DeFi vs. Goliath

Can Decentralized Finance Survive the Inevitable Battle with Central Bank Digital Currencies?

As central banks sound the alarm against decentralized finance (DeFi) and its currency (stablecoins), a new David vs. Goliath battle is catching fire. While the former has the advantage of regulation, institutions, and government oversight, the latter has decentralization and a community built against the overreach of government. As central bank digital currencies (CBDCs) take economies by storm, can the DeFi survive? This article has been written in collaboration with Tommy La for Polygon, you can connect with us on twitter at Tommy La and 0xlol.

This article was originally published at https://medium.com by @0xlol on April 14, 2022.

In the Biblical story, champion fighter Goliath decimated the armies of Israel. His strength was unmatched, leaving only death in his wake. As he destroyed David’s homeland, David took the mantle to challenge him. Armed with the inferior weapons of a simple shepherd — a slingshot — but empowered by unique combat strategies, David killed the “invincible” Goliath. Often, David’s Biblical victory over Goliath is seen as an exception, an abnormality in a world where Goliaths always seem to win. In a society where the “little guy” always seems to lose, the tale of a shepherd whose five smooth stones topple a giant seems increasingly out of reach.

Today, a new ‘David vs. Goliath’ battle is emerging: the battle between DeFi (stablecoins) and central banks (CBDCs). As the widespread adoption of DeFi and stablecoins proliferates, governments throughout the world are taking notice. The elephant in the room, regulation, has quickly become the issue in the closer-than-it-appears side-view mirror. As central banks from China to the Bahamas float their ideas for CBDCs and begin implementation, Goliath’s sword is being drawn — and David’s slingshot pulled.

Before we dive into an analysis of CBDCs and their battle against DeFi, we must first understand what prompted central banks to adopt a digital currency. That answer lies in stablecoins.

When the DeFi architects on Ethereum envisioned a new financial system in the early 2010s, they settled on a core principle: the world of finance ought not to be beholden to the Goliaths. So, they developed fast, easy ways to send and receive payments on the blockchain while also using cryptocurrency as a store of value. Transactions occurred on blockchains, with many stable assets being minted. This is how the concept of “stablecoins” came into existence. Stablecoins are exactly what they sound like: cryptocurrencies that are designed to retain a specific value. From tracking the value of dollars to gold, stablecoins seek to ensure a predictable, stable currency that individuals can reliably transact with.

The world’s first stablecoin “BitUSD” was created in 2014 by two developers, Daniel Larimer and Charles Hoskinson. Launched in July 2014 on the BitShares blockchain, its goal was to use native BitShares tokens as backing for BitUSD tokens. But there was a problem. Without “tangible” assets to back BitUSD, how were users supposed to evaluate its worth? That’s where RealCoin (today known as Tether) came in. Through the acquisition of assets and fiat currency, RealCoin minted USDT tokens backed by real, tangible money. Today, USDT maintains a relative peg of 1 USDT: 1 USD, acquiring more than 50% of the stablecoin market share to date.

So, you’re probably wondering. Why can’t we just use a digital currency to transact with instead of using the blockchain? While electronic payment systems in traditional finance are on the rise, they are still expensive to purchase and maintain. When individuals transact, their credit card company, bank, transacting bank, merchant, and merchant bank all take a cut — leading to fees of up to 10%. All this while large corporations are able to aggregate — and sell — consumer data to third parties without their knowledge. Stablecoins on the blockchain solve all these problems.

Today, fiat-collateralized stablecoins take pointers from USDT’s legacy. Most are simple. When users deposit fiat currency, they are able to withdraw the same amount of stablecoins. This fiat currency is held by a centralized entity that controls the stablecoin until the user decides to withdraw their collateral. Decentralized applications like Maker accept a user’s fiat or cryptocurrency, which goes into a treasury or vault controlled by that application. The users can then mint a stablecoin pegged to the value of their deposit. These stablecoins, like USDC and BUSD, are considered the “safest” stablecoins and are now the backbone of DeFi.

‘Crypto-collateralized’ stablecoins on the other hand, allow stables to be backed by other cryptocurrencies like ETH and BTC. In these, an entity maintains a treasury or vault of cryptocurrencies while issuing their own stablecoins pegged to the assets within them. One such example is DAI, which is pegged to USD but also backed by crypto assets.

Algorithmic stablecoins have also been on the rise. Many protocols have begun using complex algorithms to maintain stablecoin pegs. For example, FRAX, a stablecoin protocol, doesn’t require the native stablecoin $FRAX to be 100% backed by collateral. It has got an ‘agnostic-deterministic-reflexive’ mechanism to regulate the peg where it makes no assumption about the market-demand of its stablecoin, nor the collateral-ratio the market is going to settle on. Often, these stablecoins have algorithms that are extremely efficient, only allowing for 2–3% fluctuations in price.

Increasingly, stablecoins have allowed market participants to move digital assets with lower fees and without regulation. Instead of moving money electronically through a system of banks like SWIFT, stablecoins on blockchains like Solana and Polygon allow for almost instantaneous, cheap transactions. On SWIFT, each transaction is required to be settled and verified by intermediaries. Most importantly, unlike bank transactions, stablecoin transactions on the blockchain are anonymous, barring any central entity from being able to track its users. Overall, the myriad uses of stablecoins have resulted in them becoming the center of thousands of dApps.

Stablecoins Have Witnessed a Significant Growth Probably as a Result of Trade in Cryptocurrencies in Last Few Years. Source: McKinsey & Company and IMF

With so many advantages, stablecoins’ abrupt rise has sounded the alarm at central banks. Without regulatory oversight and power over them, DeFi stables represent an existential threat to the banking system. Without the ability to track and exert influence over currencies, governments fear an “unstable” financial system arising. U.S. Senator Elizabeth Warren even dubbed it as “The Wild West of Finance.” And that’s why central banks are scrambling to create their own coins, i.e. so called CBDCs. Without an ability to control currencies, central banks will lose their power. As central banks race to combat DeFi, the battle between David and Goliath seems inevitable!

Source: McKinsey and Company

So, what are the Goliaths of the financial world creating to defeat the Davids and their stablecoins? Well, increasingly, central banks are almost exclusively developing CBDCs that don’t rely on a transparent-ledger technology at all. Instead, they’re developing proprietary technology that retains the status quo.

Functions to be carried out in a CBDC environment. Source: IMF

In order for CBDCs to work, a central bank must first create or issue the currency. The currency must then be validated by a network, guaranteeing its authenticity. Once created, a shared ledger or database of “who owns what” has to be updated to reflect the new currency created. All this while central banks continue to collect data on users to “ensure anti-money laundering” and “combat the financing of terrorism” via a policy of “Knowing your Customer.” So, the question here is — did terrorism and all those illicit activities start only after the invention of cryptocurrencies?

As we are now aware about the Goliath’s mischief, let’s look at what’s actually cooking? There are three main conceptual models that central banks have used to develop CBDCs: unilateral, intermediated, and synthetic CBDCs. Unilateral CBDCs are designed so that central banks unilaterally control currency. The central bank issues CBDCs, performs all transactions, and creates all infrastructure to interact with both merchants and consumers. In doing so, central banks maintain total control over their currencies. Another purported strategy for CBDCs is the creation of ‘intermediated CBDCs’. Similar to those created in the Bahamas and China, these intermediated CBDCs utilize a network of intermediate banks which are in charge of settling and executing transactions. All the central bank does is issue the CBDC. It’s these intermediaries — think your local Chase or Bank of America — that will continue doing all the transactions. The last strategy is the creation of Synthetic CBDCs. In this, non-central bank actors issue money that is backed by central bank assets acquired by central banks. Sound familiar? This is how reserve-backed stablecoins operate in DeFi!

Ultimately, every one of these systems have their pitfalls. Unilateral CBDCs deprioritize efficiency (as the transaction network is only as strong as the central bank’s systems) and resilience in favor of security and tracking capabilities. Intermediated CBDCs, on the other hand, simply route CBDC transactions through existing financial institutions (banks) who process and verify payments. This approach is similar to that currently done with credit card payments. In essence, this strategy is simply an extension of the status quo — governments print money, with banks creating networks to transact. While synthetic CBDCs look promising (as they would give consumers the choice of providers that prioritize different aspects of transacting) no central bank developing CBDCs has been reported to favor this technology.

Three Conceptual CBDC Operating Models. Source: IMF

So, it’s pretty clear now that CBDCs allow central banks to retain a significant amount of autonomy and control over their currencies. Most claim that their oversight will bolster safety and accountability for their users. Who are they trying to fool?

By far the most advanced of these is China’s Digital Yuan. Following the successful adoption of the Digital Yuan for millions in China (260 million active users), the Chinese central bank and Chinese Communist Party (CCP) are seeking to expand their CBDC to over a billion individuals by 2022. Today, people can access the digital yuan via an app on their smartphone and on platforms like Alipay and WeChat. The Digital Yuan makes it impossible for users to maintain anonymity in transacting. Big brother in China can see everything inside your wallet! While anonymity for small transactions is being proposed, the ability of the government to continue tracking users is inevitable.

Ultimately, the Chinese government’s authoritarian solution to David’s growing strength is to create a tool that makes him totally obsolete. Goliath seeks to use his sword to destroy everything David stands for in the process.

As one of only two fully-released retail CBDC projects, The Bahamas’ “Sand Dollar” CBDC has taken hold in the small island country. In PwC’s ranking of the top 10 retail CBDC initiatives across the world, the “Sand Dollar” took first place. However, instead of using a transparent ledger, The Bahamian central bank uses an Intermediated CBDC strategy similar to that of China’s.

While the central bank has claimed that the Sand Dollar has “built speed, efficiency, and security in payments,” it also claims to provide an excellent record of income and spending. While this is a great tool to track individuals’ credit (which has been touted to be used for application of revolutionary microloans in the country) the CBDC’s purpose is clear: to ensure the Bahamian central bank’s authority over transactions. For a nation that’s built a culture of throwing Goliath, the British Empire, off its back in the 1970s, it seems that its own central bank once again seeks to put a yoke on the back of its people.

Moreover, the same is true for Uruguay’s CBDC. Uruguay’s e-Peso is being widely used for peer-to-peer transactions in the Latin American country. However, each e-Peso includes a digital ID serial number, meaning that every transaction made using the e-Peso is being tracked by the government. Not only are individual transactions tracked, but so are the individuals who currently hold those specific bills. This means that individuals who haven’t been involved in illicit transactions, but simply have possession of specific bills in the electronic wallets, will likely be subject to regulatory scrutiny.

Overall, it seems like governments all over the world want to have greater control and surveillance over their people through central banks in the name of so-called efficient currency.

In order for CBDCs to have significant power over the status quo financial system, they need to provide tangible benefits to speed, efficiency, and safety. However, it seems as though most CBDCs are using the existing FinTech architecture. They are specifically using intermediate banks that are already responsible for our everyday transactions.

The Digital Yuan is not on the blockchain, it instead utilizes Chinese government-developed technology routed through existing financial institutions. The Chinese Digital Yuan system is built upon private-sector banks’ distribution and maintenance of the Digital Yuan, creating ledgers for each customer — and records of every transaction. While faster than traditional clearing systems, as Huang Qifan, the chairman of the China International Economic Exchange Center put it, “[The Digital Yuan] can achieve real-time collection of data related to money creation, bookkeeping.” In this system, CBDCs don’t provide anything revolutionary — they’re simply an extension to the status quo.

The Sand Dollar does the same. It uses existing financial institutions and banks to verify and hold digital currencies, giving them to account holders. Those who’d like to transact with the Sand Dollar need an official mobile app or physical payment card. Moreover, in order to decrease possible abilities for users to sell assets quickly, the Bahamas has created quantitative restrictions on the number and size of transactions with the Sand Dollar, just like existing credit limits in centralized finance. In the end, no CBDC implementation till now has shown an improvement over existing financial systems — largely because central banks likely don’t want it.

Design Features of CBDC Projects. Source: IMF

While few fully-fledged CBDCs have been rolled out, the majority of central banks in the world have plans to release them in the near future. That provides some hope to those wishing for better, more innovative architectures for CBDCs. From India to Japan, CBDCs are becoming inevitable.

Unfortunately, it seems that few central banks are willing to embrace DeFi’s spirit of decentralization and privacy. In what will be the largest nation in the world in the next two decades, India represents an enormous opportunity for blockchain technology. Yet, its CBDC is seemingly looking the other way.

As the former finance secretary of India wrote, “A dematerialised form of banknotes will serve as the best option instead of a blockchain cryptography-based digital currency. I think the RBI will find it very difficult to develop an appropriate design for the retail digital currency. India should do a pilot with dematerialised banknotes.” It seems he was right, as the Indian central bank announced it would design its own CBDC using proprietary, trackable technology — not a blockchain or synthetic CBDC technology.

On March 10, President Joe Biden signed an executive order to mandate the Treasury and Federal Reserve to begin urgent, government-wide focus on the research and development of potential American CBDCs. This order marks the first official presidential nod to a Fed-backed CBDC. With the order, now both the Federal Reserve and European Central Bank (ECB), arguably the two most influential central banks in the world, have announced plans to develop and research a CBDC. Yet, it still doesn’t look well for DeFi. The Goliaths of the ECB and the Fed have awoken and are ready to battle David.

As SEC Chairman Gary Gensler described in response to a question on stablecoins, he likens stables to “poker chips” in the “Wild West Crypto Casino.” The G7 also committed to endorsing 13 public policy principles for CBDCs, including adherence to central banks’ ability to track currencies. While ECB’s President Christine Lagarde may be more reserved in her sentiments, it seems that sweeping regulation and the introduction of centralized, trackable CBDCs is imminent.

While India, the EU, and the US seem to be antagonistic to stablecoins, the UK tells a different story. On April 4th, the UK’s Chancellor of the Exchequer Rishi Sunak released a comprehensive plan for the UK government to “make the UK a global cryptoasset technology hub,” promising to implement stablecoins as a legal form of payment. While the UK does plan to comprehensively regulate stablecoins, the country provides hope (and a roadmap) that other nations could follow.

So, why will people use CBDCs? That’s the million dollar question, isn’t it? The reality is that the proliferation of CBDCs will likely occur simply because powerful “Goliath” institutions want it to happen. And they certainly will try to lure you with ridiculous incentives.

In an IMF report, they found that prudently designed CBDCs will offer more resilience, more safety, greater availability, and lower costs than private forms of digital money. The Federal Reserve also released in a report that their potential CBDC could serve as a new foundation for the payment system globally, including identity verification to reduce crime,money laundering, and “balanced privacy protections.” Although CBDCs are touted to have myriad benefits, one problem still remains: CBDCs don’t hold true to the spirit of a decentralized economy. They in no way favor the rights of common people.

Stablecoin-based DeFi has the advantage that it can provide all of the above benefits while maintaining user privacy. DeFi protocols using stables are often backed by tangible U.S. dollars, representing a strategy of synthetic CBDCs. With the introduction of layer 2 blockchains, transaction speeds have rocketed while the gas fees have come down significantly. On the other hand, stablecoins on DeFi could also comply with anti-money laundering and crime regulations. Perhaps more protocols and watchdogs should be dedicated to tracking suspicious wallets or even ban/blacklist known illicit wallets.

Imagine a world where peer-to-peer transactions are seamless, free of government regulation, and enable complete freedom and transparency to users. That’s the world stablecoins and DeFi offer! Indeed, if central banks recognize this, there’s a possibility that both CDBCs and stablecoins can co-exist.

As bridges and vaults allow users to convert one asset to another on the blockchain, it’s possible that traditional DeFi infrastructure could incorporate CBDCs to become another stable currency for transactions. Users could deposit CBDCs into a vault or wallet on traditional central banks’ user infrastructure, which could then be minted into tokens on-chain alongside stablecoins. That would grant users access to so called security of CBDCs with the flexibility, yield, and *some* decentralization of DeFi and its decentralized apps (DApps).

The UK seems to be on this track. Their intent is to regulate stablecoins while also researching a CBDC. In future, perhaps you’ll see their citizens transact in CBDCs while financial institutions and individuals leverage the blockchain for its features and yield applications. While the utopian world of synonymous and commonplace DeFi may never take hold, it will still hold a large and out-sized role in the world of finance.

In the Biblical version of David and Goliath, Goliath doesn’t just dwarf, outmatch, outmuscle David. No, he brings the social order of the Philistines against David. “And the Philistine cursed David by his gods”. Like central banks, Goliath uses the existing social order as a weapon to detract from David’s strength. For when David plays by the rules of the status quo, David loses.

But even with the weight of traditional warfare bearing down upon him, David chooses to stick to his guns, his unorthodox fighting style. When David “hastened and ran out of the lines toward Philistine,” it was David’s difference and deviation from the “norm” that brought him victory. That’s what the Davids have to do to beat the Goliaths: play outside the normal rules. Yes, CBDCs have an unfair advantage against DeFi. With regulations, institutions, banks, and the apparent “world order” against DeFi, this truly is a battle of David vs. Goliath. But DeFi has made it this far without playing by Goliath’s rules! If David wants to win and survive the onslaught of regulation from Goliath, he needs to continue doing what would make him unique. The sacred principle of decentralization!

In the millions of battles between David and Goliath, David often wins.

1. CBDC and stablecoins: Early coexistence on an uncertain road
2. DeFi May Push Governments to Adopt CBDCs
3. G7 Finance Officials Endorse Principles for Central Bank Digital Currencies
4. CBDCs and DeFi: The Future of Stablecoins
5. The Future of Money: Gearing Up for Central Bank Digital Currency
6. Behind the Scenes of Central Bank Digital Currency
7. Money and Payments: The US Dollar in the Age of Digital Transformation

Authors are decentralised finance (DeFi) research analysts at Polygon. They can be reached on twitter at Tommy La and 0xlol.