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Why the advent of decentralized finance (DeFi) and Central Bank Digital Currencies (CBDCs) will usher the dawn of finance 2.0, and how this will affect traditional finance spelling a possible end for commercial banks’ monopoly over money markets.

Enter DeFi

Decentralized finance, DeFi for short, is a term used to refer to blockchain based solutions that enable a variety of financial operations. For the purpose of this article, it is sufficient enough to consider the term decentralized simply as referring to a “decentralized” entity; that there is no central decision maker to trust. In decentralized blockchain, solutions control and decision making are not ceded to a centralized entity or individual, it is instead said to be decentralized; controlled by a distributed network, which is backed and secured by cryptography. This is tech that has now withstood the test of time.

Hence, it follows that DeFi is simply an umbrella term referring to blockchain enabled, decentralized platforms offering several financial services ranging from simple depository and lending facilities, to covering more complex financial use cases.

Users of digital currencies can lend or deposit their holdings in return for interest, or take-out loans with digital currencies as collateral. The best part, all this is done on the spot, without any time-consuming processes or requirements for approval. Additionally, all these services can be done from the comfort of your own home with your mind at ease that your loan and/or deposit will be paid back. As blockchain by definition is decentralized and trustless; does not require faith to be placed in a third party for execution.

More complex financial and commercial services can be offered by utilizing smart contracts; however, this use case is beyond the scope of this article. For our purpose it is sufficient to understand that DeFi will enable digital currency holders to lend and/or deposit their holdings in return for interest with virtually zero risk of default, and for borrowers to borrow liquidity against their digital currency holdings.

Which brings us to a very valid question, one that I have been asked many times.

“How will DeFi disrupt the traditional finance space as a whole and the banking sector in specific given that about three percent of the global population owns digital currencies?”

At this point it is worth noting that DeFi has grown 15-fold from a USD1 billion industry in March 2020 to about USD15 billion as of date of publishing of this article. And also…

…CBDCs, Take a Bow!

Central Bank Digital Currencies, or CBDCs for short, and this one is easier to explain and make a case for. A central bank currency is simply the currency issued by my and your central bank. Cash and coins in circulation is as explicit as a central bank currency gets.

A CBDC is then a central bank currency that has no physical form, think of it as digital cash that is issued directly by your central bank.

In practice full adoption of CBDCs means that traditional bank notes and coins will be rendered obsolete and would eventually cease to exist. This is by no means a long shot, we currently use PayPal, Revolut and our bank’s online services to transfer money digitally, pay online or to tap the point-of-sale devices with NFC enabled mobile phones. The process of using digital money issued by central banks would be exactly the same. The fact that this money would be issued on blockchain does not mean that the way we use it on a daily basis would be different.

Back in December 2018, while on vacation in London, I was surprised to see many family-owned cafes and restaurants in addition to a number of international franchises refuse cash payments!

It is also worth noting that, counter to popular belief, blockchain makes payment systems more transparent! Take this from me at face value as once again the details of this are beyond the scope of this article. Or better yet, do your own research! Digitization of money has been happening for a long time now, CBDCs is only a matter of (short) time.

But how does this affect commercial banking? In the “How Does Money & Banking Function” in part one, we highlighted the role of banks as depository institutions in addition to intermediaries between central banks and retail.

With CBDCs all you need to deposit, receive, lend or borrow funds is a mobile application linked to the central banks blockchain to which the currency is native to. In affect you can now deposit your funds directly with the central bank!

CBDCs are happening as we speak with talks about the euro going digital by Q2 2022. In the Bahamas, the central bank has already issued its digital currency (The Sand Dollar, research the name its quite interesting), which is solving very real problems the inhabitants and locals of its remote islands used to face. Elsewhere in China, the digital Yuan or the e-Renminbi continues to gain traction with festivals celebrating its launch and raising awareness running year long. Only digital money is accepted at these festivals.

There are also whispers of the FED’s USD going digital sooner than later. This is happening whether you choose to believe it or not.

Part three to follow.

The opinions expressed in this article are those of the author. They do not necessarily reflect the opinions or views of The Business Reel.

If you missed part one: Traditional Finance and the Ice Picking Industry (Part One)

Also Read: Traditional Finance and the Ice Picking Industry (Part Three)

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