Central banks that enter the cryptosphere could save DeFi
PremiumThey have a role but must first help DeFi get off their ‘animal farm’
Ayn Rand’s fans dreamt of decentralized finance (DeFi) as the ultimate realization of their techno-anarchist utopia: freedom from both governments and large custodial organizations. But somewhere along the way, they got stuck on George Orwell’s Animal Farm where some animals are more equal than others. Much of what passes as DeFi today is just “decentralization theatre," as Fabian Schar, a University of Basel professor of blockchain, describes it. In theory, this hot new crypto corner wasn’t envisioned to be controlled by big-bulge intermediaries. The self-executing computer code deciding how digital assets would be lent or invested was meant to be manipulation-proof. Developers weren’t expected to have special rights.
The reality has turned out to be different: From backdoors to kill switches, discretionary power is concentrated in a few players. You even have to pay for protection from ‘sandwich attacks’ that place one transaction before and another after yours on the blockchain to steal your profit. Distributed ledgers were supposed to leave all this Wall Street chicanery behind. But if a big chunk of DeFi has moved away from its original vision, why not at least make it safe for all users by bringing in the biggest centralizing force of regular finance? The central bank.
Central bank digital currencies (CBDCs) are in various stages of trial, partly as an answer to stablecoins. These private tokens peg their value to an official unit of account (such as the dollar), giving crypto investors a less volatile pathway than Bitcoin or Ether. Stable, however, doesn’t mean safe. To the extent stablecoins invest in risky assets, it’s natural for the Bank for International Settlements—the bank for central banks—to probe if these tokens are really needed for DeFi liquidity. Letting people buy digital assets with CBDCs, which are direct claims on monetary authorities, will nix threats to stability from a stablecoin going bust.
‘Does safe DeFi require CBDCs?’ was the topic of a recent conference held in Zurich by the BIS and the Swiss National Bank. In his talk, Schar answered that with an emphatic ‘no’. DeFi relying on central banks would be a paradox. “It’s like asking, ‘Does safe decentralization need centralization?’" he said. But that doesn’t mean that monetary authorities can’t do some good. “Could a CBDC in a DeFi ecosystem be mutually beneficial? That’s a much more interesting question," Schar said.
To play this part, though, central banks must be prepared to take their digital currency projects in a new direction: public blockchains.
Blockchain validators can extract value in excess of the usual block reward and energy used in mining by including, excluding and reordering transactions. The selling point of DeFi is its ‘composability’ feature. A smart contract can make an exchange of virtual assets and money part of one composite transaction, which takes place in its entirety or not at all. Counterparty risk goes away. As a result, regulated financial institutions don’t need to act as trustworthy middlemen.
But that’s only true of some protocols that are completely decentralized, transparent and immutable, with no operators and special privileges, Schar said. In practice, much of DeFi isn’t like that. Assets of USDT, a widely-used stablecoin, are managed by Tether, its British Virgin Islands-based issuer, across a range of traditional options outside the blockchain. For an investor, a digital dollar issued directly by the US Fed would be safer than accepting a stablecoin that keeps its collateral in various assets.
It’s a Catch-22, though. A CBDC on a blockchain whose access is under central bank control can’t be included in a composite financial transaction on a permission-less public blockchain (such as Bitcoin or Ethereum). It isn’t clear if any central bank will provide fully open access to its ledger, or if doing would serve purposes of transaction speed, security and privacy.
DeFi’s linkages with traditional finance will grow, and not only because banks, brokers and asset managers will come under pressure to let customers to pay, save, lend, borrow, trade, invest and insure in crypto. To Lex Sokolin, fintech co-head at ConsenSys, a DeFi project risk analyst, the real opportunity—and threat to a central bank’s relevance—might lie elsewhere. “You have this web3 economy that’s generating actual operating activity that matters, and out of this grows a finance system," he said on a panel at the same BIS conference. “How do we build a pathway of fiat money there?"
Left to itself, even the metaverse may not gravitate towards fully decentralized finance protocols. Meta, Facebook’s parent, is exploring a centrally controlled virtual currency for users to experience alternate reality. Before Big Tech takes the lead, central banks have to start thinking about hawking their digital currencies in this brave new world, if they can first help DeFi get off the animal farm.
Andy Mukherjee is a Bloomberg Opinion columnist covering industrial companies and financial services.
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