Cryptocurrency has witnessed a phenomenal rise post the global financial crisis of 2008. Amidst the different technological innovations that facilitated its creation, one of the most critical aspects has been the declining trust in the interface of policies, governance, financial system and institutions to maintain the value of existing fiat currencies. It was not a pleasant experience for individuals and businesses booking losses and suffering due to excessive greed and risktaking by some banks and financial institutions elsewhere despite a supposedly robust regulatory system. Losses were in terms of employment, income and investments intertwined with the purchasing power of currencies.
So, can there be a system involving the businesses and individuals within the transacting fraternity where settlements could occur without institutional interferences? Especially when there is an associated cost with limited to no protection from the aftereffects of their negligent decision makings? Can there be a way to preserve the value of transactions and the transacting units? Right or wrong, there came the “bitcoin”, a cryptocurrency founded in 2009 by an individual or a group under the pseudonym “Satoshi Nakamoto” supported by the dimensions of a specific type of distributed ledger technology – the blockchain. It has taken the world by storm, followed by many other cryptocurrencies disrupting the existing regulatory mechanism in the financial system.
As a digital asset generated from a technological process involving transaction validations through the underlying mix of distributed ledger and blockchain technology and not issued by any central authority, it remains outside the purview and interference of government agencies. For this reason, unlike legal tender, it remains protected from inflation besides the technology protects against counterfeiting concerns.
BENEFITS OF DISTRIBUTED LEDGER & BLOCKCHAIN
A distributed ledger can be perceived as a database across several locations and accessed by multiple participants operating in this transactional ecosystem. All participants thus can view all records in question. Think of this in contrast to the usual “Centralised Databases”, which necessitate a central authority or intermediary to process and authenticate transactions. In such a centralised system, individual transactions must pass through the authentication processes through financial intermediaries, and settlements ultimately occur in a centralized database in a fixed location. One, it involves cost as these intermediaries charge fees. Besides, there can be inefficiencies related to security/transparency, and audit trails need not be entirely immutable.
Usage of blockchain reduces the counterparty risk as it facilitates a trustless transaction. The technology guarantees the simultaneous transfer of assets and the payments thereof, making it impossible to execute one leg of the transfer if the other leg gets interrupted for whatever reason. It facilitates the distribution of trust across different participants/stakeholders in the system (trusting everyone in aggregate) from being concentrated in a single entity in a centralised system.
In such a decentralised system, defined protocols allow transactions amongst individuals involving the digital transfer of value over the internet in a “peer to peer” manner without requiring any intermediary to trust. Here, the trust is on the underlying blockchain system (public-key cryptography and consensus mechanism in particular) that facilitates the transfer and simultaneously ensures sender authenticity and currency validity.
WHAT ARE THE OUTCOMES?
Since the distributed ledger and blockchain underlying cryptocurrency facilitates transactions without a third-party centralized clearing agency, it: (i) reduces counterparty risks; (ii) enhances the efficiency of the settlement process by minimizing transaction time, allowing 24/7 processing through increased automation, thus (iii) reduces cost and enhance savings for various businesses. It also brings transparency, relegating control of all its information and transactions to the users in the blockchain ecosystem and has greater security in the inherent immutability of such ledgers reducing the chances of errors and frauds.
But, several technological, legal, and policy hurdles have been thrown open by this disruptive innovation. There are concerns about the lack of intrinsic value as it is not backed by a sovereign or verified bullion (except in some stablecoins). It makes them highly volatile, further amplified in uncertain times like now.
There are governance concerns amidst a lack of clarity of jurisdictions in the absence of centralized infrastructure and regulatory purview. Existing criminal laws and macroprudential and micro-prudential regulations cannot provide the necessary safeguards from any illegal activity perforating through this technology.
Further, there are apprehensions surrounding the immutability of transactions necessitating changes in the entire history of transactions to initiate changes at any specific point in the transaction chain. Not to mention worries surrounding the susceptibility of keys associated with recording to thefts or loss, making digital assets irretrievable. The differences in distributed ledger technology systems can create integration and interoperability problems. Not to forget the costs and the level of industrywide coordination of integrating this technology with legacy infrastructure.
SHOULD INDIA ALLOW CRYPTOCURRENCY?
Certainly not at this stage, but there should not be shying away from harnessing the underlying potential of the technology. Given the lack of maturity of this technology and associated risks, an element of caution is always warranted in the absence of its regulatory vetting and acceptable industry standards. At the same time, staying away from leveraging the benefits of the underlying technology is equivalent to a missed opportunity.
The distributed ledger technology appears well suited to address various issues across domains. There are benefits of reduced costs and inefficiencies of manual data verifications and interventions, unlocking liquidity and enabling better balance sheet management across and between firms through intraday repo using tokenised collateral and digital cash. The Society for Worldwide Interbank Financial System (SWIFT) is continuously testing and analyzing the use of this technology in their business. Besides at the back of the rising use of digital finance, there are opportunities to provide easy and accessible financial products and services to the country’s unbanked population, facilitating financial inclusion.
Hence, there is little doubt that as a country, we should remain open to promoting innovations and usage of this technology initially in baby steps to equip us for its gainful use over time. Developing the necessary regulatory and technological infrastructure to rein in this technology and putting in essential safeguards against any malicious usage remains the key.
That said, the presence of technology, its continuous innovation, refinements and increased adoption globally will likely keep the crypto attraction alive as an alternative asset in the immediate term. Besides, persistence in global inflation can only elevate its status as a competing threat to fiat currencies, implying greater responsibilities for central banks and policymakers. Ultimately, it boils down to either succeeding in maintaining the value of fiat currencies or being ready to compete with phenomena like cryptocurrencies. (The author is a professor and the Area Chairperson of Economics Environment and Policy at IMT, Ghaziabad)