CBDC and DeFi for the Masses

The race to implement CBDCs is on. Central Banks around the world have setup dedicated committees and kicked off pilots to explore how this technology can be used issue legal tender digitally. These countries hope to usher in a new era of payments and fintech solutions.

For the uninitiated, Central Bank Digital Currencies or CBDC for short is a digital currency that is issued by the Central Bank of a country.  Like Bitcoin, Ethereum and other cryptocurrencies, these are digital assets, which are not backed by a physical asset like gold or fiat currency. However, unlike Bitcoin or Ethereum,CBDCs are backed by a Central Bank. For all intents and purposes, they maybe considered to be at par with the fiat currency issued by the Central Bank.In most cases CBDCs are implemented or are being implemented using Blockchain Technology.

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Central Bankers believe that issuing their legal tender in the digitized form as a CBDC would allow them to build the next evolution of their fintech and payments ecosystem. Some of the important ideas being discussed are as follows  –

1. Leveraging smart contracts to build automated or semi-automated settlement workflows. These are contracts where legal clauses are written as computer code and recorded immutably on a blockchain ledger. Such automations can have multiple applications such as –
   1. Faster and easier Open account and LC trade finance settlement
   2. Traceability of government funds
   3. Enabling low-costescrow accounts for small businesses and individuals
   4. Automating medical insurance premium collection and claims settlement, etc.
2. Traceability of transactions to ensure last mile delivery for government schemes and benefits. Low reconciliation cost across central and state governments owing to the triple accounting feature of blockchain.
3. Efficient, low cost and faster cross border remittances and domestic payments.

Since 2020, many countries have built and deployed CBDC projects. Below are some of the more notable ones –

1. Sand dollar (Bahamas), Bakong (Cambodia) and JAM-DEX(Jamaica) CBDC projects have been released to the general public with great success. Currently they are being used by more than 50% of the residents of these countries. These CBDCs can be spent across major retail outlets. The Bakong is also available for Cross Border Remittance with Malaysia’s MAE app.
2. India launched the Digital Rupee (e₹) pilot in Dec 2023. Presently the option to pay with Digital rupee is available in select cities and at select retail outlets. The retail outlets include a prominent Indian grocery chain. India also announced a partnership with UAE to pilot the Digital Rupee for cross border remittances. Apart from retail applications, India is also exploring a wholesale CBDC model with select banks for settling government securities.
3. China launched the Digital Renminbi(eCNY, also known as the Digital Yuan) on August 2021. Since then, the currency has been undergoing public testing within 20+ major Chinese cities. The currency was available to athletes and visitors during the 2022 Winter Olympics. It will also be used during the 2022 Asian Games, which is scheduled to start on 23 Sept 2023. eCNY is also integrated with WeChat and can be spent across major retailers in China.
4. Singapore(Project Ubin), Canada (Jasper), France, United States, UK are in advanced sandboxing and research stage and are expected to launch their CBDC soon.

As CBDCs become prominent and accessible to more users, it is important to evaluate what innovative solutions can be built to benefit the end consumer using this technology. For this we may look no further than the popular DeFi platforms of the day.

DeFi or Decentralized Finance apps are financial platforms built on public blockchains. The core value proposition of such platforms is that unlike traditional finance, the funds are not held by a centralized entity and are in the control of the users. This is owing to them prioritizing decentralization by building on public blockchain and leveraging smart contacts. The underlying assets for such platforms are generally cryptocurrencies like Bitcoin. Ethereum, or crypto tokens like Aave, Maker, WETH, WBTC or stablecoins like USDT, DAI, USDC etc.

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There are several use cases implemented by DeFI that can be readily transferred over to the CBDC world with benefits for the end customer. Some of these are –

1. Debt refinancing – The DeFi world offers users the service of flash loans. A flash loan is an uncollaterized loan that has to be paid back within the same blockchain transaction. Such a transaction can be used to transfer liability from one lender to the other within seconds. if the borrower is unhappy with the services provided or fees charged by the first lender within seconds, he or she can move their liability to a new lender. In the traditional finance world, such a feature would prevent lock in and allow borrowers to move across lenders to get the best service and rates in the market.
2. Better Debt Securities – Staking is the process of keeping your cryptocurrency locked in a smart contract for a time period. In return, users are rewarded proportional to the amount and staking period, in crypto. Staked assets can be viewed at any time by any user on the blockchain. In the traditional finance world, staking infrastructure can help us create more transparent and secure debt securities and avoid credit defaults.
3. Insurance –DeFi insurance companies protect users from events that negatively effect their crypto assets. Such events could be protocol failures, smart contract hacks or other on chain risks. To claim the insured amount, users submit a proof of loss and their claims are settled on chain in a matter of days. A similar simplified and semi-automated workflow can greatly reduce the hassles and paperwork that the average insurance consumer must go through today for getting a claim approved.
4. Access to Credit – Access to credit can be difficult for lenders. Typically a borrower has to go through a cumbersome process where various financial and non-financial details are collected and a credit risk assessment is done before approving a loan. DeFI allows you to borrow a crypto asset by providing collateral in another crypto asset. The protocol maintains a ratio between the value of the borrowed asset and the collateral. In case the ratio exceeds a pre-agreed value, a portion of the collateral is liquidated by the lender to recover the cost. A similar smart contract based lending platform can be created with CBDCs to provide faster access to credit for SMEs or individuals
5. Globally accepted currency – Stablecoins can be said to be similar to CBDCs, in the sense that they both have a stable value because pegged to a popular fiat currency like US Dollar. However unlike CBDC, stablecoins are issued by private institutions and are often backed by Bitcoin, Government Securities or US dollar. Stablecoins are popular as a medium of exchange in the DeFI world given their low volatility. CBDCs could replace stablecoins once they are more widely accepted. Traditional finance use cases include faster and cheaper cross border remittances, acceptance as a legal tender for payments globally, faster merchant settlements for eCommerce, enabling payroll for global remote workforces, etc.

These are just some of the examples of the impact CBDC and DeFI would have once they mature further. We are entering a brave new world and we can expect these technologies to positively impact how we run our businesses, how we work and how we live in the coming decades.

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[To share your insights with us, please write to sghosh@martechseries.com]