How Would the Introduction of CBDCs Affect DeFi?

After nearly a decade on the sidelines, governments, led by their apex banks, are now preparing to plunge into the blockchain space with central bank-issued digital currencies.

From barter to banknotes and now to Bitcoin, humanity’s systems of value exchange and transfer of assets have been dramatically transformed over the past two centuries. Today, the advent of cryptocurrencies and blockchain technology further underlines our innate need to carry out transactions and access essential financial services ever more efficiently.

This article dissects CBDCs and how they could disrupt the nascent world of decentralized finance (DeFi) — while highlighting the positions of notable DeFi & TradFi industry experts.

What is a CBDC and why have they suddenly become necessary?

In technical terms, CBDCs — central bank digital currencies — are digital units of money issued by the government of a sovereign country, typically leveraging the use of web-based technology systems i.e. blockchain technology. They are essentially a digital (crypto) version of a country’s fiat money or legal tender.

Amid other factors, the rise in the popularity of blockchain technology, cryptocurrencies and decentralized finance has coincided with a sharp global decline in the use of cash for payments globally.

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This decline in cash transactions is expected to be exacerbated even further in the coming years.  Evidently, as the mainstream adoption of cryptocurrencies grows (especially in developed economies), countries are anticipating further decline in the use of physical cash, or paper money.

Consequently, governments around the world have been contemplating ways to create digital channels for issuance of money and regulation of financial transactions in order to retain their supervisory role and sovereign control of their respective financial jurisdictions. And CBDCs present the perfect in-route for government participation in the nascent alternative — the blockchain space.

CBDCs: common characteristics

For most countries today, CBDCs remain at the ideation stage. This makes it quite difficult to understand exactly how every nation would structure theirs. And, if monetary policy variations and global socio-economic landscape is anything to go by, it is expected that CBDCs too, will take on different outlooks in terms of design, interoperability framework and technological deployment mechanisms from one country to another.

However, drawing inferences from countries like the Bahamas (SAND Dollar), Nigeria (e-Naira) and China (Digital Yuan), who have successfully launched their own digital currencies, we can identify the following five crucial characteristics that differentiate CBDCs from other forms of cryptocurrencies.

• A digital currency — non-cash balances, recorded as a store of value and used for payments across digital channels.
• Legal tender — issued and backed by the central bank and/or monetary policy authority within a given sovereign geo-political jurisdiction.
• Universally accessible — accessible to users, i.e residents & non-residents, for cross-border payments and settlement of transactions.
• Registration & KYC — to obtain CBDCs, users would have to provide basic bio-data to register and open an account either directly with the central bank or authorized counterparties.
• Surveillance & Censorship —most CBDCs will be subject to monitoring & censorship by the issuing government(s). And similar to TradFi bank accounts, CBDC users may have access to their balances restricted, or withdrawn where they (beneficial holders) are found to be in infringement of certain laws.

What are the areas that CBDCs could affect DeFi?

Unsurprisingly, the introduction of CBDCs has led to ideological dissonance among blockchain maximalists and stakeholders around the world .

Hence, to objectively weigh the merits of both arguments, it is crucial that we analyze the areas of potential synergy and dissonance between CBDCs and DeFi. These key areas include;

• Stablecoins
• On- & Off-Ramping
• DeFi Investing & Yield Farming
• Security & Privacy
• Talent Attraction

1. Impact of CBDCs on Stablecoins

For any system of value creation and exchange to thrive, there must be a universally accepted “unit of account.” And up until now, stablecoins have played the “unit of account” role in decentralized finance, similar to the role that fiats play in the stock exchange and money markets. Essentially, this role allows investors and users to switch and swap efficiently between different digital assets without having to off-ramp back into fiat. Units of account also provide the element of price stability and a reference point of benchmark for financial products and services rendered on the blockchain.

Basically, stablecoins have three broad use cases in DeFi: payments and remittances, volatility hedging and on- and off-ramping. CBDCs could disrupt each of them to varying degrees, as they generally would seek to mirror these roles. Let’s have a look.

1. Payments:

By offering instant settlement at near-zero remittance costs, stablecoins have increasingly become a widely adopted medium of payment in International trade.

While some countries like El Salvador and Central African are embracing the use of cryptocurrencies i.e. Bitcoin, most nations around the world are reluctant to relinquish their monetary sovereignty, hence the accelerated introduction of a domestic digital currency to mirror,  replace or rival the role currently played by stablecoins in the crypto economy.

“What has been termed by international organizations as “The Bitcoin Experiment”, is nothing more than the world watching how mass adoption changes a country's economy.” — Nayib Bukele, President, El-Salvador.

“The current monetary sovereignty argument for central bank digital currencies (CBDCs) is that without them, private and foreign digital monies could displace domestic currencies — a process called currency substitution.” — Bank of Canada

VERDICTS

In terms of efficient payments & remittances, CBDCs will offer stiff competition to stablecoins in the following areas;

• Reduction in demand for stablecoins — If CBDCs offer some of the core properties of stablecoins, such as ubiquity, security, on-chain validation of payments with instant settlement, they could negatively impact the demand for stablecoins in terms of international payments.
• Reduced domination of the U.S. dollar — Today, stablecoins are only available in only a handful of fiat currencies, with the U.S. dollar dominating the stablecoin market offering by well-over 90%. All of the top 10 ranking stablecoins by market capitalization are denominated in U.S. dollars (USD).

The introduction of CBDCs could potentially cause a major disruption in this regard. With 90% of countries, including large economies like China and the EU launching on-chain government-backed digital currencies, we could witness a significant reduction in the dollar-domination of the stablecoin market.

2. Volatility Edge

Another key function of stablecoins is to serve as neutral vehicles for users to shelter their on-chain assets against volatility. In spite of the significant growth in adoption, the public perception on the reliability of stablecoins has come under intense scrutiny in recent times.

VERDICT

• Reduction stablecoin dominance on the global crypto market cap

With national deposit Insurance, tax incentives and other monetary policy incentives, CBDCs could offer better stability & reliability to users, especially for institutional investors who invest high-volume on-chain assets. This could lead to a drop in the circulating capital of prominent stablecoins.

2. Impact of CBDCs — on-/off-famping

The dearth of on-/off-ramping methods is a key factor that has slowed down the mainstream adoption of cryptocurrencies and DeFi products globally. Today, stablecoins currently serve as the easy route for many new users on-ramp into the crypto world and also off-ramp back into desired fiat currencies. Since they are denominated in familiar fiat-currencies, they offer transactional simplicity.

However, due to the fact that the prominent stablecoins are denominated in only a few fiat currencies, such as the USD, EURO, SGD, WON, etc., it creates transactional bottlenecks for users in other countries around the world, who do not have any stablecoins denominated their local currencies. The introduction of CBDCs in many countries could then significantly disrupt the current on/off ramping methods in DeFi.

VERDICTS

With the introduction of CBDCs, residents of such countries will now have an effective and reliable on-/off-ramp route, thereby boosting retail and institutional participation in DeFi within those regions.

3. Impact CBDCs on Yield Farming & DeFi Investing

Yield farming is a novel process that allows users of decentralized finance (DeFi) platforms to maximize returns on their digital assets. In practice, users deploy their assets on platforms like Maker, COMP etc. to lend or borrow crypto assets in a bid to earn passive income.

For CBDCs to disrupt this largely decentralized world of unique financial products and passive income opportunities from yield farming, they must offer some level of utility and Interoperability within the existing blockchain infrastructure.

• VERDICTS
  

Limited interoperability & composability could forestall impact of CBDCs on yield farming

CBDCs are going to disrupt the crypto world to a significant degree; however, the level of utility of these on-chain government backed currencies are still very much up for debate.

Yield farming requires a high-level of agility in the infrastructure of crypto assets. To maximize yield, users need to be able to move their assets efficiently and securely between different DeFi protocols.

With indications given by central banks, it is obvious that governments face a trade-off trilemma when it comes to their active involvement in the blockchain space. These trade-offs include macroprudential control, interoperability and utility.

This design trade-off essentially means that governments have to choose between having CBDCs achieve a significant degree of penetration in the yield farming sector, or maintaining 100% sovereign monetary controls by attempting to localize the functionalities of digital currencies in a largely ubiquitous world of CBDCs.

Yield farming protocols may take a hit if governments successfully digitize bond markets

Some people speculate that CBDCs are only the first step of full-scale government participation in the blockchain space. The introduction of CBDCs effectively clears the coast for the digitization of bond markets, where governments may trade bonds and treasury bills on the blockchain.

Since government-backed assets generally offer a more reliable and yield-bearing option — especially for large institutional investors — a transparent, instant and liquid bond market that is open 24/7 would pose serious competition to existing yield farming strategies.

4. Impact of CBDCs on Security, Privacy & Censorship in DeFI

The architectural and functional design of a CBDC is expected to allow central banks and regulators to impose stringent KYC requirements and transactional restrictions.

These transaction limits can range from constitutional macroprudential standards, including anti-money-laundering and anti-terrorism financing, to arbitrary rulings by autocratic regimes.

Conversely, since all transactions are traceable and verifiable with distributed ledger technology, the data generated by CBDCs would also offer new levels of transparency and fraud prevention — making it easier to monitor retail transactions and detect unusual payment patterns.

Some of the biggest criticisms of decentralized finance today include: security vulnerability and non-existent mechanism for legal recourse against bad actors, i.e. hacks, proprietary trading, over-leveraged trading and other forms of unethical fund management by DeFi protocols.

Blockchain users could face a tradeoff between the semblance of safety that CBDCs could offer and the anti-censorship & privacy of DeFi.

Verdicts

CBDCs & crypto regulatory clarity may encourage institutional participants & risk-averse retail users to dump DeFi

In addition to the introduction of CBDCs, many governments around the world are simultaneously working on standardized laws to provide regulatory clarity on cryptocurrencies.

These laws seek to distinguish between pure utility tokens and tokens that function as securities in a bid to create a standard mechanism to enforce compliance and corporate governance in the blockchain markets.

The catastrophic capitulation of centrally-controlled “CeFi” platforms that act as DeFi liquidity providers —  like Celcius, Voyager and 3AC in the wake of the TerraUST crash, further highlighted these gaping flaws. Many users have now had to turn to traditional legal frameworks to gain some recourse against the founders and top execs of these platforms.

This could impact the demand for DeFi products among institutional participants and retail users who are risk-averse — causing them to gravitate towards CBDCs and other forms of legally-backed and secure on-chain assets.

Privacy & censorship concerns may limit the adoption of CBDCs by retail users

Transactional restrictions and KYC requirements are two distinct design features of CBDCs — and these features are antithetical to the premise behind the creation of cryptocurrencies as outlined by the famed Satoshi Nakamoto in the original Bitcoin whitepaper.

This censorship could see many retail users, i.e. Bitcoin maximalists, completely eschewing the use of CBDCs. Even when they use CBCDs for efficient on-ramping and local retail payments, most privacy-sensitive users may choose to dump CBDCs and turn to censorship resistant DeFi assets when it comes to long-term day–to-day usage, such as high-volume savings and investing or cross-border payments.

5. Impact of CBCDs on the Competition for Web3 Talent

Though less discussed, another crucial area how the introduction of CBDCs by central banks may affect DeFi is the competition for top Web3 talent.

Due to the decentralized and ubiquitous nature of the blockchain, it is quite difficult to obtain reliable headcount data on the number of Web3 developers today. On-chain data suggests that there are less than 1 million Web3 developers globally.

To build out, deploy and sustain their various versions of digital currencies, central banks must attract an appreciable quantity of top quality Web3 developers. And to achieve this, they will have to compete head-to-head with existing DeFi platforms for top Web3 talent.

VERDICTS

Budget restrictions may hamper govt’s capability to attract top talent

CBDCs, like most publicly-funded projects, are subject to bureaucracy and budgetary constraints.  Globally, the public-sector has the reputation of paying significantly less wages than the private sector. Hence, this could hamper the ability of governments to attract the best talent to build-out and run their digital currency projects.

Low job stability in DeFi may see top developers turn to public sector

This reputation of job instability in the private Web3 sector could see many top talents turn to the public sector to work on CBDC projects in their respective countries.

Web3 devs’ preference for the gig economy, national security precautions may further limit central banks ability to attract talent.

Financial sovereignty is one of the major premises behind the creation of CBDCs. Therefore, the development of digital currency projects would have national security implications. Consequently, central banks may be reluctant to employ non-citizens or allow employees work remotely on sensitive government-funded projects such as CBDC.

Web3 is notably the most remote-friendly industrial sub-sector globally. The decentralized ethos in blockchain and the cryptocurrency industry means that remote work, individualized schedules and geographical flexibility are the norm — it would be difficult for central banks to offer these perks while maintaining the goal of minimizing national financial stability, macroprudential and espionage risks.

Potential Areas of Synergy Between CBDCs and DeFi

While experts on both sides of the TradFi-DeFi divide continue twittering about their differences, it is not all discord between CDCDs and DeFi. It is important to note that CBDCs and DeFi have some crucial areas of synergy where government participation could positively impact the blockchain industry, leading to a win-win situation for both sides.

• Financial inclusion & crypto literacy — A key observation in the few CBDC pilot programs in China, Bahamas and Nigeria is that CBDCs are widely advertised on national media channels. As a result, global roll-out of CBDCs could indirectly improve crypto literacy by raising public awareness about cryptocurrencies and blockchain technology globally. Likewise, the synergy between TradFi and DeFi through CBDCs could significantly improve financial inclusion.
• Instant payment settlements — Today, cross border transactions take between 2-10 working days, while settlement between institutions may take even longer. The introduction of CBDCs could see the accelerated application of blockchain technology to crossborder & international trade standards, leading to more efficient transactions and lower fees, and increased ease of doing business across the board.
• Easy on-ramping & off-ramping —  CBDCs will bring down barriers to entry into the blockchain space in many countries by easing the on-ramping/off-ramping process. The introduction of CBDCs could mean that people are now able to on-ramp with their own local currencies with better efficiency, compared to complex international card transactions which are often declined or cost huge transaction fees.
• Anti-fraud & security — Active participation of national & regional governments in DeFi will finally remove the wild-wild-west tag that has become synonymous with DeFi since its inception — and directly signal to hackers and bad actors that it is no longer business as usual. In 2022 alone, over $1B has been stolen by hackers from various DeFi protocols. Government participation through CBDCs could help bring an element of authority and recourse into DeFi which could ultimately reduce the incidence of exploits .

Final thoughts

We all recognize that technology like CBDCs have the potential to reshape the global financial system and revolutionize payments. It will be interesting to see how governments implement digital currencies without inadvertently crowding-out or stifling innovation in the DeFi sector.