What Does CBDC Mean for DeFi and Stablecoins

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Permissionless stablecoins and finance face an existential danger from central bank-issued digital currencies (CBDC)

The story of central bank digital currencies (CBDCs) has progressed significantly in the last year. CBDCs have progressed from a mostly theoretical debate to different levels of research and development to determine how they may operate in practice.

The digital yuan of China presently leads the pack. The Chinese government plans to roll out the CBDC to a population of over a billion people in 2022, following various trials. While no other country has yet attained the same level of CBDC development as the United States, the country has made significant progress. G7 finance ministers recently met and agreed on certain defining elements for CBDCs. However, some of the most notable outcomes have come from Asian countries outside of China.

In Hong Kong, Charles d’Haussy is a managing director of ConsenSys. This op-ed is part of CoinDesk‘s “Policy Week,” a discussion of how authorities are dealing with cryptocurrency (and vice versa).

The Hong Kong Monetary Authority (HKMA) and its coordinated efforts deserve special mention. The HKMA has been looking at the possibility of a CBDC since 2017. The first project, named Project LionRock, looked at the idea of a “wholesale” CBDC, a digital currency for interbank settlement.

It has teamed up with the Bank of Thailand to research CBDCs for cross-border payments by 2019. Following the involvement of the Central Bank of the United Arab Emirates, the People’s Bank of China’s Digital Currency Institute, and the Bank for International Settlements (BIS), the partnership began a new phase to construct a multiple CBDC bridge termed mBridge.

The most recent discovery, on the other hand, has the potential to have the greatest influence on the status quo. CBDCs, in particular, pose a serious danger to the permissionless financing to which crypto has become used.

An invitation to consult on a CBDC for retail

The HKMA issued a CBDC white paper in early October, seeking comments from experts in monetary policy, banking, and distributed ledger technology on the possibility of an electronic Hong Kong dollar (e-HKD).

Many problems are raised in the study, including how monetary responsibility will be shared between central banks and the financial sector. But there’s enough more to chew on for those of us in the blockchain and cryptocurrency communities.

While the article seems unconcerned with the technological infrastructure required for a CBDC, it does solicit feedback on seven “issue statements.” Privacy, interoperability, scalability, and performance are among them, as are cybersecurity, compliance, operational robustness and resilience, and a retail CBDC’s technology-enabled functional capabilities.

A well-known group of mysteries

Any company or group considering deploying blockchain or decentralized ledger technology has been confronted with any or all of these concerns. Finally, the question is whether the advantages of a permissionless, open, and decentralized public network like Ethereum outweigh the disadvantages. Is it possible that a permissioned implementation would be preferable?

The decision between permissioned and permissionless ledgers has far-reaching repercussions in the context of CBDCs. Providing a satisfactory answer to one of the problem statements often causes problems in another.

For example, we can safely assume that a central bank would not want a CBDC to provide the same amount of anonymity as a cryptocurrency like bitcoin (BTC) or ether (ETH), and would take advantage of the chance to incorporate compliance-based safeguards into the design. One obvious example is requiring a user to pass know-your-customer (KYC) and anti-money laundering (AML) procedures before opening an account.

Identity checks, on the other hand, raise valid concerns about government monitoring and user privacy, which must be balanced against the need to accommodate financial law enforcement and prevent CBDCs from being utilized in illegal activities.

There is strength in numbers

When it comes to balancing operational robustness and resilience with cybersecurity, the trade-off is identical. Because of the sheer magnitude of their networks, permissionless blockchains like Ethereum and Bitcoin have shown to be resistant to assaults over time. The permissionless structure of the system invites involvement while also resulting in a highly robust design that is prohibitively expensive to hack.

However, there are disadvantages from the CBDC’s standpoint, the most prominent of which is a lack of control over performance and scalability. The process of updating public blockchain networks can take a long time, especially when a majority of members in a decentralized network must agree.

There are arguments for and against on-chain governance, but it seems unlikely that a central bank would want to hand over full governance control of a national currency to a decentralized network, even if it could somehow verify that all network participants were trustworthy and that the scope of control was limited.

In the end, it appears that a permissioned implementation of some kind will ultimately win out. Central banks, on the other hand, will have to address privacy and security concerns without jeopardizing their requirement for compliance, control, and performance.

Stablecoins face an uncertain future

One component of the HKMA paper, and indeed the CBDC argument in general, that is absent is the potential for decentralized finance (DeFi). DeFi arose and expanded as a result of crypto’s unique characteristics and benefits, such as the capacity to create programmable money with automated transactions regulated by smart contracts. Traders may use arbitrage in the moment to settle payments of any amount almost instantly, 24 hours a day, 7 days a week, from anywhere in the globe. CBDCs, as a result, have the potential to alter the global asset markets.

However, this creates a slew of challenging issues concerning stablecoins’ future. Regulators have become increasingly outspoken in recommending caution as the value of crypto and DeFi markets has soared and institutional interest has grown by the week. Gary Gensler, the chairman of the Securities and Exchange Commission in the United States, recently referred to stablecoins as “poker chips,” and it appears that law overseeing dollar-like digital analogues is only a matter of time.

It’s a topic that’s gaining traction among attorneys, analysts, and consultants working in the crypto, financial, and technology industries. Although regulated stablecoins and CBDCs might coexist, McKinsey recently gave its own take on the subject, arguing that it’s equally likely that one would triumph over the other.

Is there an unfair advantage?

CBDCs offer two key benefits over stablecoins that should be noted right away. To begin with, CBDCs provide the possibility to include compliance and digital identity elements from the start, as previously stated. Stablecoins, such as tether (USDT), which are issued across various blockchains, function under the platform’s regulations.

Tether couldn’t unilaterally require KYC checks to utilize USDT in its present form. However, such a feature would reduce the compliance load and expense to financial institutions, which may account for up to 5% of bank profits.

Second, CBDCs may automate tax collection and distribution, relieving banks of yet another problem. Many governments, such as Switzerland, withhold tax at the source on certain transactions, such as those involving foreign citizens. In all nations, banks are required to cooperate with government disclosure requests in situations of tax evasion.

Given these benefits, CBDCs would be a no-brainer for practically all financial institutions if they had to choose between CBDCs and regulated stablecoins.

Because of the numerous challenges that come with developing a retail CBDC, it might be several years before the actual impact is realized. CBDCs, on the other hand, appear to provide significant prospects for the financial system, but they may also pose an existential danger to stablecoins and the current DeFi scenario.

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