Thoughts on How Cryptocurrencies Could Have Prevented the Big Short

For those of us that weathered the financial meltdown of 2008, we would do anything possible not to go through another one. It took years to stabilize national and global economies. Now that things to appear to be back on track, the main concern is not letting the same processes and people let greed get the best of them again, putting all of us in jeopardy by cutting off access to credit, compromising jobs and business sustainability, and lowering our quality of life.

Hindsight always tells us what we could have done differently. And, in this case, hindsight may have come in the form of cryptocurrency and the technology that oversees it known as blockchain. Some contend that, if we had this technology back then, it could have prevented the Big Short. And, it could be that blockchain technology helps stop a similar future crisis should we continue to use the same models for transactions that are void of true transparency and accountability.

A Quick Look Back

For those who may not remember or blocked it from their minds, the 2008 housing bubble burst and the economy basically imploded in the U.S. Then, the global economy took a huge hit as a result. Recently, a book and movie, entitled, “The Big Short,” provided an excellent overview of how this mortgage and financial disaster occurred.

A New York Times article hit on the main point the book and movie was trying to make: While people were worried that housing prices were overinflated and mortgages were being handed out to anyone who put their hand out, the real underlying problem was much more serious. The bad mortgage loans infected the securities market, creating worthless bonds that were supposed to be highly rated. As the article further explained:

“The key transmission mechanism that turned a simple correction in the housing market into a global financial crisis were those bonds. Global banks had loaded up on these supposedly safe securities, and were at risk of becoming insolvent when their true value became known. Some banks blew up; others were bailed out. Either way the global credit system froze.”

The key phrase here is “transmission mechanism.” This is where there could have been some type of flags put into place to halt this type of transaction. Instead, everyone turned a blind eye or was just not aware of what the signs actually meant in terms of a financial apocalypse. As the article further noted:

Few of them understood the connections between housing prices and poor lending practices; the connection from poor lending practices to complex, highly rated securities; the connection between those securities to the balance sheets of major banks; and the peril to the economy if just a few of them faltered.

At each link in that chain, there were people aware that something was wrong, but who lacked the ability to put those pieces together and connect bad lending in Florida suburbs with the existential risk being taken by companies like Bear Stearns and Lehman Brothers.

This illustrates a failure in accountability and oversight – much of which is now trying to be fixed with tons of regulations and criteria so high no one seemed to qualify. There had to be a better way, especially seeing that the basic transaction checks and balances had not really changed so there was still plenty of space to replicate the same greed, fraud, and abuse of the financial system.

Fast-forward to Cryptocurrency and Blockchain

Years later, we think we now have the solution for what could have prevented the Big Short in the ledger that drives the Bitcoin and cryptocurrency environment. First, the database, and digital records kept within it, cannot be altered. These permanent records are accessible by anyone. What these two factors do is create complete transparency that has not been achieved by any other platform or process plus it has a built-in mechanism to combat fraud attempts.

Going beyond that, this permanent ledger is a way to see the entire transaction process, including every link in the transaction chain. This will be a way to see what is being purchased in terms of a security and then how it changes over time because every transaction block will be there in the permanent ledger. A fraud safety net is also built in through blockchain’s proof-of-process concept in which an individual has to prove the validity of the transaction.

Within this blockchain system, smart contracts can be created for these credit transactions. Rather than a contract that relies on the semantics found in a contractual clause to specify the agreement, computer code is used. This code works in a way that sends out a penalty should the person not comply with the payments contained within that smart contract. This type of self-enforcement has never previously been available for use in such transactions. And, this self-enforcement actually comes in the form of less human involvement in the process, further decreasing the concern that bad and greedy behavior will result.

Lastly, if it comes to the point where people don’t pay their mortgages again like in the last financial meltdown, there won’t be the same toxicity unknowingly spread into packages of securities. Since the previous system did not let investors know what anything was worth individually within these packages, the trouble began as values plummeted. With the blockchain framework, there is individual records of worth for each transaction to easily segregate the bad from the good ones.

Peering Ahead

With online peer-to-peer lending continue to grow, which had appeared soon after the financial crisis to provide more lending opportunities for consumers and small businesses, it is critical that we start seriously considering an alternative system that could ensure that this new generation of lending doesn’t lead down the same disastrous path. Having a system like blockchain in place that oversees the investment and entire credit process in a way that has never been used before within the financial industry, stability and confidence could return to a system that has been shaken to the core more than once before in history.