessment.

Note the other benefits. Similar banks could arise freely, small or large because in a decentralized world, everyone is free to create a similar service. With blockchain, the bank would be transparent, and easily auditable. No middleman could change the rules at will. The bank would not have a CEO who could abuse his position. There would be no one to corrupt.

Success, i.e. profit for banking services, is shared fairly and transparently between the bank and the money providers. A free competitive environment would push service fees down. The quality of service would naturally improve.

Note that a decentralized bank addresses many of the shortcomings that centralized ones suffer from. If a centralized bank were to fail, it would only lose its own capital and depositors would be protected. If there is no need to bail out the bank, there is no need to print money.

Conclusion

Cryptocurrencies did not cause the current financial crisis, but they are the solution. Note how easy it is to create an alternative bank on Cardano that will have much better features than the current ones. I don't expect the blockchain industry to be successful in this crisis and replace banks. It is not mature and adopted enough for that. Many people, institutions, officials, and bankers see blockchain as a solution, just maybe some don't want to admit it. I believe that in the next financial crisis, there will be a mass exodus of people from the current banking system toward blockchain. Technologically, we will be ready for it.

Bitcoin is volatile and an alternative banking system cannot be built upon it. I've seen the tagline "Bitcoin is bankless" somewhere. That is true to a certain extent and it is not Bitcoin's fault. It can be a good store of value in the long run, or it can serve as collateral for algorithmic stablecoins. What we need to change in the way the financial system works is not just money, but mainly rules.

Even if we went to a Bitcoin standard, banks could continue to use fractional reserves and nothing would change except that it would probably be impossible to save the bank through printing money. This could lead us to consider abandoning the Bitcoin standard during a crisis, much as we have abandoned the gold standard in the past. That is why I think we need to change the way the banking system works, not just the money. Bitcoin and Cardano can complement each other in this respect and it makes no sense to think of them as competitors. The competition for the blockchain industry is central and commercial banks, where irresponsible people make decisions and change the rules as needed.

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