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Decentralized Finance: Building a new finance ecosystem for Cryptocurrency in India

With having the highest fintech adoption rate of 87% in emerging markets, as compared to global average of 64% (as per report published by EY & IVCA), India provides huge opportunities for a decentralized banking system to exist. Already being progressively adopted in the US and EU, decentralized finance (DeFi) is expected to take off in India and as well as other Asian markets. It could be a potential market for tapping and expanding into the underbanked/unbanked population in the country. 

 

Decentralized Finance (DeFi) is a financial ecosystem that uses cryptocurrency and blockchain technology for executing financial transactions. In layman’s language, it allows consumers to trade, borrow, transfer, and lend a digital currency, independently of traditional financial institutions and regulatory structures. It eliminates the need for middlemen for transactions.

 

Centralized Finance (CeFi): Present Ecosystem

 

Today, almost every aspect of financial services is managed by centralized systems, operated by governing and regulatory authorities. The consumers need to depend on the financial intermediaries for getting access to almost everything from loans/capital to trading in stocks.

 

As a result, it creates dependency for consumers as they cannot bypass the middlemen like banks, NBFCs, or exchanges, who get a share of income for every financial transaction.

 

 Decentralized Finance: The Future

 

DeFi is unbundling of this centralized financial system, enabling financial services anywhere for anyone, thereby empowering regular people via peer-to-peer exchanges. 

 

DeFi services are built and operate on blockchain technology and cryptocurrency, in a completely secured environment, with no manual intervention. Blockchain is a decentralized and distributed public ledger, where all transactions are recorded in encrypted code. It means that all parties will have access to an identical copy of the ledger that records each transaction in encrypted code. This secures the system by keeping anonymity of sensitive data of the users.

 

Further, all transactions are executed and recorded by parties who use the same blockchain, as there are no middlemen involved for managing the system. It provides users with more control over their money as this ecosystem caters to individual needs.

 

This makes the financial transactions transparent, low-cost, and more secure than the traditional systems employed in CeFi.

 

How to use DeFi?

 

It is powered by decentralized applications or other programs called protocols. Currently, these apps and protocols handle transactions mainly in two cryptocurrencies, Bitcoin and Ethereum (more adaptable than Bitcoin for DeFi). 

 

Some of the current use cases of DeFi apps and protocols include the following:

 

  • Traditional financial transactions
  • Decentralized exchanges (DEXs)
  • E-wallets
  • Stable coins
  • Non-fungible tokens (NFTs): Creating digital assets out of the non-tradeable assets

 

Adoption of DeFi is powered by the omnipresent nature of blockchain. Further, as they exist outside the purview of regulations of governing bodies, thereby increasing their potential benefits.

 

Downsides of DeFi

 

DeFi being a recent innovation, is still not defined by any regulations/rules. Some of the risks involved are:

 

  1. In the absence of any regulation, the user has no protection/recourse in case of any error in executing a transaction
  2. While there is no manual intervention, still the software systems pose a serious risk of being hacked and have potential threat of online data breach

 

DeFi: A Potential Revolution in India

 

DeFi in India can be the new front for Cryptocurrency market, provided the government defines a legal framework for digital currency. It will provide an opportunity to improve the livelihood of people, earlier excluded by traditional institutions by allowing them to engage in financial transactions cheaply and securely. It will provide with additional investment options to investors, through Bitcoin, Ethereum, etc., thereby providing financial independence on how and where to deploy their money.

 

Cryptocurrency has the potential for majority of the population to increase their consumption levels, achieve financial security and contribute to the economic development of the country.

 

Way ahead

 

These alternatives to traditional banking methods are seeing a positive response, predominantly by India’s young population, as they are recognizing the potential benefits that it will offer to the economy if successfully implemented. However, with lack of regulations and lack of necessary infrastructure, it is yet to be seen how it will play out in future.

 

With governments of many countries supporting the same and cryptocurrency market growing rapidly, it is only a matter of time when DeFi will become the new normal. 

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Digital Currency: The future of the Global Payment System

Digital currency would shift the world’s economy towards a cashless economy. Digital currency has the capability to change the perspective of individuals towards money. The continuous rise of cryptocurrencies such as Bitcoin, Ethereum has led the global central banks to explore the benefits and challenges of a regulated Digital Currency – Central Bank Digital Currency (CBDC). Few countries have even started work on the same and most of them are at the R&D stage and China is in the pilot stage of CBDC.

 

What is Digital Currency?

 

The Digital currency has all the intrinsic properties of cash/ physical currency except the form. Cash/Physical currency has both physical and electronic form, however Digital currency exists only in electronic form. Digital currency can be accessed with computers or mobile phones. Digital currencies can be used to purchase goods or pay for services like cash/physical currency. For example, Instead of using cash or making e-payments, customers can make the payment to retailers by transferring digital currency using a mobile phone. 

 

Success Stories from the Past

In the early 80s, all the trading of equity stocks and the Government securities was done offline through paper-based certificates but in today’s world of technology, all the trading of stocks and government bonds is being done only digitally. The digitalisation of the complete trading process has been seamless and created more growth opportunities and transparency. Similarly, digital currency can remove the intermediaries and perform direct peer to peer transactions with higher speed, accuracy, transparency and traceability. 

 

Distributed ledger technology-based cryptocurrency such as Bitcoin,  Ethereum exist and are being used around the globe. Their production is completely digital and is not regulated by any government authority or central banks. Central banks around the world are also researching regulated digital currency (CBDC).

 

How Digital currency differs from Virtual and Cryptocurrency

                                                                             

From a broader perspective, virtual and cryptocurrency are subsets of Digital currency. Virtual currency is an unregulated digital currency mainly controlled by its developer, the founding organisation, or the defined network protocols such as cryptocurrencies and coupon- or rewards-linked monetary systems. 

Virtual currency that uses cryptography to secure, control and manage the creation of new currency units and finally verify the transactions is commonly known as cryptocurrency. Bitcoin and Ethereum are the most popular decentralised cryptocurrency and Facebook’s Diem is an example of centralised cryptocurrency. 

 

Concept of CBDC and how it would work?

 

Digital currency that will be issued and regulated by the country’s central bank is known as a central bank digital currency (CBDC). For example, think of a cryptocurrency being managed and backed by the full faith and support of the country’s central bank like RBI in the case of India. This cryptocurrency would be stated as CBDC. At present, no central bank across the world has its own digital currency. 

 

CBDC would work in a similar fashion as the cash/ physical currency. Only difference is that, once a payment is made using CBDC then the counter-party can neither cancel nor reverse the transaction, However, in regular online payment, such transactions can be reversed and cancelled. This is because CBDC uses blockchain technology which does not let users make alterations in past transactions. This is one of the key features of Digital currency. CBDC would be legal in the country and can be used for any purpose.

 

Benefits of Digital currency

Faster payments – All inbound and cross border transactions gets completed on a real-time basis

Cost-effective– Digital currency reduces intermediaries in peer to peer transactions especially in the case of cross border payments causing significant reduction in terms of fee charged.

24*7 Accessibility– At present, Post working hour financial transactions take more time but with digital currency, the transactions can be performed at any time with the same speed.

Transparency & Traceability – Digital currency brings more transparency and easy traceability of transactions to all the parties involved in the financial transactions particularly in the case of cross border transactions.

Support for unbanked or underbanked– CBDC helps all unbanked individuals to pay bills and make payments online using the digital currency with no extra charges.

More efficient government payments– It also helps governments to make the payments to individuals in a quick and seamless way especially in the case of an emergency like the Covid-19 pandemic. It is very difficult to help the gig workers financially in this situation when lockdown is imposed everywhere and no source of earning for them. Digitally currency (CBDC) would have helped them by enabling governments to transfer the fund on a real time basis even in case of unbanked workers. 

 

Digital currency Disadvantages

High efforts to learn how to use digital currency- To learn all the basic tasks of digital currency like how to open a wallet account, store digital currency is a bit challenging especially for uneducated or illiterate users. 

Blockchain transactions can be expensive-  Current digital currency like Bitcoin uses blockchain where electricity cost is very high because computers are used to solve complex equations to record and perform the transactions. Cost charged Per transaction, independent of transaction value so it is not an efficient option for  small value transactions.

The large swing in digital currency price-  Current digital currency value is very volatile due to consumer sentiment and psychological triggers. However, CBDC is expected to be more stable like current fiat currency.

Developing CBDC is a very time-consuming process – Currently global central banks are exploring the opportunities with CBDC and even if some central banks decide to create CBDC, it would be very costly and time consuming to develop, implement and replace the current Fiat currency.

 

In countries like ours which is predominantly a cash dominated economy where most SME and MSME transactions are done through either cash or cheques. The anonymity and untraceability of cash transactions make it even more challenging to completely accept digital currency (CBDC) in India. 

However, India has always been ahead of other countries in terms of adoption of technology and digitization. So, Now is the time for our central bank to start exploring the opportunities in central bank digital currency to launch the World’s first CBDC.

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