This is the second part of series looking at banking and how Hive can avoid such the fate we see so often today.
The first article dealt with separating the idea of the currency, the Hive Backed Dollar (HBD), and that which is providing financial services.
In this one we will discuss what is befalling these financial institutions and how to avoid it.
The Banks Dilemma
There are a couple things resulting in the demise of many banks.
We are witnessing some bank runs. This is a situation where people fear the failure of a bank and rush to get their funds out. It is a problem since, under fractional reserve banking, the bank does not have 100% of the deposits on hand in cash. To pay interest, the bank has to take the money and use it garner a return. This obviously causes a liquidity crisis.
This is further enhanced by the fact that banks are investing in different bonds. Due to the rapid increase in interest rates, the yield curve is showing how the demand on the long end is dropping. When the 3 month is paying over 100 basis points higher than the 10 year, it is obviously what people are going to invest in.
Banks such as Silicon Valley Bank were looking to the markets to provide liquidity. When long dated bonds have no buy demand this makes the value fall even further. When trying to collateralize, this means less money will be raised. The same is true when liquidating.
Either approach reaches the same point: liquidity is not found.
This means it is impossible for the banks to meet the demand of depositors who are seeking to get their funds back.
Naturally there are other variables in these situations but this covers the majority of what we are looking at.
Great Financial Crisis
This differs somewhat from the Great Financial Crisis. That was also a bank run albeit on the banks ends.
That started with the idea of mortgage backed securities (MBS) being rated as equal to U.S. Treasuries. Because of this, financial institutions started to accept them as collateral in the same manner. The problem was that they did not rate like Treasuries. In fact, over time, it was realized that these were, to a large degree, rather risky assets.
As a result, when pricing them became a problem, due to a lack of buy demand, the race was on. All started to question the value of their positions, something that magnified the problem.
In the end, everyone ended up on at the door of AIG simply because they were the insurer behind it all. That company was effectively insolvent, requiring the U.S. Treasury to step in.
Even today, 15 years later, there is still a problem with the collateral the system uses. Unfortunately, it is due to a lack of high quality collateral being available.
How Can Hive Prevent This?
There are a couple different issues we can solve.
The latter is addressed by the idea of Hive Bonds. Here we have the idea of locking up HBD, a debt instrument that pays an interest rate. Putting putting the currency in savings, or possibly a time vault, we can create a token associated with this transaction. This mirrors a bond in that it has a par value (the amount of HBD), a coupon rate (the interest rate), and a time duration.
Creating such as instrument, one that is tied to blockchain, means we have transparency that allows anyone on the other side of the trade to fully understand the components of the asset. At the same time, the counterparty risk is mostly limited to the blockchain.
As long as we are under the haircut rule, there is a full backing of the bond.
The idea behind the Hive Financial Network is to build a system at the second layer. This removes the risk at the base layer. We have to continually develop with the idea of any attacks taking place on sidechains. Here is where barriers of defense are erected.
When it comes to financial services, resiliency will come from those applications operating using a derivative of the base coins. Hive Bonds are an example. This asset is a derivative of HBD (money transformed into another form) and traded using a wrapped version of the stablecoin (sHBD). The stablecoin cannot be used to create Hive Bonds, while being backed by HBD at the base layer.
It is possible that application start to enter into risky territory. We cannot control what people create. They might form different kinds of derivates, the kind Warren Buffett calls weapon of mass destruction. Projects might leverage up into areas that are risky. This cannot be controlled by the ecosystem.
Ultimately, we are going to see failure on the second layer. People are going to take positions that are simply wrong. This is going to causes losses, which will put applications or projects under.
What Hive can prevent is what is commonly known as systemic risk. The ecosystem makes no claims about individual projects. What it does focus upon is the currency along with the stability of the base layer projects.
Over the past year, we proposed a number of ideas regarding fixed income instruments that could be built into the blockchain code. These are all low risk, non-leverage type arrangements.
Another factor in this is to build the layer 2 financial network based upon these same principles. The concept of the Apiary is to provide a monetary system that is can offer financial services such as lending but in a sensible way. This means that collateralization is center to what is taking place.
Will this stop others from creating riskier applications? Of course not. However, if the ecosystem can branch out and provide sound services while being tied to HBD, then we have another level of protection.
The larger this aspect of the ecosystem is, the less threat an individual application, no matter how nefarious, has simply due to the size difference. If the build of the financial system is sound, and the base layer assets defensed, an implosion at the second layer might be a hindrance but it will not take down the system.
This is the power of decentralization. While things are interconnected, they are at arms length.
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