Fragile Markets, Liquidity Shocks Ring Alarm Bells for Structural Change

John Wu, President of AVA Labs

Covid-19 is re-shaping the fabric of our society for generations to come. However, like all crises it also offers an opportunity for change. 

In the wake of the 2008 financial crisis, we saw policy makers endeavor to create stability through restrictions on leverage and higher capital thresholds. While there was some laudable progress made, there are still significant holes that undermine our ability to respond to and cope with the challenges posed by a shock across the global financial system.

Nowhere has this been more evident throughout this crisis than access to liquidity and the flow of credit from financial institutions to businesses. 

Today, financial institutions are in a much stronger position than 2008 as a result of those policy efforts. According to the New York Federal Reserve, the largest banks held some $1.69 trillion in cash and savings accounts in Q3 2019 (compared to only $590bn in Q3 2008). Economic experts have outlined that the healthy state of financial institutions’ capital holdings mean there is theoretically sufficient liquidity in the system to cover cash flow shortfalls in the medium term. 

And yet, such holdings are only of use if the liquidity can flow to the sectors which are most in-need. Sectors like real estate and travel that are reaching dire straits for capital, but hampered by the antiquated infrastructure currently in place.

Unsurprisingly, it’s the individual investors who are least in control of this market structure that have been left most exposed.

Platforms purpose-built for the digital era will substantially open markets to new investors by reducing barriers between these natural counterparties, while also providing new revenue opportunities for businesses with cash on-hand.

It’s the type of rare win-win situation that must be explored for mutual survival and new growth, but it won’t happen without a fundamental shift to embrace innovation in both the culture and technology governing these markets.

Decentralized Finance: Liberating and Accelerating the Use of Capital

Wind the clock back a year, and you’d find more doubters calling the world of decentralized finance (“DeFi”) – that being the use of blockchains and distributed networks to create applications to program and deploy capital for financial services – more like a science project than competitor institutions and traditional fintech firms.

But now, a boom in the market cap of stablecoins to over $9B (digital assets which are typically backed by fiat currencies or commodities like gold), and nearly $1B in value locked in the top 25 DeFi apps on Ethereum has changed the narrative.

For institutional investors, monetary authorities, and traditional market infrastructures, this dramatic and rapid evolution of market structure toward decentralization is rapidly leaving the “ifs,” and becoming a “when.”

Admittedly, it doesn’t look like the most appealing transformation to be proactive in undertaking, as decentralization removes much of the friction that generates heat and profit for third-party intermediaries – but the alternative is to be steadily phased-out of a new market structure centered around velocity, efficient use of capital, and resiliency against security breaches at single points of failure. Characteristics that equally benefit the institutions and monetary authorities, as it does their clients and constituents.

By embracing DeFi now, institutions can access new classes of users and capital, create new revenue streams, and re-define their relationships with clients as a partner instead of a purely a service provider.

Increasingly, there are signs that institutions and monetary authorities are beginning to understand the need for a reinvention of the financial system, with the original draft of the two trillion dollar CARES Act calling for a digital dollar, while in Europe, Christine Lagarde, president of the European Central Bank (ECB), has outlined the desire for a fast and low-cost system of payments as a priority for the EU.

But intent will not suffice where action is needed.

It’s time to bring high-performant financial infrastructure to everyone, not just those with the most stocked warchests. Technology engineered for the future, not bolted onto the past, will optimize liquidity for every participant. In doing so, we will all be best equipped to manage financial risks, protect our investments, and even grow our assets when the next crisis hits.

As policy makers and institutions begin to consider how we will rebuild the global financial system after this crisis, please understand that incremental progress is a luxury you no longer have. 

John Wu is President of AVA Labs, an open-source platform for launching highly decentralized applications, new financial services, and interoperable blockchains. It was founded in 2018 by Cornell Professor Emin Gün Sirer, Kevin Sekniqi, a computer science researcher; and Ted Yin, the lead developer of Libra's HotStuff protocol. It is backed by Andreesen Horowitz, Abstract Ventures, Polychain Capital, Initialized Capital, and MetaStable Capital, as well as angels like Naval Ravikant and Balaji Srinivasan.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.