Crypto Finance

• 07 Sep 2021

Why in News

The development of Bitcoin and other Cryptocurrencies in a decade has changed the definition of money and generated a parallel universe of Alternative Financial Services (AFS).

• The development has allowed crypto businesses to move into traditional banking territory.
• AFS is a term often used to describe the array of financial services offered by providers that operate outside of federally insured banks and thrifts.

Key Points

• Alternative Services Offered by Crypto:
  
  • About: Most notably, lending and borrowing.
  • Advantages over Banks: Investors can earn interest on their holdings of digital currencies - often a lot more than they could on cash deposits in a bank - or borrow with crypto as collateral to back a loan.
    
    • Reason: By law, banks are required to have reserves to ensure that even if some loans go bad, customers can still withdraw funds, whereas crypto banks do not have the same reserve requirements and the institutions they lend to can take risky activities.
  • Risks: Deposits are not guaranteed by the central bank’s backed Deposit Insurance Corp. Cyberattacks, extreme market conditions, or other operational or technical difficulties could lead to a temporary or permanent halt on withdrawals or transfers.
• Stablecoin:
  
  • They are cryptocurrencies pegged to stable assets, commonly the dollar. They are meant to provide the steady value of government-issued money in digital form for blockchain transactions, but they are issued by private entities.
    
    • Crypto is very volatile, making it less practical for transactions like payments or loans. That’s where stablecoins come in.
  • Stablecoin issuers are supposed to hold and monitor reserves as government institutions do. But there is no guarantee they actually hold the one-to-one dollar backing they claim.
• Central Bank Digital Currency:
  
  • It is the virtual format of a fiat currency (issued by the government and regulated by a central authority such as a central bank) for a particular nation or region.
  • Central bankers are examining the potential for issuance of a government-issued cryptocurrency. That would theoretically offer the convenience of crypto with the reliability of money controlled by a central bank.
  • Many countries, including the US and India, are considering developing a central bank digital currency.
• Decentralized Finance:
  
  • Decentralized finance, or DeFi, loosely describes an alternative finance ecosystem where consumers transfer, trade, borrow and lend cryptocurrency, theoretically independently of traditional financial institutions and the regulatory structures.
  • The DeFi movement aims to “disintermediate” finance, using computer code to eliminate the need for trust and middlemen from transactions.
  • DeFi platforms are structured to become independent from their developers and backers over time and to ultimately be governed by a community of users.
• Benefits of Crypto Finance:
  
  • Financial Inclusion:
    
    • Innovators argue that crypto fosters financial inclusion. Consumers can earn unusually high returns on their holdings, unlike at banks.
  • Quick and Cheap Transactions:
    
    • Crypto finance gives people long excluded by traditional institutions the opportunity to engage in transactions quickly, cheaply and without judgment.
    • As crypto backs their loans, the services generally require no credit checks, although some take customer identity information for tax reporting and anti-fraud purposes.
    • On a DeFi protocol, users’ personal identities are generally not shared, since they are judged solely by the value of their crypto.

Way Forward

• New technology demands a new approach; novel risks can be addressed without necessarily restricting innovation.
  
  • For example, instead of mandating that DeFi protocols maintain the reserves of a bank and collect customer information, officials might create new kinds of requirements devised for the technology and products, like code audits and risk parameters.
• Questions of identity, which are crucial to fighting financial fraud, need to be addressed. Instead of starting with specifics — collecting the identity of individuals — law enforcers could take the broad view.
• Using artificial intelligence and data analysis to monitor suspicious activity and working back to track identity.

Source: IE