CBDCs and DeFi: opportunities for co-existing

By their nature, central bank digital currencies (CBDCs) are an antithesis of decentralization. However, CBDCs employ DeFi innovations, while decentralized financial systems might adopt CBDCs.

Central banks worldwide have established committees and initiated pilot projects to explore the issuance of CBDCs, aiming to digitize payment solutions. CBDCs are backed by a country’s central bank and powered by decentralized ledger technology or its hybrid models. According to the CBDC tracker, over 100 countries are currently considering issuing a CBDC and conducting proof of concepts, including the USA, China, Canada, EU states, Switzerland and the UK. In Sweden and China, CBDCs are already in pilot stages.

CBDC implementation

CBDC implementations can vary from country to country. For example, they may be distributed through commercial banks that issue and offer CBDC wallets. Transactions are made through a distributed ledger, which can also be a private blockchain, providing high speed and cryptographic protection. However, access to information about all money movements would be controlled by intermediaries.

Central banks are adopting different models of CBDC regulation: direct, indirect (two-tiered) and hybrid models. In the direct model, the central bank keeps a record of all transactions and balances. In the indirect model, the main role is played by commercial banks. They keep records, register users and create wallets, while the central bank only records wholesale transactions. In the hybrid model, the central bank and commercial banks share the responsibilities.

Wholesale CBDCs settle payments (including cross-border transfers) and wholesale transactions between financial institutions, while retail CBDCs are issued to the general public.

Why central banks are considering CBDCs

Faster and cheaper cross-border transactions. In conventional currency transactions processed through correspondent banks, users might experience long delays or reversed transactions involving the withholding of fees. The global acceptance of CBDCs can also solve the stable exchange medium issue.

Overall improved payment system

Wholesale CBDCs can automate cross-border transfers and connections between banks, while retail CBDCs can connect clients directly to central banks, eliminating the need for expensive infrastructure. Thus, they can enable automated settlement workflows for various applications, such as trade finance, distributing basic income, government fund traceability or escrow accounts. Also, CBDCs can provide remote access to banking services to more people, which can be essential for developing countries and hard-to-reach areas.

Control over taxes, money laundering and counterfeiting

A full transition to a cashless economy, as encouraged by the introduction of CBDCs, can improve the regulation of tax payments and reduce the share of the shadow economy. The central bank and other entities can receive transaction data, so taxes can be controlled automatically. Plus, CBDCs are immutable to counterfeiting due to crypto technology.

Still, multiple issues still need to be solved in implementing CBDCs, including regulatory concerns, since a cross-border payment via CBDC may come under greater scrutiny than a domestic payment. According to the CBDC risks-related paper issued by the World Economic Forum (WEF), there are also multiple security issues. They include the theft and loss of credentials, the potential of CBDC users with privileged roles, double-spending attacks and the threat of quantum computing for CBDC systems.

Possible use cases for synergy between DeFi and CBDCs

DeFi platforms, built on public blockchains and leveraging smart contracts, offer innovative financial solutions that can be transferred to the CBDC world, benefiting end users.

Scaling solutions. With potentially growing transaction demand, CBDCs might experience a scalability issue. To increase throughput, CBDCs could employ solutions like Polygon or ZK-rollups.

Lending and borrowing. CBDCs might aim to offer more accessible credits, just like DeFi platforms that equalized users with a cutting-edge approach to lending and borrowing. The spread of digital wallets could facilitate lending and borrowing in CBDC. Some CBDC-based projects could also harness DeF lending protocols for efficient ways to deliver services.

On-ramping. DeFi requires fiat onboarding. Stablecoins are popular on-ramps into the crypto world, allowing people to buy cryptocurrencies with fiat. However, stablecoins carry some risks, and CBDCs could potentially provide one more secure way to on-ramp into crypto. Plus, efficiency could be improved if a CBDC were designed to be used as an on-ramp. Currently, the on-ramping process includes utilizing a card network to connect with a brokerage layer. This process involves multiple systems and fees, which make it expensive and time-consuming. A CBDC could simplify the on-ramping process by providing a direct link between users and their central bank, allowing them to on-ramp with their own local currency.

Currently, both central banks and DeFi protocols are testing different synergy initiatives and working on potential collaborations. The Bank for International Settlements (BIS) has published a report for Project Mariana, a cross-border CBDC pilot program that leverages Curve’s AMM design. The report points out that AMMs could improve the processing of foreign exchange trading. As part of the examination, BIS launched an AMM exchange for wCBDCs on Ethereum’s Sepolia testnet that borrows its bonding curve from Curve v2.

According to PYMPTS, Ripple is working on a project for tokenized property, leveraging a DeFi lending protocol. DeFi developers are also starting to build projects integrating CBDCs, and that subject is being studied from the central banks’ side. For instance, potential for collaboration is discussed in a paper issued by BIS.

DeFi protocols could use CBDCs to improve their liquidity and security, while CBDCs could use DeFi protocols to increase their accessibility and innovation. However, privacy concerns, security risks and regulatory uncertainty still need to be addressed before DeFi and CBDCs can fruitfully collaborate.