DeFi versus Fiat currencies, which is better?
Byline: Hannah Parker
With technology evolving at an incomprehensible pace, many major sectors are being transformed from their once traditional way of functioning to a more hybrid functioning, where new technology is being integrated to improve these sectors. A major sector that is being transformed is the financial industry which is transforming as the cryptocurrency adoption rate increases.
If we consider the traditional financial sector, the central bank lies at the crux of the monetary system. While the central bank circulates fiat currencies and maintains its core functions, trust in the monetary system is essentially grounded in trust in the central bank – even though the central bank does not operate in isolation. Commercial banks and other private payment service providers (PSPs) carry out the greater part of payments and offer customer-facing services. This division of responsibilities promotes competition and allows for the ingenuity and creativity of the private sector in serving clientele. As a result, private sector innovation benefits society largely because it is built on the foundations of the central bank. You can read more about some of the latest private sector innovations on the Bitcoin Method site.
On the flip side, the cryptocurrency industry builds on the premise of decentralisation. In crypto, instead of relying on central bank money and trusted intermediaries, checks and balances are provided by a multitude of anonymous validators to maintain self-sufficiency and eliminate the influence of powerful entities or groups. Decentralised finance, better known as “DeFi”, aims to replicate conventional financial services, but within the crypto sector. These services are made possible by innovations such as programmability and composability on permissionless blockchains. These systems are “always on”, meaning that global transactions can be performed 24/7 based on open-source code and knowing no borders.
One might wonder, with the advancement of the DeFi sector, what is stopping cryptocurrencies from large-scale adoption? Because the DeFi industry is still immature, there are a number of flaws preventing this. The two most prominent flaws are the bottleneck congestion present in the DeFi space, as well as the reliance on volatile assets. Instead of entirely replacing traditional monetary systems with cryptocurrency, it is suggested a hybrid industry combining DeFi and traditional monetary systems has great potential for the financial ecosystem. Governments across the globe view central bank digital currencies (CBDCs) as a means to improve the existing fiat ecosystem. According to an International Monetary Fund (IMF) publication, cryptocurrency’s technical prowess, supported by the central bank’s underlying trust, is suggested to be the key to enabling a rich monetary ecosystem. It has been expressed in the publication that “digital technologies promise a bright future for the monetary system”.
A study by the Bank for International Settlements (BIS) has revealed that cryptocurrencies outdo fiat ecosystems when it comes to achieving the high-level goals of a future monetary system. However, as previously mentioned, bottleneck congestion in DeFi and the reliance on volatile assets are preventing large-scale crypto adoption across the globe. Both wholesale and retail CBDCs could potentially inherit abilities from the crypto ecosystem that benefit end users. It has been highlighted that “by embracing the core of trust provided by central bank money, the private sector can adopt the best new technologies to foster a rich and diverse monetary ecosystem”. It has also been further recommended that central banks utilize innovations such as tokenisation to allow purchases using multiple fiat currencies – further benefiting merchants and customers.
With the rate of crypto adoption increasing globally, it will be interesting to see if this suggested hybrid system will prove a good step for the future of the financial sector.