Inverting The Pyramid

Category: Basics

  • Consensus Mechanism Contd..

    Picking up from where we left last; some more about the 2 most common mechanisms- PoW & PoS.

    Proof-of-Work (PoW) is a consensus mechanism that uses mining to validate transactions and create new blocks on a blockchain. Mining involves solving complex mathematical problems that require a lot of computational power and energy. The first miner who finds a valid solution gets rewarded with newly minted coins and transaction fees. PoW ensures that the network is secure and resistant to attacks, as anyone who wants to alter the blockchain history or create fraudulent transactions would need to control more than 50% of the network’s hashing power, which is very costly and impractical. PoW is most commonly used by Bitcoin.

    Advantages of PoW:

    • PoW is considered a more secure consensus mechanism as it is difficult for any single entity to control more than 50% of the network’s computational power.
    • PoW provides an incentive for miners to participate in the network, which helps to ensure that the network remains decentralized.
    • PoW has been widely tested and used in various cryptocurrency networks, making it a well-proven and reliable consensus mechanism.

    Disadvantages of PoW:

    • PoW is energy-intensive, which leads to high electricity consumption and carbon footprint.
    • PoW can also lead to centralization of the network, with a few large mining pools controlling a significant portion of the network’s computational power.
    • PoW can also be vulnerable to 51% attacks, in which a group of miners controlling more than 50% of the network’s computational power could potentially manipulate the blockchain.

    Proof-of-Stake (PoS) is a consensus mechanism that uses staking to validate transactions and create new blocks on a blockchain. Staking involves locking up some coins in a smart contract as a collateral that can be slashed if the validator behaves dishonestly or lazily. Validators are randomly selected to propose new blocks or vote on the validity of existing blocks based on their stake size and other factors. Validators get rewarded with transaction fees and sometimes newly minted coins. PoS aims to be more secure, energy-efficient, and scalable than PoW, as it does not rely on wasteful computations and reduces the risk of centralization and 51% attacks. PoS was first proposed as an alternative to PoW by Peercoin and later implemented by other cryptocurrencies such as Cardano, Tezos, and Ethereum

    Advantages of PoS:

    • PoS is less energy-intensive than PoW, which can reduce the carbon footprint of the network.
    • PoS can also be more decentralized, as validators with smaller amounts of stake can still participate in the network and earn rewards.
    • PoS can also be more resistant to 51% attacks, as a group of validators would need to control a significant portion of the network’s stake in order to manipulate the blockchain.

    Disadvantages of PoS:

    • PoS can lead to centralization of the network, with validators with the largest stake having the most influence over the network.

    Some of the main differences between PoW and PoS are:

    • PoW requires miners to expend energy and hardware resources, while PoS requires validators to stake coins as collateral.
    • PoW rewards miners with newly minted coins and transaction fees, while PoS rewards validators mostly with transaction fees and sometimes newly minted coins.
    • PoW adjusts the difficulty of mining based on the network’s hashing power, while PoS adjusts the stake size and other parameters based on the network’s participation rate.
    • PoW is vulnerable to 51% attacks if a malicious actor controls more than half of the network’s hashing power, while PoS is resilient to 51% attacks unless a malicious actor controls more than two-thirds of the network’s stake.
    • PoW consumes a lot of electricity and contributes to environmental issues, while PoS consumes much less electricity and has a lower carbon footprint.

    I hope this helps you understand the basics of Proof-of-Work (PoW) and Proof-of-Stake (PoS) consensus mechanisms. In the next post, will try to take a step back and talk about the Blockchain Trilemma.

  • What is ‘Consensus mechanism’ in a blockchain?

    The consensus mechanism is a crucial component of a blockchain project as it ensures the integrity and security of the network. It is responsible for reaching an agreement among all participants on the current state of the blockchain and the validity of new transactions. This is important for maintaining the trust and reliability of the blockchain network. In essence, consensus mechanisms are what impart the defining characteristics of a particular project/network. There are several types of consensus mechanisms that are used in different blockchain networks, each with its own strengths and weaknesses. The two most popular and widely used consensus mechanisms are: Proof of Works (PoW) & Proof of Stake (PoS) – more on them in detail, later.

    This is just a simple primer on the consensus mechanisms I have heard of. I cannot guarantee that all of the below mechanism make sense! But anyways, here they are-

    1. Proof of Work (PoW): This is the most widely used consensus mechanism, and is the foundation of the Bitcoin and Ethereum networks. PoW is a computational process that requires miners to solve complex mathematical problems in order to add new blocks to the blockchain. The first miner to solve the problem gets to add the next block and receives a reward in the form of new coins.
    2. Proof of Stake (PoS): This mechanism allows participants to “stake” or lock up a certain amount of their coins as collateral in order to validate transactions and add new blocks to the blockchain. The validators are chosen based on the amount of coins they have staked, and they are rewarded with transaction fees.
    3. Delegated Proof of Stake (DPoS): This mechanism is similar to PoS, but allows token holders to vote for a select group of validators, who are responsible for maintaining the blockchain. DPoS is designed to be more efficient and scalable than PoS, but is also more centralized.
    4. Proof of Authority (PoA) : PoA is a consensus mechanism where a group of validators is pre-approved by the network’s creator. These validators are responsible for verifying transactions and adding new blocks to the blockchain, and are often chosen based on their reputation or identity.
    5. Proof of Burn (PoB): In this mechanism, miners burn or destroy a certain amount of their coins in order to prove their commitment to the network. This process is used to determine which miner gets to add the next block to the blockchain.
    6. Proof of Elapsed Time (PoET): This mechanism is specifically designed for permissioned networks, such as consortium blockchains. PoET uses a random wait time to determine which miner gets to add the next block to the blockchain, but unlike PoW, it doesn’t require significant computational power.

    Since the technology is relatively new, new consensus mechanisms are still being developed and experimented with. As you would have heard already, the most common ones are PoS & PoW. More on them in the next post!

  • e₹..CBDC?.. what’s that!

    CBDC has been a buzzword with RBI kicking off the pilot. I will try to explain the What, Why & How of RBI’s CBDC, which would be true for most CBDCs globally. In this first part, we will explore the What & Why of it and will do the How part in the following post. These posts will mainly refer to the concept document from RBI, released in October 2022 (https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/CONCEPTNOTEACB531172E0B4DFC9A6E506C2C24FFB6.PDF), because that’s all there is when it comes to e₹.

    The first major mention of e-Rupee was in the Union Budget presented on 01st Feb, 2022. CBDC which stands for Central Bank Digital Currency is a global term used for legal tender issued by a central bank in digital form. e-Rupee is the name given to India’s CBDC.

    Let’s start with Why RBI considered coming up with its own CBDC. I see two primary reasons- the first is to bring about a reduction in cash circulation. Cash management- right from Cost (printing, distribution, etc) to logistics, is a costly and inefficient method that RBI is trying to disrupt (remember demonetization?..eh). The second and more pressing reason I am quoting it right from RBI’s note referred to in the opening para- As of July 2022, there are 105 countries8 in the process of exploring CBDC, a number that covers 95% of global Gross Domestic Product (GDP). 10 countries have launched a CBDC, the first of which was the Bahamian Sand Dollar in 2020 and the latest was Jamaica’s JAM-DEX.
    Currently, 17 other countries, including major economies like China and South Korea, are in the pilot stage and preparing for possible launches. China was the first large economy to pilot a CBDC in April 2020 and it aims for widespread domestic use of the e-CNY by 2023. 

    There is a reason why all countries are lining up in a hurry to come up with their CBDCs and it is what lies at the heart of the Blockchain/bitcoin revolution. The key word here is ‘decentralization’. As you might know, the primary motivation behind blockchain technology was the 2008 financial crisis and the general despise of the public against the ‘System’, which includes Banks- both commercial and central, Governments, etc. Thus, the idea of a decentralized currency was born of which Blockchain is the best-known example. While Bitcoin and many other such cryptocurrencies had a wild run since then, I have held a very strong opinion that no Sovereign will ever allow loss of control over Money! It is probably the most important control they have over the lives of their citizens and they will just not let it happen. Having said that, Blockchain technology will change the world (it already is..). I will save the larger discussion of Blockchain, Bitcoin, etc for another day. So in a nutshell, Governments/Central Banks don’t want a decentralized Crypto to grow which undermines their control. If you read the RBI concept note, there are more than sufficient words dedicated to explaining the oh! so very important functions the central banks undertake and how private cryptocurrencies pose a risk. Hope you can read what’s not spelled out. So that concludes my point on Why.

    Now let’s get to the What part. To understand what is CBDC/e-Rupee better, we should delve a bit into what is Currency/Rupee. Our fiat currency-Rupee acts as the following three-

    •        Store of Value
    •        Medium of payment
    •        Unit of Account

    So any new offering that tries to undertake functions of the Rupee, must fulfill the above 3 roles. I will straight get to the biggest question that I have had when I heard e₹ for the first time and I presume most other people would have the same question as well- How is it different from the money in my Paytm wallet or my savings account balance in my Kotak Mahindra Savings account? The key difference between the two is-

    CBDC is issued by the Central Bank just like the physical rupee, whereas the balances we see in our accounts with Banks or wallets are provided by the Commercial entity we are dealing with. Simply put, the balance in Paytm wallet is as good as Paytm whereas the e₹ is as good as RBI. You can extend the logic to answer your specific case. All other differences stem from this key difference-

    1. e₹ is the liability of RBI whereas others are the liability of their respective institutions. 
    2. e₹ will only carry sovereign credit risk, whereas the other also carries counter-party risks (Settlement risk, solvency risk, etc).
    3. e₹ account will be maintained with the Central Bank whereas the other (digital rupee) is held with commercial banks. (There is one finer point to keep in mind that we will note in the next post on How.  

    Hope I have been able to answer some questions about the Why & What that you had. Will follow up with How, in the next post. 

    Side note- the most unimpressive way to depict an impressive feat is straight from RBI’s concept note:

    Screenshot_20221112_204720

  • What is this Card Tokenisation?

    You would have come across this term ‘tokenisation’ on all e-commerce checkout pages. In case you, like me need some visual anchors to develop understanding and still don’t know what is this card tokenisation- this might help.

    In its bid to improve security of Card transactions, RBI rolled out tokenisation norms on Jan 08, 2019 (Ref: RBI/2018-19/103 DPSS.CO.PD No.1463/02.14.003/2018-19). It came into effect finally on 1st Oct 2022.

    So let’s understand first what is tokenisation. In simplest of words it is sort of having an alternate code generated for your card details so that they can be transmitted from merchant, Payment gateway to Card network more securely. Basically, preventing your actual card details travelling over the network between various entities (Merchant, Banks, Payment Network etc) every time you make a payments.

    Now with the basics out of the way, let try to understand- How does Tokenisation happen?

    The information that every time your merchant transmits through the Payment Gateway includes the following identifiable: Card holder’s name, 16 digit Card no, Expiry/Validity, CVV no, Merchant/platform. Through tokenisation all these information are converted to a single code using an algorithm by process called Hashing (very similar to the world of Blockchains & Bitcoin..more on that in posts later).

    As simple as this!

    One such algorithm is SHA-256; just land on this page https://emn178.github.io/online-tools/sha256.html and have fun with it. If you spend some time playing around you might notice some of the most important facets of this process and why is the world so enamoured by this new tech. Will come back to this later in the post; for now back to tokenisation. Now in the process lets assume, you agree to tokenise a Visa Card with Amazon.in. Amazon will request for the token with the card information that you entered on the website. From now on Amazon will only store the last 4 digits of teh card to help you identify in case of multiple tokens and the Token itself. In short, merchants will no longer store your card details and it will only be available with the issuing bank. The issuing bank will be able to match the token coming in from a merchant with the token they have on file and if both match, the transaction goes through..Simple!

    Now coming back to the features of this Token and what makes it so secure:

    • You can generate token from the card details but you can’t get back the card details from the token; isn’t that fantastic!!
    • A very small change in the input makes a significant change in the token, thereby making it very easy to identify tampering during transmission.
    • Irrespective of the input data, teh output in SHA-256 is always 256 bits long, equivalent to 32 bytes, or 64 bytes in an hexadecimal string format.

    On the first feature, you might ask- well what if someone cracks it. So, hashing is not an encryption hence you can’t decrypt it. It is a simple one way process (hashing is ‘not injective’ is you want to get technical). Even then, let’s say you just love probability so much that you do need a number. So this is how it goes- assuming the output has only nos. and lower case alphabets and you could do a million tries every second, then how long it would take someone-

    36 character in set
    64 number of characters
    1,000,000 attempts/second
    ~315,36,000 seconds/year

    ((36^64)/100000000)/31536000= 12,700,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000 years.

    So let’s just agree that it’s pretty secure. Hope this answers some of your questions, feel free to ask if you have more- we will try to find the answers together.

  • Privilege Banking Redefined

    Our idea of classic privilege banking is that the bank comes to the door-steps of the rich to deliver services. How would you react to the latest developments in financial inclusion where an agent comes to your door-step to deliver various financial services like credit, savings, RD, insurance, and other services like mobile, DTH recharge, rail/bus ticket bookings, payment of insurance premiums etc? And hold.. we are talking about these services in a rural backdrop, where ferrying to and from the branch would sometimes cost about the average ticket size of the transaction itself. (You should be surprised only if you don’t know about RBI’s BC initiatives). If you are not amused please proceed no further, because you will be just wasting your time 🙂
    In recent times RBI has made more concrete moves towards achieving financial inclusion, one of which is introducing the BC (business correspondent) model, for places where having brick-mortar branch is unviable for banks. RBI’s aim? – is to make banks reach places having a population above 2000. Banks appoint BC agencies/service providers in these areas, who on behalf of the bank provide these services in the hinterland. This development is in economic favour of banks too- estimates show that cost of a transaction at a typical bank branch costs the bank somewhere around Rs 60, and given the small average size of transaction in rural areas it becomes unfeasible for the bank to set-up a branch at these places. Going via the BC route the bank incurs a much lower cost per transaction. For the customer, he/she gets the service at his/her doorsteps without any branch visiting costs. So naturally, it looks to be a win-win situation for the bank as well as the customer (Having said that, we have to remember that banks are being told to do so. If they had their way it would’ve still been a long time before they reached these places, but that’s what regulators are for, isn’t it?).
    It sure looks like privilege banking being delivered to the bottom of the pyramid (long live Dr. Prahlad). Now, the people who make it possible- the BC service providers. It’s a market that is growing at a phenomenal rate, it already has quite a few players like FINO, Eko, ALW (Please don’t get me wrong- I’m not getting paid for this 😉 ). These players try to leverage technology to reduce the transaction costs, and the kind of technology they employ to make this happen is really impressive. Well, you might not find it as impressive if you haven’t been to any of the place where these services are being delivered; I mean it’s really a tough task to imagine its extent if you don’t have the first hand experience of being in an regular rural set-up at least once. The bouquet of services/products being offered through this model are already pretty much all the essentials, and its set to expand furthermore as these players try to leverage their existing infrastructure of agents & technology in place for maximum benefit. Seems finally something is happening somewhere..will it help invert the pyramid? Only time can answer that 🙂

  • Microfinance & the way forward…

    The term Microfinance refers to small-scale financial services- both credit & savings, provided to the poor in rural, semi-urban & urban areas. The service providers in this space are banks, insurance companies, agricultural & dairy co-operatives & MFI s (Micro Finance Institutions) etc.

    Since MFI s don’t have a banking license, they can’t take deposits which prevents them from offering the savings facility. So largely the savings facility in micro-finance is provided by banks only as of now. In fact in India microfinance is synonymous to micro-credit, the reason behind is that savings, micro-insurance etc comprise a very miniscule segment of the microfinance space here.

    Now what is the definition of a micro-loan?

    The Development & Regulation bill 2007 defines Microfinance loans as loans with amount not exceeding Rs 50,000 in aggregate per individual/enterprise. However, in practice most micro-loans are in the range of Rs 5000- Rs 20,000.

    How big is this market we are talking about?

    The microfinance sector and MFIs in India are estimated to have outstanding total  loans of Rs.16,000 crore to Rs.17,500 crore, and Rs.11,000 crore to Rs.12,000  crore,  respectively,  as  on  March  31,  2009.  The microfinance sector in India is fragmented – there are more than 3,000 MFIs,  NGOs,  and  NGO-MFIs,  of which  about  400  have active lending programmes. However the good thing is that the top 10 MFIs account for about 74% of the total outstanding.

    In the past the microfinance industry in India has witnessed astounding growth. One of the measures- the total loan amount outstanding has grown from Rs 1600 crore in March’06 to an impressive Rs 11,400 crore by March’09! (We hope it grows even faster going forward so as to fetch us all PGDM-DSF students at IFMR a worthy job 🙂 )

    Understanding MFI s Better-

    MFIs according to their lending model can broadly be classified under two heads- The ones lending as per the SHG(Self Help Groups) model & the ones lending as per the JLG( Joint Liability group) model. Now we will try to chalk out how these two models are different-   Under the SHG model the MFI lends to a group of 10-20 people( women essentially in the present Indian context). Under the SHG-bank linkage model, an NGO promotes a group and gets banks to extend loans to the group. Under the JLG model,  loans are extended to, and recovered  from, each member of the group  (unlike under  the SHG model, where the loan is extended to the group as a whole). The most  popular  JLG  models  are  the  Grameen  Bank  model (developed by Grameen Bank, Bangladesh) and the ASA model (developed by ASA, a leading Bangladesh-based NGO-MFI). Most of  the  large MFIs  in  India  follow a hybrid of  the group models. 

    The model of  lending  to  individuals  is similar  to  the  retail  loan financing model  of  banks.  In  India, MFIs  adopting  the  group-lending  models  extend  individual  loans  to  more  successful borrowers who have  completed a  few  loan  cycles as part of a group  (who have  relatively  large credit  requirements and good repayment track record). Corporates and cooperatives, typically dairy  farms  and  sugar  mills,  are  also  known  to  undertake
    microfinance  by  extending  credit  to  farmers;  this  helps  the companies  strengthen  their  procurement  and  distribution channels. 

    Now coming to the what I call the not-so-pleasant part of MFI operations 🙂 – the interest rates charged by these MFIs.

    MFIs  following  the JLG model charge  flat  interest rates of 12  to 18%  on  their  loans,  while MFIs  following  the  SHG model charge  18  to  24%   per  annum!!  based  on  the reducing  balance method.  In  addition  to  interest  rates,  some MFIs  also  charge  a  processing  fee  comprising  a  certain proportion  of  the  loan  amount  sanctioned,  at  the  time  of disbursement. I know we all couldn’t agree more on that these interest rates are bit too high for the poor people we are serving. But if I may take the liberty to leave the complete humanitarian point of view and draw your attention to the MFI as a business..like any other business ( remember this business about doing well by doing good 🙂 ) we should see that the cost of loan disbursements in the case of MFIs is higher than a bank, also the risk involved( as no collaterals) is also on the higher side. So we can’t just blame the MFIs for leaching on to the poor..afterall they are still doing some good work, and so no reason they should be deprived  of their credit, that they rightfully deserve.

    We know that this sector has grown multitudes in the past..so what does the future hold for MFIs?

    Well, the way I see it- taking SKS as the flag bearer of the industry ( I guess it’s not a vague assumption, after all it account for about 25% of loans outstanding alone!) – it’s cost-of-capital stands at 9.58%(sep’08), charges 23.6% in Andhra & 28% in other states!..it has a very healthy margin to operate in. Most if not all the MFIs are highly leveraged, now once SKS goes public for funds (which it plans to do in the current year) it will be able to de-leverage it’s financials considerably, bringing down the cost-of-capital. A reduction in cost of capital keeping other factors constant will surely provide the company a cushion in operations and profitability.

    Also, I expect that going forward the MFIs will get a banking license ( well not all, but I hope a few big ones do). That will be the turning point in terms of reducing CoC, and probably then only we can expect the MFIs to charge a lower interest rate from the people. Looking at the way banking system in India is regulated it’s very unlikely to happen any time soon, but that is what I think can bring about the next big revolution in the MF industry, and so I sincerely hope it does.

  • What is Financial Inclusion?

    Ok..so before I run out of my josh to blog let’s get something useful here 🙂

    So what is this ‘Financial Inclusion’ that the newspapers keep talking about?

    Financial Inclusion in simple words is the idea of providing banking services at very low costs to the poor. So now the next question comes that why has it become so important all of sudden that every bank is talking about it? Well largely the reason why every bank is talking about it is because their banker i.e RBI wants them to do so!  The reason behind  this move is again pretty simple- the ratio of number of current & savings a/c to adult population in our country is still low (it is .59 as per the last census data of 2000 & no of a/c as of 2004). The urban population has a fair access to banking services, and since providing them these services is more profitable even the banks prefer serving the urban population. Now some stats to substantiate what we are trying to say- only 39% of rural adult population has access to a/c as compared to 60% in urban areas. Still worse, only 14% of Indian adult population has a loan account with a bank which again for rural population is as low as 9.5%!

    Most of the commercial banks except for regional rural banks have stayed away from serving the rural population, the reason is quite apparent too- 44% of total deposits come from the top six metros! So, the grand daddy of all banks RBI steps in to tell them what they need to do in order to provide the poor in semi-urban & rural areas access to banking. Banks were told to offer ‘no-frills’ savings a/c to the poor and given targets to increase their number of accounts. There are many ways in which the RBI is trying to push the banks towards the goal of inclusion. It has relaxed the norms of KYC for a/c with deposits less than Rs. 50,000. Other important steps have been, allowing RRBs’( Regional Rural Banks) / Co-operative banks to sell Insurance and Financial Products, Relaxing norms for ATM, Kisan Credit cards etc. But the most significant thing that RBI is ‘banking’ on is technology! They are hoping things like mobile technology will help the banks to reduce their cost of providing the service, thereby making it a profitable proposition for them.

    Now what has prevented the banks from doing that in the past? I guess it’s not difficult to understand the high transaction cost incurred by the banks in providing these services to the poor. Also there is a limitation in providing cash access points. But it’s not that this sector can’t be serviced profitably. We have had organisations like Sewa Bank of Gujarat which have shown that providing services to this segment can also be profitable. Then the world third world also witnessed great microfinance revolution, which again reinforced the idea. The main motive is to relieve the under privileged from the clutches of moneylenders, pawn brokers etc (how successful we are in that attempt we ll see that later). Now the aim is to provide services like credit, insurance, health care/life insurance to this segment at an affordable cost so that they can also join the growth run that we are having. Probably only then we can boast of our GDP growth rates in real sense.

    Going forward I will try to touch upon what is microfinance and other related topics. My apologies for my myopic view on the topic, as it only talks about India. It is so because I intended to keep it that way 🙂 .