Is crypto en-route

to revolutionize
traditional
financial systems?

ARTICLE
DECENTRALISED FINANCE

October 24, 2021

by Mahesh V M

1
Is crypto en-route to revolutionize
traditional financial systems?
by Mahesh V M

Meaning

Decentralised Finance (DeFi) is the financial ecosystem built on blockchain

applications that can be used for remitting, borrowing money, trading, investing
or executing other financial transactions against cryptocurrencies. It essentially is
a financial system which uses block chain technology or cryptocurrencies to
execute financial transactions and operates without middlemen, like banks,
exchange, brokerage firms. Instead, DeFi uses Smart Contracts (self-executing
contracts) or simply, a computer code that automates the process and eliminates
the need for intermediaries. DeFi aims to make the current financial system more
efficient, accessible and faster.

2
Layers of DeFi Stack

Source: Fabian Schär, BCG, Crypto.com

Major DeFi Protocols

• Decentralised Exchanges: Built on Automated Market Maker protocol,

are crypto exchanges that allow users to trade without giving control of
their funds to intermediaries.
• Lending Platforms: that allows anyone to borrow and lend currencies.
Similar to traditional financial system, interest is earned on the funds lent.
The platforms may also allow to exchange other crypto currencies.
• Asset Management: Under DeFi, asset management products are non-
custodial, meaning there is no need for users to share their private keys
or transfer funds. This aims to make investing easier, cheaper and more
accessible.
• Derivatives: Decentralised synthetic asset issuance protocol allows
derivatives trading on its platform that enables to gain on-chain exposure
to a vast range of assets. This provides infinite liquidity up to the total
amount of collateral in the system, zero slippage, and permission-less on-
chain trading.

More than a Digital Currency

DeFi has pushed crypto from being a digital currency to a software tool that can
be used to improve efficiency in the traditional financial system. Through

3
“Crypto Staking”, stakers lock-up a portion of their crypto holdings as a way to
contribute to the blockchain network and in return earn rewards, normally in the
form of additional crypto currency. Because crypto backs their loans, the services
generally require no credit checks, although some take customer identity
information for tax reporting and anti-fraud purposes.

It’s argued that crypto fosters financial inclusion. Consumers can earn unusually
high return on their holdings, unlike at banks. It could even provide financial
stability for customers in countries with volatile government-issued currencies.

Stable coins: While cryptocurrencies are exceedingly volatile, stable coins

attempt to stabilize their values by tying them to non-cryptocurrencies

Non-fungible tokens (NFTs): NFTs create digital assets out of typically

non-tradable assets, like the first tweet on Twitter. NFTs commodify the
previously uncommodifiable

Problems and risks associated

• Blockchain scalability and high network fees: Scalability and efficiency
of modern blockchain networks usually are not enough to use DeFi with
a comparable volume to centralised services.
• Limited liquidity: Despite an impressive growth, DeFi services are still in
demand of financial resources to provide the necessary market liquidity.
• Security risks and Technology risk: Though DeFi smart contracts are
usually open source, the current level of security audit is not always high
enough to guarantee the security for all operations. Further, if there is an
issue with a developer’s code, then there could potentially be weaknesses
within a DeFi protocol.
• Asset Risk: Although easy-to-use and accessible, DeFi lending services
and synthetic assets require a very high level of collateralisation,
sometimes up to 100% of the value of the loan.
• Regulatory risk: DeFi services are not yet approved as legal financial
instruments in many countries.
• No consumer protections: DeFi has thrived in the absence of rules and
regulations. But this also means users may have little recourse should a
transaction go foul.
• Binding to a single network: Most DeFi protocols work well within one
given blockchain network (say, Ethereum). But cross-chain functionality
is usually limited or even cannot be implemented in a fully decentralised
manner. This makes it difficult to transfer assets between different
networks and limits the DeFi market liquidity.

4
 • Hackers are real threat: While a blockchain may be nearly impossible to
alter, other aspects of DeFi are at large risk of being hacked, which can
lead to funds theft or loss.

What next?

Across the globe, many platforms are offering DeFi services. Currently, few
Indian companies are exploring opportunities to launch DeFi services, few others
have already made their inroads. India ranks sixth in terms of DeFi adoption,
according to the 2021 Global DeFi Adoption Index by blockchain data platform
Chainalysis. However, the regulator - Reserve Bank of India, has shown its
concerns on the cryptocurrencies for various reasons such as: crypto is
completely off the current regulated financial system; could impact adversely on
the stability of financial system; could be a target for cyber warfare to bring
down the economy.

In order to overcome these concerns, RBI is working on Central Bank Digital

Currencies (CBDC) project to launch its own digital currency. Such innovations
could give far greater control for the Governments over its citizen’s money, but
would also disrupt the existing financial equilibrium.

We have this rare opportunity to witness and be a part of entirely new financial
ecosystem blossom. We could speculate that this would initially play a catch-up
with today’s financial ecosystem. But over time, it’s hard to even fathom what
innovations will come about when the power to build financial services is
democratized to anyone who can write code■

Bibliography

▪ CNBC International video article (Crypto’s Next Big Thing: Decentralized Finance Takes
On Wall Street) accessed on October 21, 2021; CNBC article (‘People have been
participating without understanding the risks’: Here’s what to know about
cryptocurrency-based DeFi) accessed on October 24, 2021
▪ Forbes article (Decentralized Finance Is Building A New Financial System) accessed on
October 24, 2021
▪ Cassiopeia Services article (DeFi Series: Understanding Asset Management) accessed on
October 21, 2021
▪ The Indian Express article (Explained: Crypto banking and decentralized finance)
accessed on October 24, 2021
▪ Mint article (India sixth biggest country in terms of DeFi adoption: Chainalysis) accessed
on October 24, 2021
▪ Coinbase article (A Beginner’s Guide to Decentralized Finance (DeFi)) accessed on
October 24, 2021
▪ The Paypers article (DeFi in a nutshell) accessed on October 24, 2021
▪ Images: medium.com, Financial Times, crypto.com