How Would DeFi Be Affected by the Introduction of CBDCs

CBDC

The emergence of cryptocurrencies and blockchain technology today emphasizes even more our fundamental demand for faster transactions and access to basic financial services. In this essay, renowned DeFi & TradFi industry professionals outline their perspectives as they analyze CBDCs and how they can disrupt the emerging decentralised finance (DeFi) market.

What Impact Would CBDCs Have on DeFi?

Humanity’s systems of value exchange and transfer of assets have undergone a tremendous transformation over the past 200 years, going from barter to banknotes to Bitcoin. The emergence of cryptocurrencies and blockchain technology emphasizes fundamental demand for faster transactions and access to basic financial services. In this essay, renowned DeFi & TradFi industry professionals outline their perspectives as they analyze CBDCs and how they can disrupt the emerging decentralised finance (DeFi) market.

If the crypto market were a nation, it would have the fourth largest GDP in the world at its last all-time high of north of $3 trillion. Government engagement in the financial industry became inescapable due to the potential systemic repercussions and extensive benefits of decentralised finance.

With the release of the e-CNY (digital yuan) in April 2020, the People’s Bank of China became the first major economy in the world to test-run the eagerly awaited central bank digital currency (CBDC) in a hugely successful, if not particularly popular, pilot programme that included more than 25 million Chinese citizens. According to the Bank of International Settlements, since then, more than 90% of nations have started legislative initiatives to implement their own government-backed cryptocurrency (BIS).

Why have CBDCs Suddenly Become Necessary? What Exactly Are They?

CBDCs, or central bank digital currencies, are technically digital units of currency issued by the government of a sovereign country. They often make use of web-based technology platforms, such as blockchain technology. In essence, they are a digital (crypto) representation of a nation’s fiat currency or legal tender.

Among other things, a dramatic global reduction in the usage of cash for payments has coincided with the emergence of blockchain technology, cryptocurrencies, and decentralised finance.

The amount of cash transactions in the UK decreased by over 70% during one of the notable crypto boom phases, from 2013 to 2018, going from £20 billion in 2010 to £6 billion in 2022. The average Bitcoin trading volume on UK exchanges increased from £100,000 to £15.5 million during the same time frame.

In the upcoming years, this reduction in cash transactions is anticipated to worsen much more. Evidently, nations anticipate a continued fall in the use of hard currency, or paper money, as the mainstream adoption of cryptocurrencies increases (especially in developed economies).

In order to maintain their oversight function and sovereign authority over their separate financial jurisdictions, governments around the world have been thinking about ways to develop digital channels for the issuing of money and regulation of financial activities. And CBDCs offer the ideal entry point for government involvement in the emerging alternative – the blockchain industry.

CBDCs
CBDCs

CBDCs- Typical Attributes

CBDCs are still in the conceptual phase for the majority of nations today. This makes it quite challenging to comprehend just how each country would organize theirs. Additionally, it is anticipated that CBDCs will adopt various perspectives in terms of architecture, interoperability frameworks, and technology deployment procedures from one country to the next in light of variances in monetary policy and the global socioeconomic landscape.

But by extrapolating from nations that have successfully introduced their own digital currencies, such as the Bahamas (SAND Dollar), Nigeria (e-Naira), and China (Digital Yuan), we can pinpoint the following five essential qualities that set CBDCs apart from other types of cryptocurrencies.

Non-cash balances that are kept as a store of value and are utilized for payments through digital channels are referred to as a digital currency.

A specific sovereign geopolitical jurisdiction’s central bank or other monetary policy authority may issue and back legal money under its auspices.

Accessible to all users, both residents and non-residents, for the settlement of transactions and cross-border payments.

Users would need to furnish basic biodata to register and open an account either directly with the central bank or with authorized counterparties in order to get CBDCs.

Most CBDCs will be subject to monitoring and censorship by the government that issued them (s). Additionally, just like with TradFi bank accounts, users of CBDC risk having access to their holdings restricted or removed if they (beneficial holders) are discovered to be breaking specific rules.

What Are The Potential Locations Where CBDCs Might Impact DeFi?

Unsurprisingly, among blockchain maximalists and stakeholders worldwide, the emergence of CBDCs has caused ideological conflict.

Some ardent DeFi supporters, like Vitalik Buterin, view government involvement in the form of CBDCs as a welcome development that would give the DeFi world some credence, legitimacy, and sanity. Others, like Edward Snowden, have called them “cryptofascist currencies that would annihilate savings of the average worker.” The creator of Ethereum demonstrated his support for CBDCs in 2020 when he tweeted about potential applications if governments can make CBDCs transparent and interoperable within the context of already-existing blockchain networks.

The heated discussions about the dangers of stifling regulatory oversight, censorship, and centralization, which are in direct opposition to the fundamental principles of decentralised finance, as well as the potential effects of CBDCs on the long-term viability of current DeFi protocols, have not, however, been stopped.

Therefore, it is essential that we examine the potential areas of synergy and dissonance between CBDCs and DeFi in order to fairly assess the merits of both arguments. These crucial areas comprise;

Stablecoins

On- & Off-Ramping

DeFi Investing & Yield Farming

Security & Privacy

Web3 Talent

1.Impact of CBDCs on Stablecoins

Any system of value generation and exchange needs a widely recognized “unit of account” to function effectively. Stablecoins have previously served as the “unit of account” in decentralised finance, much like fiats do in the stock market and money markets. Essentially, this function enables users and investors to efficiently switch between various digital assets without having to exit into currency. The element of price stability and a standard for comparison are also provided by units of account for the financial goods and services offered on the blockchain.

Basically, payments and remittances, volatility hedging, and on- and off-ramping are the three main use cases for stablecoins in DeFi. As they often try to duplicate these roles, CBDCs could disrupt any of them to variable degrees.

2. CBDCs’ effects on on- and off-Ramping

One major factor that has held down the global adoption of cryptocurrency and DeFi products is the lack of on-/off-ramping techniques. Stablecoins currently provide as a simple on-ramp into the cryptocurrency ecosystem as well as an off-ramp back into desired fiat currencies for many new users. They provide transactional ease because to their use of well-known fiat currency.

For customers in other countries across the world who do not have any stablecoins denominated in their local currencies, this creates transactional bottlenecks because the popular stablecoins are only denominated in a few fiat currencies, such as the USD, EURO, SGD, WON, etc. The current on/off ramping techniques in DeFi could then be seriously disrupted by the advent of CBDCs in many nations.

3. Effects of CBDCs on DeFi Investing and Yield Farming

The blockchain industry has quickly expanded into a multi-sector industry. Yield farming is by far the most valuable industry inside DeFi, with approximately $100B total value locked in various DeFi protocols, claims DeFiLlama, a major blockchain analytics platform.

Users of decentralised finance (DeFi) networks can maximize earnings on their digital assets through the new technique of yield farming. In order to borrow or lend cryptocurrency in order to generate passive income, individuals actually deploy their assets on platforms like Maker, COMP, etc.

CBDCs must provide some level of utility and interoperability within the current blockchain infrastructure in order to disrupt this mostly decentralised market of distinctive financial products and passive income prospects from yield farming.

4. CBDCs’ Effects on DeFI’s Security, Privacy, and Censorship

Central banks and regulators should be able to enforce tight KYC criteria and transactional limits thanks to the architectural and functional design of a CBDC.

These transaction restrictions may be based on arbitrary decisions made by autocratic governments or macroprudential rules outlined in the constitution, such as those addressing money laundering and the funding of terrorism.

In contrast, the data produced by CBDCs would also provide new levels of transparency and fraud protection since all transactions are traceable and verifiable with distributed ledger technology. This would make it simpler to monitor retail transactions and identify odd payment patterns.

Decentralized finance is currently facing criticism for its security flaws and lack of legal redress against bad actors, such as hackers, proprietary trading, over-leveraged trading, and other instances of unethical fund management through DeFi protocols.

Blockchain users may have to choose between DeFi’s anti-censorship and privacy features and the appearance of safety that CBDCs may provide.

5. The Effect of CBCDs on the Struggle for Web3 Talent

Although less talked upon, the rivalry for elite Web3 talent is an important area where the adoption of CBDCs by central banks may effect DeFi.

The skill pool for Web 3.0 is rather modest when compared to the traditional tech sector. In the final months of 2021, about 3,000 new developers joined Web3, according to a report created by Electric Capital, while Consensys, a well-known platform for web3 developer tools, revealed that just over 350,000 developers used its proprietary blockchain development infrastructure, called Infura.

The decentralised and pervasive nature of the blockchain makes it challenging to gather trustworthy headcount data on the current population of Web3 developers. According to on-chain data, there are fewer than 1 million Web3 developers worldwide.

Central banks need to entice a sizeable number of top-notch Web3 developers in order to build up, deploy, and sustain their various kinds of digital currencies. In order to do this, they will need to directly compete with other DeFi platforms for the best Web3 talent.

Final Thoughts

If there is one thing that all participants in the financial sector, including banks, regulators, DeFi businesses, and consumers agree on, it’s that the current financial system needs to be more effective, inclusive, and affordable, said anchor Julia Chatterley earlier this year during the CBDC panel discussion at the World Economic Forum in Davos.

We are all aware of how technology, such as CBDCs, has the power to transform payments and the global financial system. It will be interesting to observe how governments deploy digital currencies without unintentionally driving innovation out of the DeFi market or restricting it altogether.

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