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Why are banks failing and how can Cardano help?

Published 29.3.2023

Computers changed the world because we were able to write more efficient software. Computers have automated many tasks that were previously performed by humans, especially in areas such as accounting, science, and other fields that involve large amounts of data processing. In many industries, we didn't mind, and greater efficiency was seen as an advantage. Technology is now getting into areas where we are becoming more vigilant. Even though banks are using modern software and the internet, now is the time when technology can take the next step and replace other financial services processes. Could decentralized technologies be the next step that fundamentally changes the financial sector? And what role can Cardano play in this?

TLDR

Banks have never failed because of a software bug. It is time to reflect on whether decentralization can improve the functioning of banks. We can certainly write software better than we can put responsible and reliable people in key positions. So far, people have mostly failed us. Software can't do that and does exactly what it's programmed to do. It's time to trust the code more than the people. We will always need people to make risk assessments or investment recommendations. So we need to look for the right connection between people and a decentralized bank. Decentralization can solve some of the problems of banks and better protect depositors' assets. Smart contracts can form a key part of banking software and all assets will be on the blockchain.

How much more of the pie can technology take a bite out of?

The development of technology is not stopping and, logically, it plays an increasingly important role in many processes. People have been in a position where they use technology as a tool and play a kind of supervisory role. People are still responsible for process design, decision-making, risk assessment, creativity, and finding solutions to problems. In general, people set the rules and software helps to achieve greater efficiency.

One of the reasons why banks fail is the violation of rules and abuse of the position of CEOs and management. There is also low transparency and susceptibility to corruption. Some mistakes are due to human failure caused by inattention or poor judgment. Mistakes happen because of the complexity of today's world, the inability to predict the future, low or no responsibility for making decisions, and the desire for endless growth.

Banks have never failed because of a software bug. Software can't break the rules and doesn't make stupid mistakes. The results are always transparent and the same while keeping the same inputs. We have been making software for several decades and we know how to do it relatively well. The question arises whether software should be given more responsibility within the banking system.

Can decentralization solve any current problems? This is the key question.

Blockchain is essentially a distributed and decentralized network that is owned by the community. Smart contract platforms allow you to define rules within applications that cannot be changed.

The key features of blockchain technology in the context of the paper are as follows. Decentralization, transparency, incorruptibility, the immutability of rules, openness, the possibility to own digital assets (self-custody), and fairness. Is any of this useful for banks and could it have prevented the current problems?

This is a very complex question and it depends on how much imagination you have.

We could think about cryptocurrencies replacing fiat currencies, but I'm afraid that's too distant a dream and it doesn't solve the problem with the banks. Let's try to imagine something more realistic.

Decentralized banks will operate very similarly to today in terms of management and risk assessment experts. What may change fundamentally is the technology on which assets will be held, the way rules will be defined, and the way customers will interact with the bank. The bank's staff will essentially be programmers writing smart contracts.

What can a decentralized bank look like?

If banks started to operate on a tokenized fiat currency (or CBDC) and other tokenized assets (stocks, bonds, debt, etc.), all financial flows could be 100% transparent. Transparency does not mean that everyone in the world has to see all financial flows. Some transactions may be private, but what can remain transparent are things like bank reserves, loan volumes, liabilities, etc.

Through smart contracts, processes could be set up that could not be changed (or could be changed transparently through some form of DAO). If the bank committed not to use fractional reserves and all loans were 100% backed by the bank's assets, a mechanism could be created that no one in the bank could fool or influence.

Depositors should be assured that they can never lose their deposits because even if the bank lends their money to a third party if the borrower fails to repay, the depositor will get his money back from the bank's assets. The bank will be responsible for assessing the risk and will bear the consequences of poor decisions.

Another advantage would be that individual bank services could be strictly financially segregated. Loans, insurance, and savings would be separate services and if one sector did not do well, or even collapsed, it would not affect the other sectors. If the lending sector was losing money, it would not affect the savings sector. It would not be possible for a bank to use savers' deposits for loans, or for savers to lose their deposits because the bank collapses because of loans. Savers' deposits must be invested to grow in value over time. Through strict rules, it would be very easy to define under what conditions and with what level of risk the deposits can be used.

A decentralized bank will be forced to share profits more fairly with its customers. Profit will be transparent and more correlated to the level of risk borne by the bank and the bank's customers. Today, this ratio is unbalanced. The bank keeps most of the profit but bears the minimal risk. Clients bear the risk, but the bank that holds (and invests) their money takes most of the profit. In a decentralized world, people can keep their money without a bank. If they entrust it to a decentralized bank, it is only if they get a profit for doing so.

What will bank governance look like? Management will think about services and these will be implemented through smart contracts. Bank users will assess individual services (smart contracts) and choose the one that suits them. New services may emerge to help customers interpret individual smart contracts. Artificial intelligence may do this. All terms and conditions of the service will be binding and unchangeable. The bank will have a team of experts responsible for risk assessment, investment, etc. These experts will have only a limited ability to influence individual services.

When someone asks a decentralized bank for a loan, the bank simply estimates the risk and defines how much it is willing to cover with its own capital. It can be 100% (and the bank keeps an adequate part of the profit) or less (50%), and the person who wants to lend the money through the bank can also bear part of the responsibility.

The profit must be fairly distributed. Even if the bank covers 100% of the loan, whoever lends the money is entitled to a fair share. Of course, the bank can lend its own money and keep all the profit. But if the bank uses the users' deposits, it must share the profit. Transparency of accounts and cash flows will play an important role.

The key functionality of blockchain is self-custody. When people deposit tokenized money into the bank, they will get back tokens that represent a refund claim. In a decentralized bank, for example, what happens is that when a user deposits, a portion of the bank's capital is locked up for the benefit of the depositor. This can be 100% (ideally) or less, depending on the risk the depositor wants to bear. If it were 100% each time, the question is whether it is beneficial for the bank, since the deposit does not increase the bank's total capital. Alternatively, the depositor may receive tokens representing the right to the bank's profits over a longer time horizon or decision rights (on key issues). In other words, the depositor would become an investor in the bank with profit rights. This is certainly a better position than depositors have today.

Cardano's role in the future of banks

Cardano's mission is to be a bank for those who don't have one. Cardano can tokenize fiat currencies (USDA will be a USD-backed stablecoin) and even create an algorithmic overcollateralized stablecoin. DJED is an example. It is theoretically possible to issue a country's currency on Cardano. Blockchain has already been used for these purposes, unfortunately, they were mostly private versions.

Financial stability is an essential prerequisite for banking services. Beyond that, it's just a matter of defining the rules. That's where smart contracts come in. As far as deposits to the bank are concerned, this could be done through smart contracts, so that the depositor gets back tokens that represent the obligation of the bank (the right to get his money back). The deposit will then be used according to clearly defined rules that will be part of the smart contract. If risk assessment plays a role, this will be only one of the inputs of the smart contract. The important thing is that the deposit cannot be misused for anything other than its intended purpose and that the depositor receives the promised profit.

These are key concepts and specific implementations may vary. Cardano is a platform on which to build decentralized banks, whatever you think of that term. Hydra Head has already been opened up on the Cardano main-net, so scalability will improve significantly in the near future. Ouroboros Leios will greatly improve the scalability of the first layer.

It is already possible to start building the decentralized banks of the future on Cardano. If more than 1% of the population is using them within 5 to 10 years, this will be a very solid foundation for further changes in society.

Cardano has one advantage that could be crucial. So far, there have been no hacks in DeFi and it turns out that the Plutus platform makes it possible to build secure applications. If Cardano maintains this status, it will be the go-to solution for financial services requiring 100% reliability and security.

Conclusion

No one knows what the banks of the future will look like. Change is not only about technological possibilities but mainly about changing mindsets and habits. People are not used to self-custody and are afraid of the possibility. But the bigger obstacle is laws, regulations, and the fear of politicians accepting technological advances. History is proof that technology will catch on sooner or later. The bank we have described is only a vision, and things may be very different. AI technology is on the rise and it may play a role in risk assessment and bank operations. Cryptocurrencies will be an alternative for a minority of the population for a long time to come. However, it would be good for decentralized banks to emerge, as only a working example and good experience will cause wider adoption. Developing countries will drive adoption and are very likely to leapfrog developed countries in terms of finance. Are you ready to take a loan from the African bank?

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