DIGITAL ECONOMY & TECHNOLOGY

Down the Rabbit Hole: The Beguiling Promise of Decentralised Finance and its many Perils

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4 years ago

September 25, 2021

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The sceptics have plenty of fodder. The earliest adopters of bitcoin, the original cryptocurrency, used it to buy drugs, while cyber-hackers now demand their ransom in it. Hundreds of millions of dollars of ether, another digital money, were stolen this year after hackers found a bug in some code. Many “believers” are in reality trying to get rich quick from the global mania that has seen the value of cryptoassets reach $2.2trn. Others are freakishly devoted. The entrepreneur who announced in June that El Salvador was adopting bitcoin as an official currency sobbed on stage, claiming it would save the nation.

The crooks, fools and proselytisers are off-putting. Nevertheless, the rise of an ecosystem of financial services, known as decentralised finance, or “DeFi”, deserves sober consideration. It has the potential to rewire how the financial system works, with all the promise and perils that entails. The proliferation of innovation in DeFi is akin to the frenzy of invention in the early phase of the web. At a time when people live ever more of their lives online, the crypto-revolution could even remake the architecture of the digital economy.

DeFi is one of three tech trends disrupting finance. Tech “platform” firms are muscling in on payments and banks. Governments are launching digital currencies, or govcoins. DeFi offers an alternative path which aims to spread power, not concentrate it. To understand how, start with blockchains, vast networks of computers that keep an open, incorruptible common record and update it without the need for a central authority.

Bitcoin, the first big blockchain, created in 2009, is now a distraction. Instead, Ethereum, a blockchain network created in 2015, upon which most DeFi applications are built, is reaching critical mass. Its developers view finance as a juicy target. Conventional banking requires a huge infrastructure to maintain trust between strangers, from clearing houses and compliance to capital rules and courts. It is expensive and often captured by insiders: think of credit-card fees and bankers’ yachts. By contrast, transactions on a blockchain are trustworthy, cheap, transparent and quick—at least in theory.

Although the terminology is intimidating (fees are “gas”; the main currency is ether, and title deeds over digital assets are known as nfts), the basic activities taking place on DeFi are familiar. These include trading on exchanges and issuing loans and taking deposits through self-executing agreements called smart contracts. One yardstick of activity is the value of digital instruments being used as collateral: from almost nothing in early 2018 it has reached $90bn. Another is the value of transactions that Ethereum is verifying. In the second quarter this reached $2.5trn, around the same sum as Visa processes and equivalent to a sixth of the activity on Nasdaq, a stock exchange.

The dream of a low-friction financial system is just the beginning. DeFi is spreading to more ambitious terrain. MetaMask, a DeFi wallet with more than 10m users, acts as a digital identity. To enter a decentralised “metaverse”, a looking-glass world with shops run by its users, you link your wallet to a cartoonish avatar who roams around. These digital worlds will become the subject of intensifying competition as more spending shifts online. Big tech firms could impose huge taxes on these mini-economies: imagine Apple’s App Store charging fees, or Facebook selling your avatar’s intimate secrets. A better alternative might be decentralised networks that host applications and are run mutually by users. DeFi could provide payments and property rights.

Crypto-enthusiasts see a Utopia. But there is a long way to go before DeFi is as reliable as, say, JPMorgan Chase or PayPal. Some problems are prosaic. A common criticism is that blockchain platforms do not scale easily and that the computers they harness consume wasteful amounts of electricity. But Ethereum is a self-improvement machine. When it is in high demand the fees it charges for verification can climb, encouraging developers to work on minimising the intensity with which they use it. There will be new versions of Ethereum; other, better blockchains could one day replace it.

Yet DeFi also raises questions about how a virtual economy with its own norms interacts with the real world. One worry is the lack of an external anchor of value. Cryptocurrencies are no different from the dollar, in that they rely on people having a shared expectation of their utility. However, conventional money is also backed by states with a monopoly on force and central banks that are lenders of last resort. Without these, DeFi will be vulnerable to panics. Contract enforcement outside the virtual world is also a concern. A blockchain contract may say you own a house but only the police can enforce an eviction.

Governance and accountability in DeFi-land are rudimentary. A sequence of large irrevocable transactions that humans cannot override could be dangerous, especially as coding errors are inevitable. Money-laundering has thrived in the ungoverned grey zone of services lying between Ethereum and the banking system. Despite the claims of decentralisation, some programmers and app owners hold disproportionate sway over the DeFi system. And a malign actor could even gain control over a majority of the computers that run a blockchain.

Alice’s adventures in DeFi-land

Digital libertarians would prefer that DeFi remain autonomous – imperfect but pure. Yet to succeed it must integrate with the conventional financial and legal systems, as Gary Gensler, a crypto-expert who is America’s financial watchdog, has outlined. Many DeFi applications are run by decentralised organisations which vote on some issues; these bodies should become subject to laws and regulations. The Bank for International Settlements, a club for central banks, has suggested that govcoins might be used in DeFi apps, providing stability.

Finance is entering a new era in which the three novel but flawed visions of tech platforms, big government and DeFi will compete and intermingle. Each embodies a technical architecture and an ideology about how the economy should be run. As with the internet in the 1990s, no one knows where the revolution will end. But it stands to transform how money works and, as it does so, the entire digital world. ■

This article appeared in the Leaders section of the print edition under the headline “Down the rabbit hole”

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DIGITAL ECONOMY & TECHNOLOGY

The Digital Currency that could Upend how the Gulf Trades

Published

7 months ago

September 29, 2024

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By Shruthi Nair

Project mBridge – a China-led central bank digital currency initiative, which the UAE and Saudi Arabia are part of – could have “broad strategic implications” for regional trade, according to market analysts.

A CBDC is a digital form of a country’s fiat currency, which is backed by a government. It eliminates the need for intermediaries like banks, or even other currencies such as the US dollar, to facilitate real-time, peer-to-peer, cross-border payments.

“When we look at international trade, not much has changed over the decades. It is a primitive method in the digital age,” Arun Leslie John, chief market analyst at Century Financial, said.

China’s global digital yuan transactions amounted to 7 trillion yuan ($986 billion) in the first six months of this year. The UAE’s inaugural cross-border payment utilising the digital dirham amounted to AED50 million ($13.6 million).

Considering the UAE and China are major trading partners with the total volume of bilateral trade between the two countries reaching $95 billion last year, project mBridge would significantly reduce and replace the use of dollars in this case. However, analysts believe that it might be too early to conclude whether CBDCs could result in global de-dollarisation.

“Dollar is the choice of transaction for global trade. The US has the deepest capital, debt and equity market. Many countries around the world would want to diversify away from the dollar but they aren’t able to do so,” John said.

While Europe does not have deep debt markets, the Chinese government has capital controls over the yuan. So the only remaining choice is the dollar.

Countries such as Russia and Iran that are facing sanctions stand to be beneficiaries of CBDCs and initiatives like mBridge too. While the Russian central bank announced plans to launch its CBDC next year, the central bank of Iran said that its digital rial will be used for retail transactions, including purchasing goods and services.

“In the current international payment structure, countries can arbitrarily kick out one country from the system. This reduces strategic autonomy and political power of other countries involved,” John said.

To find out how CBDC’s work and its retail use cases, click to watch the video above

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DIGITAL ECONOMY & TECHNOLOGY

How Blockchain can Enhance Islamic Finance by Overcoming Barriers

Published

7 months ago

September 16, 2024

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By Aamer Yaqub

Blockchain technology is making waves in the financial sector with its promise of transparency and immutability. These features align closely with the principles of Shariah law, which governs Islamic finance, creating significant opportunities for blockchain to overcome barriers and unlock growth. The Islamic finance sector is projected to reach approximately $6.7 trillion in assets by 2027, as noted in LSEG’s Islamic Finance Development Report. In this evolving landscape, blockchain technology is emerging as a crucial tool for addressing the unique challenges faced by Islamic finance.

Islamic finance operates under Shariah law, which prohibits practices such as interest (Riba), excessive uncertainty (Gharar), and speculative transactions (Maysir). Blockchain technology’s core attributes—transparency and decentralization—are well-suited to address these constraints. Blockchain can effectively enhance compliance with Shariah principles by providing a tamper-proof ledger and facilitating decentralized transactions. Its ability to create a permanent, verifiable record of transactions aligns well with the Islamic finance requirement for clarity and accountability.

According to Moody’s, innovations like smart contracts are poised to improve Islamic finance transactions significantly. Smart contracts are self-executing contracts with terms written directly into code. They automatically enforce Shariah-compliant rules, reducing human error and enhancing transparency. These advancements support real-time settlements, which align with Islamic finance principles of fairness and clarity. By using blockchain to overcome barriers related to transparency and automation, financial processes can become more efficient and compliant with Shariah.

Enhancing Transparency and Efficiency

One of the most significant ways blockchain can overcome barriers in Islamic finance is through its ability to enhance transparency. The immutable nature of blockchain ensures that every transaction is recorded in a tamper-proof ledger, providing a clear and verifiable record of all financial activities. This transparency is crucial for maintaining compliance with Shariah principles, which demand a high level of clarity and accountability in financial transactions.

Blockchain technology facilitates smart contracts that automate the execution of Shariah-compliant financial agreements. This not only streamlines processes but also reduces the need for intermediaries, lowering transaction costs and increasing the speed and accuracy of financial transactions. By addressing long-standing challenges in Islamic finance, blockchain technology is helping to create a more efficient and reliable financial system.

Modernizing Charitable Giving

Blockchain technology also holds promise for modernizing Zakat, the obligatory charitable giving in Islam. Traditionally, the collection and distribution of Zakat have faced challenges related to efficiency and transparency. Blockchain can address these issues by providing a more transparent and efficient platform for managing charitable contributions.

With blockchain, Zakat collection and distribution can be streamlined, ensuring accurate tracking of funds and effective distribution to eligible recipients. This technology allows donors to see exactly how their contributions are used, enhancing trust and accountability. Additionally, blockchain can facilitate the creation of smart contracts to automate the distribution of Zakat, ensuring compliance with Shariah guidelines and reaching those in need more efficiently.

Addressing Challenges and Compatibility Issues

Despite its potential, the integration of blockchain into Islamic finance comes with its own set of challenges. The compatibility of digital assets, including cryptocurrencies and tokenized assets, with Shariah principles, is a topic of ongoing debate. Concerns about speculation and anonymity associated with these assets pose significant challenges, as they contrast with the Islamic finance emphasis on transparency, accountability, and ethical conduct.

Digital assets, particularly unbacked cryptocurrencies, have sparked discussions about their suitability for Islamic finance. The potential for speculation and the lack of intrinsic value associated with some digital assets diverge from Islamic finance principles that prioritize stability and ethical behavior. As a result, Shariah scholars and financial institutions are actively evaluating the compatibility of these assets with Islamic financial principles.

A promising alternative is Central Bank Digital Currencies (CBDCs), which align with Shariah principles by emphasizing transparency, fairness, and social welfare. CBDCs offer a way to digitize national currencies, providing a more efficient and accessible payment system while maintaining compliance with Islamic financial principles. This approach could address some of the concerns associated with speculative digital assets and provide a stable alternative for Islamic finance.

Islamic Finance Innovation in the UAE

The UAE serves as a notable example of how blockchain can be integrated into Islamic finance effectively. With a well-regulated Islamic finance sector, the UAE is at the forefront of digital assets innovation. The country’s regulatory framework for digital assets is overseen by key federal bodies, including the Securities and Commodities Authority (SCA) and the UAE Central Bank. While the SCA focuses on securities-related matters, the Central Bank regulates digital currencies and stored value.

The UAE also has three additional jurisdictions for digital assets regulation: the Dubai International Financial Center (DIFC), regulated by the Dubai Financial Services Authority (DFSA); the Abu Dhabi Global Market (ADGM), regulated by the Financial Services Regulatory Authority (FSRA); and the Virtual Assets Regulatory Authority (VARA). Each jurisdiction approaches digital assets regulation with a unique focus, contributing to the dynamic regulatory landscape in the UAE.

The UAE’s proactive stance on digital assets regulation and innovation underscores its commitment to leveraging blockchain technology to enhance its Islamic finance sector. The country’s regulatory framework continues to evolve, aligning with international trends and addressing emerging challenges.

Strategic Integration and Collaboration

For Islamic finance institutions to fully capitalize on blockchain technology, comprehensive adoption strategies are essential. These strategies should include technology integration, Shariah compliance, regulatory adherence, risk management, and customer education. Collaboration with Shariah scholars and experts will be vital to ensure that blockchain initiatives and digital asset offerings align with Islamic ethical and legal principles.

Many Islamic banks and financial institutions are exploring blockchain technology to streamline their operations. However, they face challenges related to regulatory compliance and interoperability with existing legacy systems. To overcome these obstacles, institutions are seeking solutions to integrate blockchain effectively while ensuring alignment with regulatory requirements and Shariah principles.

In conclusion, blockchain technology holds significant promise for overcoming barriers and unlocking growth in Islamic finance. By enhancing transparency, efficiency, and compliance with Shariah principles, blockchain can address the unique challenges of Islamic finance. As the technology continues to evolve, its integration into Islamic financial practices will likely become increasingly sophisticated, driving further innovation and growth in the sector. The potential of blockchain to transform Islamic finance underscores the need for ongoing collaboration, research, and strategic planning to fully realize its benefits.

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