How Currency Works
Whereas the specific meaning of money may appear evident because we all utilize it on a daily basis, it is also obscure and subtle. Currency is now commonly associated with coins or paper notes. Throughout history, however, it has assumed many various forms. Certain commodities became a traditional method of payment in many early communities. Tobacco leaves, salt, cowrie shells in pre-modern America, large circular stones in the Pacific Islands, tobacco leaves, grain or even cigarettes, and packages of ramen noodles in prison have all been used as currency. Technology has just permitted an altogether new type of payment: digital currency.
The Traditional View of Currency
The traditional perspective, that economic and monetary dominance are linked, stems from models with large network externalities, such as when first-mover advantage is important and the externalities are powerful enough that “winner takes all” is the consequence. When transacting across borders under these models, it pays to utilise the same currency.
Furthermore, these models imply that the currency of the main commercial and financial power is the natural choice for this dominant position. It will have broad international commercial and financial links as a major economy. Financial markets will be well-developed. Because its citizens are accustomed to transacting in their own currency, its national unit will have a sizable “installed base,” in network economics terms. As a result, for transactions with inhabitants of the lead economy, exporters and investors from other nations will be pulled to the currency in issue. In the quest for worldwide currency status, the currency of the largest economic power will thus have an inherent advantage. This undoubtedly elaborates how the sterling pound became a global currency in the nineteenth century and how the dollar took over in the twentieth. It remains to be seen how things will unfold in the digital currency world- will there be another crypto to supplant Bitcoin?
Individuals, banks, enterprises, and governments engaging in cross-border transactions will not be attracted to currencies other than the dominant unit in the international monetary and financial arena. Other currencies’ prices for commodities and financial instruments will be more difficult to compare. Settlements will be more difficult to forecast. The liquidity of investments will be reduced. Since they are not the dominant currency in international transactions, other currencies will lack the same transparency, predictability, and liquidity. There will be no system for coordinating a large-scale move from one international monetary and financial standard to another because individuals, banks, enterprises, and governments make decisions in a decentralized manner.
As such, this international currency designation will display inertia. It will survive even if the conditions that allow for the establishment and supremacy of a certain national unit no longer exist to the same degree. Unless a large shock prompts agents to leave established practice and coordinate a transition from one equilibrium (common use of one foreign currency) to another, that currency will remain locked in place. This, it is claimed, explains why the sterling remained the dominant international currency well into the twentieth century, long after the United States had eclipsed Great Britain in economic growth and financial power. It illustrates why the shock of World War II was necessary for the dollar to finally surpass the sterling.
These assumptions have apparent consequences for how long the dollar will be the leading international currency and what kind of shocks will be required for the renminbi to displace it. A pandemic? The ubiquity of DeFi? A world war? Bitcoin? But then again, O tempora, o mores!
The New Perspective
The traditional understanding of international currency status is more theoretical than empirical. In lieu of interacting directly with the evidence, the theoretical models in question just allude to historical facts as a source of motivation. The limitations of the existing empirical base impeded even scholars who took the findings seriously.
All of this prompts us to question the status quo. We believe that the traditional (or “old”) view of international currencies should be replaced with a “new” perspective, in which multiple national currencies can play important international roles and viscosity and persistence are not as powerful as previously assumed. This new perspective is theoretically sound. It is predicated on a body of knowledge about technological standards that stresses open systems, in which users of one technology or system can communicate with users of other technologies or systems. Herein lies the promise of DeFi, the momentum of digital currencies, and the metamorphosis of the international financial system. The Decentralized Finance (DeFi) or Open Finance movement expands on this promise. Consider a transnational, open alternative to every financial service you consume today – savings, loans, trading, insurance, and more — available to anybody with a smartphone and an internet connection anywhere on earth.
The possibility of a better match between the structure of the global economy and its international monetary and financial system suggests that there can be many consequential international currencies and multiple sources of international liquidity at any given time. Other countries do not need to rely solely on a somewhat mature, slowly rising economy in relative decline for their liquidity needs if international currency status is not a natural monopoly in which quickly increasing profits induce lock-in.
The Role of Institutions
International financial institutions (IFIs) play an important role in the social and economic development of countries with emerging or transitional economies in many regions of the world. This function entails providing development project advice, funding, and implementation assistance. The World Bank, the International Monetary Fund, and the International Finance Corporation are among them.
Distinguished by AAA credit ratings and diverse membership of borrowing and donor countries. However, they all have the same goals and objectives:
- to alleviate universal poverty and enhance people’s living conditions and standards;
- to promote regional cooperation and integration; and
- to promote sustainable economic, social, and institutional progress.
International financial institutions (IFIs) have not only expanded funding for shock financing in reaction to the global financial crisis, but they have also drastically modified their mechanisms. Nonetheless, there are some holes. IFIs should take into account the fact that most advanced low-income countries (LICs) will graduate in the near future, owing to their strong macroeconomic performance and integration into international financial markets. Especially with the nascent adoption of cryptocurrencies, these nation-states have a veritable chance of skyrocketing their political economy.
In the case of finance, centralisation refers to a point of central control, which in this situation is banking institutions. Historically, centralisation in finance was regarded to be more secure and stable than personal management as a measure and maintainer of stability in global financial operations. Because of the infrastructure’s reach, these systems were especially important for cross-border transactions. But there’s a catch: centralised finance is only as stable as we make it out to be. In reality, centralised financial systems are harmed by a range of problems such as fraud, forgeries, dubious lending practices, and so forth.
Even while centralised financial institutions are commonplace, there are still significant accessibility barriers. Although the majority of the world’s population owns a smartphone and has internet access, many countries still struggle to provide dependable banking access and financial stability or accountability. Payments, loans, insurance, and wealth management are all being reshaped by digital technologies, which have been expedited by the COVID-19 epidemic. Whilst technology makes financial services more diversified, competitive, efficient, and inclusive in many economies, it may also increase market concentration. Moreover, new threats to a variety of important public policy objectives may emerge. DeFi amplifies the consequences of digital innovation for market structure and attendant policies, such as financial and competition regulation, using the underlying economics of financial services and their industrial organization. Fintech is doing a lot to fill the gaps left by the centralised framework while DeFi has been setting the foundations of a decentralised future where blockchains such as XPRL have been streamlining cross-border remittance due to their technological advantages and economical nature.
Where Does Decentralisation Fit Into?
Decentralised finance refers to a new sort of financial system that is dispersed and based on the core open-source networks of Bitcoin and Ethereum, and which offers numerous benefits over extant financial systems around the world. These systems are unlikely to be affected by manipulation, fraud, or other issues because there is no central point of control or intermediaries; however, they are powerful and far-reaching enough to maintain the capabilities required for financial transactions to take place dependably and accountably.
So, to answer the question- where does decentralisation fit into? Decentralised finance will have the greatest impact on underbanked groups and societies experiencing financial turmoil. These individuals can easily acquire access to a worldwide financial trading market and conduct their transactions with simply an internet connection and a smart device as criteria (so far). Further, these systems are censorship-resistant and publicly auditable, making them ideal for preventing corruption and tampering as an added layer of protection. Some things to remember in this regard include, viz:
- It avoids relying on intermediaries (middlemen) like brokerages, exchanges, large banks, etc.
- Instead, it uses smart contracts on blockchains.
- Importantly, platforms in the DeFi space facilitate lending, borrowing, and transferring of funds between accounts.
- Users can also trade cryptocurrencies, and derivatives, earn interest via staking initiatives and engage in other speculative activities.
- There are some caveats/downsides of DeFi that are yet to be resolved, viz:
- Technical risks such as hardware, software, or protocol risks can lead to the compromisation of portfolios and loss of assets.
- Smart contract/code risks relate to malicious actors or hackers exploiting code vulnerabilities to modify blocks and make changes they want, such as stealing or rediverting asset transactions.
- Financial & procedural risks – pertain to loss of funds by the aforementioned and other forms of malicious exploitation as well as phishing attacks where users’ lack of understanding or goodwill are exploited. These can target both individuals and large enterprises. Therefore, being aware of and mitigating these risks is an important activity to be responsible for DeFi cryptonauts.
- Since they are a relatively young system, their stability is called into question.
- System maintenance requirements might weigh heavily into other indirect avenues such as power, climate, etc.
- Environmental impact
How to Mitigate DeFi Risks
Even schools and colleges around the world are beginning to include crypto and DeFi education in their curricula, indicating that financial education is evolving. There is an obvious need to be mindful of the risks in this domain, which is expected to expand in the future decades.
- Due diligence is critical because it ensures that you make the right decision.
- Seek trustworthy providers, platforms, products & services.
- MFA – multi-factor authentication is a much-ignored security action but it can mean a world of difference.
- It’s good practice to avoid sharing your portfolio online, keep credentials confidential, and treat your assets like any other sensitive information
- Consider alternatives to keeping your assets online. For instance, cold storage.
- Keep up to date with software updates from your chosen vendor and seek information from the community.
The potential of DeFi does not guarantee that decentralized finance systems will be widely adopted. Centralised financial institutions can process massive numbers of transactions per second, something that decentralized systems have yet to achieve. To meet this demand, DeFi developers are developing scaling solutions such as the Lightning Network, which adds a second “layer” to the Bitcoin or Ethereum blockchain and works by reducing the number of transactions on the blockchain by opening a dedicated private “channel” between two users who want to transact until an agreement is reached to close the channel. Not to mention XRPL. Transaction times are expected to grow to close to a million transactions per second if the technology is applied.
Why Cryptocurrencies Are a Big Deal in the World of Finance
Notwithstanding tremendous progress, cryptocurrencies remain divisive; some call Bitcoin “digital gold,” while others call it “evil.” They’re the latest fintech phenomenon at their most basic level, but at their most advanced level, they’re a revolutionary technology that challenges society’s political and social foundations. Cryptocurrencies represent a new, decentralized paradigm for money. In this system, centralized intermediaries, such as banks and monetary institutions, are not necessary to enforce trust and police transactions between two parties. Thus, a system with cryptocurrencies eliminates the possibility of a single point of failure, such as a large bank, setting off a cascade of crises around the world, such as the one that was triggered in 2008 by the failure of institutions in the United States.
Cryptocurrencies are a new, decentralised money paradigm. To enforce trust and police transactions between two parties, centralized intermediaries such as banks and monetary organizations are not required in this system. As a result, a system based on cryptocurrency eliminates the chance of a single point of failure, such as a huge bank, triggering a global crisis, similar to the one generated in 2008 by the bankruptcy of US institutions.
Investing in cryptocurrencies can be profitable. Over the last decade, the value of cryptocurrency markets has surged, reaching nearly $2 trillion at one time. Bitcoin was worth over $862 billion on crypto marketplaces on December 20, 2021.
One of cryptocurrency’s most notable use cases is the remittance economy. Presently, cryptocurrencies like Bitcoin act as intermediary currencies for cross-border money transfers. In a nutshell, a fiat currency is converted to Bitcoin (or another cryptocurrency), sent across borders, and then reconverted to the target fiat currency. This method simplifies and reduces the cost of money transfers. XRPL for example has contributed greatly to the remittance vertical, with the XRP network facilitating a significant amount of cross-border flows.
Cryptocurrencies promise to make it easier to move funds between two parties without the use of a trusted third party such as a bank or credit card provider. Public and private keys, as well as various incentive schemes such as proof of work and proof of stake, are used to secure such decentralised transfers. Some key points to remember:
- BTC was created 14 years ago.
- There are around 19k cryptos in existence (far more than fiat currencies).
- While few are likely to survive in the incredibly competitive landscape certain folks call the Cryptoverse, some of these digital currencies truly have the potential to disrupt the conventional banking and payment systems of today.
- Crypto users tripled in 2021 to around 300 million, predicted to reach 1bn by 2023.
- The blockchain industry that’s behind tokens and coins is forecasted to grow to $228 billion by 2028 – from the current estimate of $5bn.
- Large players in the payments sector are entering the cryptoverse, including Mastercard, which owns Start Path (a start-up engagement programme aiming to accelerate innovation in the space, increase safety and ease of trading, and holding digital assets)
The Power of Innovation in Financial Systems
Innovation, by definition, is the introduction or development of something new. It is fundamental to our ability to recognize and solve shared problems in an efficient and long-term manner. Transformational new technologies, products, and services are frequently developed, deployed, and adopted quickly to address social requirements. Thus, across the corporate, governmental, and nonprofit sectors, we may increase our capabilities, asset utilization, and resource allocation. Due to the brisk evolution of new technologies in response to some of the challenges raised, there is now a need for scalable, long-term blockchain solutions like the XRPL.
Let’s explore some key technological utility drivers!
XRP – XRPL
The XRP cryptocurrency is part of Ripple Labs’ payment system, which was designed to make international payments easier. By allowing low-cost international transactions, XRP hopes to replace, or rather be the next generation of, outmoded financial systems.
Two main reasons why even long-term investors see XRP as the future of cryptocurrencies are:
- Ability to compete in cross-border trade at a large scale, at low costs, and quickly.
- The XRP Ledger’s efficiency is what gives XRP its speed and low cost.
Despite the fact that breakthroughs like XRP address numerous difficulties and friction points (inefficiencies), we have yet to reach a point in our financial technological progress where all systems and providers are connected and working together for the welfare of society, providing value to end-users. Interoperability concerns persist, and many see this as a major roadblock to our transition to a decentralised economy.
One example is the XRPL’s lack of smart contracts, which would allow contracts to be automatically performed, boosting security, autonomy, and execution speeds, as well as providing additional benefits to blockchain users. However, to address security concerns, an escrow mechanism exists to operate as a safety net, thereby bypassing this restriction.
Moreover, as we move rapidly towards the ever-illusive interconnected, interoperable financial nirvana, we are likely to witness many such technological workarounds aimed at solving user issues. Some examples are staking, wrapping, and hooks.
Simply explained, staking is a method of receiving rewards for holding particular cryptocurrencies by putting them to work on the blockchain. They invest the money you deposit with them and share some of the gains with you, similar to a bank offering interest rates on savings accounts. Many cryptocurrency investors consider staking their assets in order to make them work for them by earning rewards.
Staking, like smart contracts, has safety and security concerns, since it increases security by making the blockchain more resistant to attacks and boosting the network’s ability to handle transactions. To ensure that security standards are followed, smart contracts are frequently required while staking cryptocurrency on a blockchain.
Wrapping is heralded as a key development in the DeFi landscape. Wrapped tokens allow digital currencies such as XRP to be used or exchanged on decentralised applications (DApps) even when they are not native to that blockchain.
One of the biggest challenges to blockchain interoperability is that there are so many blockchains with competing means of communication. Think of this as a world before the Dollar became the world’s reserve currency, and before the Euro made business in Europe so much easier.
Prior to the Euro(€) becoming a currency, there was the European Currency Unit (ECU) which was not a circulating currency, but instead used to price international financial transactions and capital transfers. Later, the Euro (€) was introduced as a currency created to accelerate growth, trade, and stability in a part of the world with vast amounts of international economic activity previously hindered by constant currency exchange requirements. Suddenly, some of the types of financial friction we discussed earlier were alleviated by this new currency that made economic activity cheaper.
Wrapped currencies fulfill a similar function as the Euro; they allow users to spend tokens from one blockchain on another. For instance, wrapped XRP (wXRP) is worth exactly the same amount as an XRP but with the added function of being legal tender on other blockchains. This feature increases the interoperability and real-life applications of the technology. Part II will dive much deeper into the specifics, alternatives, benefits, and limitations of wrapping.
Webhooks, or real-time notifications for blockchain occurrences, are critical for users of all types of dApps, including crypto exchanges, marketplaces, crypto payment apps, and any other type of DeFi app. Webhooks make it easier to get information on cryptocurrency price changes, confirm transactions, and receive payments on the blockchain, all of which can help with user profile administration.
- This crucial technology was made to solve vital user problems, which aim to bring smart contract functionality to the XRPL. Hooks are ‘’small, efficient pieces of code’’ that allow automatic execution of logic when certain conditions are met – much like smart contracts, this has advantages such as reducing human error and increasing trust & transparency on the blockchain.
- Another advantage of developing hooks is the reduced dependency on an escrow function, which, as we saw earlier in this article, was deemed a friction point in conventional financial systems.
- Removing the need to rely on soft staking and wrapping means enjoying the upside of increased efficiency, transparency, and automation afforded by smart contract usage.
- The main benefit of developing hooks is to introduce smart contract functionality in the XRP Ledger, thus expanding the use cases and functionalities of the XRPL itself.
- Now, in addition to high transaction speeds and low fees, transactions on the XRPL can also fulfill more advanced functions which have long been awaited by the community.
- Essentially, the XRPL is increasing what it can offer businesses and creative developers by maturing this capability, and we’ll likely continue to hear about.