The Significance of CBDCs in DeFi
Fusing Central Bank Digital Currencies and DeFi to Create a New Paradigm in Finance
Disclaimer: This article is written by human. To verify it yourself, visit here
Note: Thanks to the DeFi Talents, a 18-week mentoring program to empower talent for leadership in the decentralized finance space.
Introduction
Overview of CBDCs and DeFi
Let’s first understand the size of the market that we are trying to explore here, which gives a good perspective to the content ahead.
If we combine all types of “Money” in common terms, as represented by M2 in the image below, is around $125 Trillion. This includes M0 and M1 which is physical cash and money in current + savings accounts. Therefore the scope of Central Bank Digital Currency is less than 5% of the money market.
So what is CBDC? Central Bank Digital Currency (CBDC) is a digital form of currency notes issued by a central bank. While most central banks across the globe are exploring the issuance of CBDC, the key motivations for its issuance are specific to each country’s unique requirements.
Money either has intrinsic value or represents title to commodities that have intrinsic value or title to other debt instruments. In modern economies, currency is a form of money that is issued exclusively by the sovereign or a central bank as its representative and is legal tender. Paper currency is one such representative money, and it is essentially a debt instrument. It is a liability of the issuing central bank and sovereign as well as an asset of the holding public.
Importance of CBDCs in the Modern Financial Landscape
Recent innovations in technology-based payments solutions have led central banks around the globe to explore the potential benefits and risks of issuing a CBDC so as to maintain the continuum with the current trend in innovations. Through this, the target is to achieve price stability, which is missing around cryptocurrencies, and at the same time to safeguard public trust in money and ensure safe and resilient payment systems and infrastructure. Stablecoins have tried to bring some of these features into the digital asset world but these are pegged to one or more fiat currencies and offered by private entities. More on that here.
Understanding Central Bank Digital Currencies (CBDCs)
How does it work?
It is not easy to explain in simple terms, how CBDCs work without understanding how the existing cash flow works. If we compare them side by side, the intermediaries play a crucial role in all banking services for the end user. It becomes more complex if the money transfer is between two different fiat currencies. With the introduction of CBDCs, the central banks issue the digital currency either directly to the end user or to the intermediary banks which is held in digtial wallets on the end user devices.
Multiple solutions are being explored in this space which boils down to three types of CBDCs. Retail, wholesale and hybrid. What works best is yet to be determined and also depends on the requirements that are being scoped by each country. It is yet to be seen, what possibly emerges as a pattern.
Advantages and Challenges of CBDC Adoption
Regardless of which variant is implemented, it is very clear that the most obvious advantage that comes with CBDC is efficiency, both in terms of time and cost.
Supporting micro payments with CBDC will greatly enhance ease of transactions in developing economies.
At the same time, it is unclear at this stage regarding the technology use if smart contract should be part of the arhcitecture. CBDCs is likely to be used to provide functionality such as programmability, which could facilitate conditional and automated payments in potential use cases like delivery vs payment, machine-to-machine payments between consumer devices, or for industrial automation.
Decentralized Finance (DeFi) Explained
Decentralized Finance (DeFi) is a new financial paradigm that leverages distributed ledger technologies to offer services such as lending, investing, or exchanging digital assets without relying on a traditional centralized intermediary.
Many DeFi Protocols implement these features using smart contracts which include the logic that works in the traditional finance. Ethereum is by far the most popular protocol in the DeFi world, though other protocols are trying to catch up.
DeFi’s Role in Transforming Traditional Finance
Decentralized Finance is a very interesting development in the finance world. With the market size what we saw at the beginning of this article, DeFi has a huge role to play in the different types of financial instruments.
With more decentralization in the implementation layers at the bottom of the stack enables liquidity provision with Automated Market Makers in pace of Order book. The centralized elements on the top layers as application service providers should cooridinate very well to enhance trust in the ecosystem and further adoption from the traditional finance.
The Synergy of CBDCs and DeFi
Recognizing Complementary Aspects
With the advantages of the Distributed Ledger Technology, it is only a matter of time to bring it to the mainstream. With emphasis to digitalization all around the world, we will see more innovation that addresses the pitfalls in the existing finance and stabilize the new paradigm. While CBDCs can bring the technological advantages to the FX and cash, DeFi brings the decentralized version of financial instruments as in lending, borrowing, staking and derivatives thereafter. Multiple projects are being explored in both the areas like Polaris, Mariana, Rosalind are in in progress and more can be read about them here.
Benefits of CBDC-DeFi Integration for Users and Institutions
As of August 2023, the crypto market as a whole is still around $1.2 Trillion. The uncertain events in the past have shaken the trust in the ecosystem whereas the underlying technology has a lot to offer. To rebuild the trust and increase mainstream adoption, CBDCs can play a crucial role.
Users benefit from the advantages of the technology as it simplifies financial transactions in multiple avenues. Institutions who are involved in the technology innovation can contribute and adopt to the change simultaneously to bring in a new breed of institutions without the beurocracy of multiple layers of intermediaries.
Risks, Regulation, and Future Prospects
Potential Risks and Mitigation Strategies
Like any new technological innovation, DeFi and CBDCs face risks in multiple areas.
To put in simple terms, Risk is a function of threats and vulnerabilities with a probability of occurring, resulting in some form of impact.
Technology risks — the risk that any technology failure will disrupt an entity’s business or operations. The DeFi technology and the underlying protocols are still under development.
Operational risks — the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. Decenralized projects and DAOs are still very immature in terms of governance and operations.
Reputational risks — the risk of reputational damage to an entity when it fails to meet the expectations of its stakeholders and this is negatively perceived. This could be the most damaging for the trusted entities like central banks.
Fraud is inherent in all payment systems, despite real-time (or near real-time) risk analysis. Offline payments cannot benefit from real-time risk monitoring and analysis and must adopt alternative measures.
Both DeFi and CBDC systems use new technologies, some of which are as yet unproven at the scale and critical operations demands that would be required, and therefore could introduce new security and operational risks.
Enhancing Regulatory Frameworks for CBDC-DeFi Integration
Bringing transparency to the ecosystem, by publishing details of the participants of the ecosystem (like the exchanges, payment systems, protocols and all other service providers) can be very crucial. As more regulatory bodies include these financial instruments as part of their purview, it opens the door for more startups to build around the regulatory framework of each region. As the regions collaborate to bring in similar regulation around DeFi, digital assets and tokenization, a more global nature of compliance is expected to develop over time.
Conclusion
The world has come a long way in terms of technology to make DeFi a success. It is a matter of time and priority to see further progress in this area which depends on each of us who can contribute. The tremendous advantages of mass adoption with introduction of CBDCs is undeniable. The society at large needs to build trust and stay hopeful but cautious in the innovation journey.
