What can we learn from the history of building fire safety in Europe and America to alleviate systemic risks in DeFi?

This article is sourced from Placeholder, authored by Mario Laul, and compiled by Echo.

As the influence of DeFi expands into increasingly broader spaces and the exploration of composability deepens, its systemic risks are also gradually expanding, becoming one of the potential threats to the long-term development of DeFi.

Mario Laul, a researcher at the well-known crypto venture capital firm Placeholder, recently wrote about the systemic risks of DeFi, using historical experiences from fire safety in architecture in Europe and America as examples to discuss how the DeFi world should view and respond to systemic risks. His perspectives and viewpoints are quite novel, and Chain Catcher has translated this article with several edits that do not affect the original meaning.

I. Basic Situation

Speculation and risk are fundamental characteristics of all monetary economies, both closely related to the financial sector. History shows that without appropriate rules, safeguards, and codes of conduct, financial markets are more susceptible to fraud and crises. Sometimes, these crises can have systemic impacts, threatening the stability of the entire economic system. In the worst cases, financial crises can lead to economic recessions, extreme social polarization, and even violent political conflicts.

There is no universal approach to preventing financial crises. In a fundamentally uncertain world, people can freely enter into financial contracts, and systemic risks can only be partially managed.

Economic conditions, technology, and human practices can all change, so methods for mitigating systemic risks must also evolve over time. In practice, this evolution does not always progress towards a more effective and stable state, as it is constantly influenced by innovation, regulatory interventions, and the changing psychological patterns and behaviors of financial market participants. This applies equally to traditional fields and the rapidly developing DeFi space.

In contemplating systemic risks in the financial sector, a popular analogy is fire safety and building safety. Concepts such as architecture, structural integrity, safety standards, hazard detection, spread, zoning, and emergency measures help in thinking about how to reduce the likelihood of systemic risks.

Although this analogy is far from perfect, can today’s financial innovators learn from the evolution of fire safety and building safety? Before answering this question, let’s briefly review history, focusing on the UK and the US (readers primarily interested in the main content of DeFi can skip this historical overview and continue to the next section).

II. A Brief History of Fire Safety and Building Safety

Understanding the story behind modern fire safety and building safety standards involves three key parts: first, disaster events as turning points; second, the guiding role of insurance providers; and third, self-regulation aligned with technological innovation.

The world’s first fire insurance company, Hamburger Feuerkasse, was established in 1676, when it became clear that early mutual aid arrangements based on guilds were insufficient to cope with fires that could simultaneously destroy many businesses and homes. In the UK, the Great Fire of London in 1666 triggered the rise of the domestic fire insurance industry.

Initially, individual insurance companies in the UK hired their own fire brigades and affixed "fire marks" on insured buildings so that firefighters could identify which buildings to save first. Unsurprisingly, fire insurance companies quickly realized that the spread of fire did not care about the distinction between insured and uninsured buildings.

Thus, in London, insurance companies pooled their resources into a municipal authority that established fire services willing and able to respond to fires, regardless of where they occurred. Insurance companies continued to post fire marks and became known for offering bonuses to firefighters who prioritized saving insured buildings during a fire, but at least in principle, the fire department was now serving the entire community.

Fire risk insurers had strong financial incentives to prevent fires, and thus played a significant role in establishing building standards in the UK. By the mid-19th century, after a period of fragmentation, the first national building regulations were established in the UK, covering aspects such as building materials, wall heights and thicknesses, and fireplace designs.

Insurance companies employed surveyors to ensure that new buildings met basic requirements, and insurance representatives provided additional guidance when allocating risk premiums and assessing the safety of insured buildings. Subsequently, fire and building regulations in the UK evolved alongside advancements in fire safety technology.

In the US, while the timing varied by region, the overall sequence of events was similar. The first fire insurance company was established in South Carolina as early as 1732. Decades later, Benjamin Franklin played a key role in popularizing perpetual forms of fire insurance and made significant contributions to fire prevention.

The Philadelphia Contributionship, founded by Franklin, introduced different premiums based on individual risk assessments and refused to insure any buildings that did not meet specific construction standards, thereby establishing a collaborative link between private enterprise and public interest.

The late 19th and early 20th centuries marked a significant turning point in the history of fire insurance in the US. After the Chicago and Boston fires destroyed many insurance companies across the country, premiums skyrocketed, leading to the establishment of many new companies.

In the 1880s, local trade associations were formed to help coordinate relationships among them, and standardized policy forms were mandated in several major states. Most importantly, the National Board of Fire Underwriters (NBFU), established in 1866, launched a campaign against certain building forms particularly vulnerable to fire. Our understanding is clear: preventing fires is far less costly than dealing with the consequences.

Between 1895 and 1897, a series of meetings were held in New York and Boston, attended by representatives from various fire insurance and safety associations as well as manufacturers of fire protection technologies. Among these technologies, the automatic sprinkler system was the most important, having been commercialized as early as the 1870s but becoming sufficiently effective and reliable in the last decades of the century.

However, the benefits of technological advancements were limited, as there were no unified standards for the production and installation of sprinkler systems and other critical fire safety elements such as electrical wiring, water supply, and heating systems.

Two organizations played particularly key roles in developing standardized fire and building codes. The first was the American Insurance Electrical Bureau, which aimed to establish unified electrical safety methods through research, testing, and analysis.

The second was the National Fire Protection Association (NFPA), originally established in 1896 to develop standards for sprinkler systems but later responsible for managing and publishing various other guidelines related to fire safety. Adhering to these increasingly standardized guidelines quickly became the most important factor in determining fire insurance premiums. For example, in 1905, proper use of automatic sprinkler systems reduced premiums by 50-60%.

Realizing that payouts were only a small part of the fire insurance business, American insurers thus positioned themselves at the forefront of fire prevention. Since its inception over a century ago, the NFPA has been a nonprofit organization with over 65,000 members worldwide, including not only insurance providers but also engineers, elected officials, safety equipment manufacturers, and other professionals.

By historical standards, modern fire and building safety methods are extremely effective in preventing systemic damage caused by fire spread. However, it is worth noting that many of these methods faced considerable resistance when first introduced.

Even today, fire and building regulations remain subjects of debate among various interest groups, and as formal standards and laws are updated, these groups stand to gain or lose. But in general, the goal of these standards and other similar guidelines should always be to rely on science, technology, and collaboration among multiple stakeholders to maximize safety in a cost-effective manner rather than risk.

III. Lessons for DeFi

Systemic risk and risk mitigation are long-standing topics in the study of finance, economics, and public policy. As DeFi develops and increasingly integrates with other sectors of finance, it becomes increasingly important to engage constructively with this tradition. Here are some lessons that DeFi can learn from the historical development of fire safety, along with some general observations on financial innovation and stability:

Similar to houses and buildings in a city, economic entities are interconnected through contracts and debts. Digital finance, including DeFi, adds another layer of technological interdependence by linking various computer and software systems responsible for managing financial information and processing transactions related to that information. The higher the degree of interoperability in DeFi, the greater the likelihood of systemic contagion when certain parts of the system fail.

Before considering strategies to mitigate systemic risks, it is important to identify individual risk types that have systemic impacts. In DeFi, these risks include those that could lead to significant financial losses or simultaneously cause other damages to many entities, resulting in the failure of specific institutions, networks, or software protocols, which could then more broadly threaten economic and social stability.

Such risks may stem from insufficient awareness of increasing complexity, flaws in network and other security practices, mismanaged finance, excessive counterparty risk (including limited use of insurance and hedging), deterioration of underwriting or other professional standards, lack of transparency, rampant fraud, and inadequate rules or oversight, particularly regarding market integrity and consumer protection.

One of the most important steps in preventing fires is to control the flames to prevent their spread. Similarly, mitigating systemic risks in DeFi largely depends on how risks and emergencies are managed at the individual user, business, and network levels. Therefore, the effectiveness of risk management depends on the social distribution of relevant knowledge and tools, as well as the requirements and codes of conduct for adhering to best practices.

In DeFi, there are multiple pathways to enhance systemic safety standards. Depending on the specific situation, these pathways will include the role of public regulators as well as bottom-up self-regulatory approaches led by private market participants.

Historically, regulation has tended to combine these two approaches, and broader government regulatory periods are often triggered by systemic crises or the private sector's inability to enforce self-imposed rules. Generally speaking, the more prudent and effective the self-regulation in containing crises and protecting consumers, the harder it becomes to find political support for public regulation.

Therefore, the overall regulatory framework for DeFi will largely depend on the nature and effectiveness of self-regulatory measures taken by the private sector.

Similar to the historical development of fire and building safety, insurance underwriters can play a key role in promoting best practices in DeFi. There is considerable incentive alignment among risk insurers, DeFi service providers, and end-users, all of whom would benefit from higher levels of systemic safety.

Insurance providers have already played a role in guiding smart contract security practices, but there may still be room for coordination to plan for other systemic risks, create insurance products that broadly mitigate these risks, and develop standards and technologies to minimize the likelihood of catastrophic events and associated damages.

Insurance providers themselves may become sources of systemic instability, depending on how they manage capital. DeFi insurers should continuously assess the technological and financial risks they face, which can be partially mitigated through reinsurance agreements. In the long term, as DeFi evolves, there may also emerge a demand for an equivalent universal deposit insurance, as well as a need for institutional support similar to that historically provided by central banks.

In addition to collaboration among multiple stakeholders, the most important factor in the historical development of fire safety has been technological innovation. Examples include automatic sprinkler systems, fire extinguishers, fire hydrants, smoke detectors, fire-resistant materials, and construction methods. Similarly, the DeFi industry should fully leverage technology to ensure that the most effective risk mitigation technologies are standardized, continuously improved, and adopted as widely as possible.

However, technology is not a panacea; its effectiveness in mitigating systemic risks will also depend on the quality of human decision-making. In the case of DeFi, this is particularly evident in smart contract governance, operational safety procedures, and behavioral factors driving financial markets.

Compared to traditional finance, DeFi's key technological advantages in reducing systemic risks lie in higher levels of digitization, transparency, and automation.

The more DeFi relies on formally verifiable open-source code and publicly verifiable ledgers, the easier it becomes to establish automated systems for risk simulation, stress testing, monitoring, early warning signals, circuit breakers, insurance coverage, claims processing, reporting, and other embedded forms of risk management.

Ideally, these mechanisms should minimize the likelihood of catastrophic events and associated damages without fundamentally compromising end-user privacy or hindering the growth potential of DeFi, similar to how modern fire safety principles limit the areas where fires can spread freely rather than the entire scale of the building.

IV. Conclusion

Despite remarkable growth, DeFi remains an emerging industry. Therefore, considering systemic risks may seem premature, especially in relation to systemic risks associated with other economic sectors. However, this perspective underestimates the technological tailwinds behind DeFi and the real economic and political implications of not being prepared for potential systemic failures.

Good DeFi governance includes establishing and maintaining high standards of cybersecurity, risk management, and consumer protection mechanisms. The goal of such standards is not to eliminate normal business or financial risks.

Rather, the aim is to ensure that appropriate mechanisms are in place to delineate vulnerabilities and address technological or financial failures in a way that fairly distributes losses and minimizes associated damages. This can be achieved by learning from history, harnessing the power of technology, and intelligently distinguishing the strengths and weaknesses of existing regulatory and institutional frameworks. Most importantly, it requires leadership and collaboration.

DeFi is not just about rebuilding finance; it is about building it better.