The Reserve Bank of India (RBI) has published an article titled “Decentralized Finance: Impact on the Financial System” in its latest bulletin, providing a comprehensive analysis of the relationship between decentralized finance (DeFi) and traditional financial systems. The report emphasizes that speculative demand for cryptocurrency dominates the crypto market and drives market volatility, requiring retail investors to exercise more caution in this unstable and irresponsible market.
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The Reserve Bank of India (RBI), India’s central bank, released its monthly bulletin for May 2024 on the 21st, which includes the article “Decentralized Finance: Impact on the Financial System.” The report delves into the cryptocurrency ecosystem, particularly the relationship between decentralized finance (DeFi) and traditional financial systems.
The Connection between Cryptocurrencies and Traditional Finance
The report points out that the connection between cryptocurrencies and the existing financial system is primarily reflected in the exposure of banks and the financial sector to risks, as well as liquidity risks. The traditional financial system may have various ways of being associated with cryptocurrency assets. Firstly, through deposit channels, banks hold deposits from companies that provide stablecoins and NFTs, among other cryptocurrency assets. According to the September 2022 Basel III Monitoring Report, a survey showed that the risk exposure of banks to cryptocurrency assets accounted for 0.14% of the reported total bank assets.
In addition, banks engage in clearing cryptocurrency derivatives and futures, underwrite initial coin offerings (ICOs), and issue securities related to cryptocurrency assets. Banks also participate in insurance and other services such as custody and wallets. If these various interactions continue to grow, financial risks may further increase. Therefore, the report emphasizes the urgent need to formulate timely policies for financial technology and traditional financial institutions.
Cryptocurrencies’ Link to Traditional Finance
Cryptocurrencies Mainly Driven by Speculative Demand
The report also points out the close correlation between the market capitalization of Ether and market volatility, which showed exponential growth after the COVID-19 pandemic and increased synchronously with market volatility, indicating that speculative motives may be the basis for the rise of Ether. After empirical analysis, the report concludes:
This finding aligns with a survey conducted by the UK Financial Conduct Authority (FCA) in 2021. The survey showed that the majority of investors in cryptocurrency assets (38%) view it as gambling, with the goal of making or losing money, reflecting their risk-taking behavior. The report warns:
The report further explains that certain cryptocurrencies claim to have actual assets as backing, but if these assets themselves are another unstable digital asset without transparency and central bank support, the entire cryptocurrency system is prone to crises without security measures.
Currently, India lacks a specific regulatory framework for cryptocurrencies. The Securities and Exchange Board of India (SEBI) recently submitted a proposal for cryptocurrency regulation to a government advisory committee, suggesting that different regulatory bodies manage specific aspects of cryptocurrency trading.
For example, SEBI stated that it can oversee cryptocurrencies appearing in the form of securities and initial coin offerings (ICOs); the Reserve Bank of India can regulate assets supported by stablecoins and other legal currency-backed assets; the Insurance Regulatory and Development Authority of India (IRDAI) can supervise virtual assets related to insurance and retirement funds together with the Pension Fund Regulatory and Development Authority (PFRDA). The Indian Ministry of Finance has not publicly responded to this proposal.
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