Global Finance - Key Framework

Before we jump into Defi Risks, let us discuss risks in traditional finance.

Do you know the key framework developed in response to the global financial crisis of 2007-2008?

It is Basel III.

Basel III

Basel III is an internationally agreed collection of measures that have been developed by the Basel Committee on Bank Supervision in response to the financial crisis in 2007-2009. It was implemented to improve the ability of banks to handle shocks from financial stress because of the impact of the 2008 global financial crisis.

The Basel Committee on Bank Supervision (BCBS) provides recommendations on banking and financial regulations, specifically concerning capital risk, market risk, and operational risk.

The Basel norms are an effort to coordinate banking regulations across the globe to strengthen the international banking system.

Basel III Pillars

Basel regulation comprises three pillars concerned with minimum capital requirements, supervisory review, and market discipline.

Pillar 1: Minimum capital requirements across different risk categories such as credit risk, market risk, and operational risks. It aims to ensure that banks have enough capital to cover these risks.

Pillar 2: Supervisory Review Process. It requires regulators to review bank processes for calculating risk to ensure accuracy and completeness. Regulators evaluate areas including risk management.

The goal is to assess how well banks are at assessing their risks (i.e. how good they are at risk management) including risks not covered by Pillar 1: liquidity risk, interest rate risk, concentration risk.

Pillar 3: Market Discipline – which is all about transparency and disclosure requirements so that market participants can assess risk exposure and therefore promoting market discipline through informed decision-making by stakeholders.

To summarize, the main risk categories according to the Basel III regulatory framework are:

Credit risk: This is the risk of default or loss on a loan or investment due to the borrower’s or issuer’s inability or reluctance to make regular payments.

Example:

A bank lends $100,000 to a small business. The business faces challenges and then declares bankruptcy and the bank loses $80,000 on the unpaid loan.

Market risk: This is the risk of loss resulting from changes in market pricing or conditions, including interest rates, exchange rates, and stock prices.

Example:

A bank holds a portfolio of stocks and bonds. When stock markets decline by 10% over the next month, the value of the bank's portfolio decreases by $5 million.

Operational risk: This is the risk associated with inadequate or failing internal processes, people, and systems, or external occurrences.

Example:

A bank's online payment system goes offline for 8 hours due to software failure, a upgrade gone wrong or a cyberattack.

Liquidity risk: This risk addresses the danger of incurring a loss or being unable to meet financial obligations owing to a lack of liquid assets or finances.

Example:

A bank relies heavily on short-term deposits to fund long-term loans. When many depositors withdraw funds at once, the bank struggles to come up with the necessary cash to honor withdrawals.

Concentration risk: This is the risk of loss resulting from a concentration of exposures to a single counterparty, sector, or geographic region

Example:

A bank lends 60% of its total commercial real estate loans to developers in one city. When that city's property market declines, many developers default on loans simultaneously, causing large losses equal to a substantial share of the bank's loan portfolio.

Understanding the principles and objectives behind traditional banking regulations like Basel III offers crucial insights into the evolving landscape of Decentralized Finance (DeFi). While DeFi operates outside the traditional banking system and regulatory frameworks, the risks identified by Basel III—such as credit risk, market risk, operational risk, liquidity risk, and concentration risk—find their parallels in the DeFi ecosystem.

For example, market risk is equally prevalent in DeFi, given the high volatility of cryptocurrency markets. Operational risks in DeFi also echo those in traditional banking but are often magnified due to the reliance on emerging technologies and the potential for systemic vulnerabilities. However, DeFi presents unique challenges and risks, such as those related to the absence of a centralized regulatory body, which requires novel approaches to risk management.

By drawing on the foundational principles of Basel III, stakeholders in the DeFi space can better understand and navigate these risks, fostering a more resilient and transparent financial ecosystem.