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Post at: Sep 24 2021

Crypto Banking and Decentralized finance

Why in News?

  • The recent development of Bitcoin and other cryptocurrencies in a little over a decade has changed the definition of money and spawned a parallel universe of alternative financial services, allowing crypto business to move into traditional banking territory.

Key points

  • Alternative services offered by crypto business :
    • Mostly lending and borrowing.
    • Investors can earn interest on their holdings of digital currencies, often a lot more than they could on cash deposits in bank.
    • Investor can utilize crypto as collateral to back a loan.
    • Crypto loans generally involve no credit checks as transactions are backed by digital assests. Eg. Deposits are not guaranteed by the federal Deposit Insurance corporation.

Benefits :

  • promote financial inclusion
  • usually high yield for consumers.
  • provide financial stability for customers in countries with volatile government-issued currencies.

Why-such high yields?

  • Crypto outfits pool deposits to offer loans and give interest to depositors, just as traditional banks.
    • But by law, banks are required to have minimum reserves as a safety backup.
  • Other risks like cyber attacks, extreme market conditions and other operational or technical difficulties that could lead to a temporary or permanent halt on withdrawals or transfers.

Decentralized finance

  • Decentralized finance or DeFi, loosely describes an alternative finance ecosystem where consumer transfer, trade, borrow and lend cryptocurrency.
  • 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 bankers overtime and to ultimately be governed by a community of users.

Stablecoin

  • Stable coins are cryptocurrencies linked to stable assests, commonly the dollar.
    • While crypto is very volatile, making it less practical for transactions like payments or loans.
  • 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 them claim.

Way forward

  • New technology demands a new approach, saying novel risks can be addressed by without necessarily crimping innovations.
    • Eg. instead of mandating that DeFi protocols maintain the reserves of a bank and collect customer information, officials might create new kinds of requirement like code audits and risk parameters.
  • Questions of identity which are crucial to fighting fraud, could be addressed by flipping the old script etc.
  • Law enforcers could take the broad view.
  • Use of Artificial Intelligence and data analysis to monitor suspicious activity.

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