Why in the news?

  • Concerns regarding the misuse of DeFi for illicit activities are arising in recent days.

Decentralised Finance(DeFi)

  • What is it?: It refers to a financial ecosystem built on blockchain networks (primarily Ethereum) that uses smart contracts to provide financial services without intermediaries like banks, brokers, or exchanges.
  • Core Idea: Democratise finance by making it open, transparent, and accessible to anyone with internet connectivity.
  • Key Features:
    • Decentralisation: Operates on distributed ledgers, reducing reliance on central institutions.
    • Transparency: Transactions are recorded on blockchain, visible to all participants.
    • Smart Contracts: Self-executing codes that automate financial transactions.
    • Tokenization: Assets are represented digitally via cryptocurrencies or stablecoins.
    • Interoperability: DeFi platforms often allow integration across multiple apps/protocols.
  • Major Components
    • Decentralised Exchanges (DEXs): Allow peer-to-peer crypto trading. e.g.: Uniswap, PancakeSwap.
    • Lending & Borrowing Platforms: Provide interest and collateralised loans. e.g.: Aave, Compound.
    • Stablecoins: Cryptocurrencies pegged to fiat to reduce volatility. e.g.: USDT, DAI.
    • Yield Farming & Liquidity Mining: Mechanisms to earn returns by providing liquidity.
    • Insurance Protocols: Cover risks in DeFi transactions. e.g.: Nexus Mutual
  • Advantages
    • Financial Inclusion: Help in providing access for unbanked populations.
    • Lower Costs: Cuts out intermediaries in the chain, thereby reducing the cost.
    • Transparency & Security: Process of Blockchain verification reduces fraudulent practices.
    • Programmability: Customised financial products via smart contracts.
    • 24×7 Availability: Unlike traditional banks, it allows full availability of services.
  • Challenges
    • Regulatory Uncertainty: Lack of global frameworks makes India cautious on crypto regulation.
    • Smart Contract Vulnerabilities: Bugs/hacks may lead to huge losses.
    • Market Volatility: High price swings in crypto assets can cause high volatility.
    • Scams & Frauds: Rug-pulls, Ponzi schemes common in unregulated DeFi.
    • Energy Use: High energy consumption in proof-of-work blockchains.
  • Significance in India
    • Boost financial inclusion aligned with Digital India.
    • Support cross-border remittances (low-cost transfers).
    • Encourage fintech innovations and startups.
  • Concerns for India
    • Risk of money laundering & terror financing (FATF compliance).
    • Lack of consumer protection and grievance redressal.
    • Conflict with RBI’s push for Central Bank Digital Currency.