The rising currency for the future - CBDC

Tokenisation and our future

Tokenisation is defined as the process of turning real-world assets or ownership rights into digital code on a blockchain or secure ledger. This is the key component of decentralised finance, now and in future. The benefits of tokenisation range from improved efficiency of trade to greater access to different property markets for buyers and sellers. With the "DeFi" sector still growing and the trajectory of 16% of assets being tokenised by 2035¹, it is essential for all stakeholders to structure a system that could benefit society and limit the risk of financial disaster in the sector.

Digital currencies and their importance

However, any trade requires a medium of exchange. Under the Bretton Woods system, the medium of exchange, the USD, was tied to the value of gold. The United States suspended that convertibility in 1971 and the system collapsed in 1973, after which most currencies had no collateral and most of their value was based on trust in the central bank and the country's economy. Now, for "DeFi", the trading currency varies. The most common type is currently cryptocurrency, with Bitcoin dominant. Yet, due to the lack of collateral, its value is far more volatile, easily influenced by news and rumours.

If the problem is solely the lack of collateral, then the solution could be stable-coins: a currency issued by a company and held to a strict collateral ratio (an example is Tether, with 1 USDT bound to 1 USD). Trust is built and the problem is solved, isn't it?

It isn't. Although stable-coins seem to be an ideal solution, the risks of peg-breaking and of the issuing company closing do exist. Furthermore, in the example of US T-bills, an optimistic prediction has 1 trillion USD of T-bills being bought using stable-coins by 2028². This raises the concern of a financial disaster in which government bonds face a liquidity squeeze and stable-coin issuers face a run on their collateral, as one of the biggest buyers of short-term government bonds is using these bonds as collateral.

Central Bank ideal solutions and the introduction of CBDC

Stable-coins are not the perfect ideal solution, and the lack of control over decentralised finance is another reason why many central banks across the world have an increased interest in intervening and introducing their own currency. The aim of a central bank is to provide stable pricing and economic growth to its country through monetary policy. One of the main tools of monetary policy is the central bank policy rate, or the issuing of new currency. Yet in decentralised finance, as the interest rate is primarily based on demand and supply, monetary policy transmission is impaired. This means that if there is any chaos, over-optimism or pessimism in these markets, the central bank has little to no ability to intervene, and can only suffer the effects that it brings to real finance.

That is why most developed countries are interested in, or currently developing, a Central Bank Digital Currency (CBDC). As a version of digital currency that is issued and backed by the central bank, CBDC is born with the legal authority and market trust that a normal currency has. Building on that trust and on the nature of "DeFi", CBDCs are also considered one of the most efficient currencies for trading. Furthermore, the central bank is now not only able to control the amount of CBDC in the market, but also to allow more fintech to be incorporated into CBDC. For example, with the help of Distributed Ledger Technology (DLT), the government would be able to trace transactions more easily, making cybercrime more difficult.

Benefits in market and trade

The introduction of CBDC is more than just an introduction of influence for central banks. CBDC also symbolises the introduction of "atomic settlement" (DvP) for cross-market trade. As CBDCs are currencies that represent a country rather than a market or company, a group of countries can further utilise an m-bridge project where mCBDC can be used to facilitate real-time, point-to-point, cross-border payments and transactions. Compared to the traditional T+1 or T+2 settlement period, CBDC can fully eliminate the risk of counterparty fault and timing mismatch.

CBDC's ability to facilitate cross-border transactions can be exemplified by the Project Ensemble Sandbox in Hong Kong, which started in August 2024. It not only proves that all the benefits and technology for CBDC are highly achievable in real life, but further demonstrates the possibility of a seamless integration of "DeFi" with "TradFi". As in Project Ensemble the Hong Kong Monetary Authority is able to tokenise real commercial bank savings and achieve atomic settlement for MMFs and green bonds, the core capital in "TradFi" could be starting to move to "DeFi" and DLT³. Ensemble focuses on wholesale transfers of central bank money between banks, while BCG argues that the biggest impact from CBDCs is likely to come from the wholesale rather than retail side. This makes the retail case discussed below the more contested part of the argument¹.

Beyond international trade efficiency, what is the point of CBDC if it's just a digital version of traditional currency? What benefit does it offer to normal citizens compared to a traditional dollar, if it's almost the same? The answer could be that CBDCs also offer revolutionary tools for domestic economic management, with the future of "nowcasting" and the introduction of non-biased macro-economic policy making.

Traditional currencies hide their flaws for monetary policy making. As there is no way of tracing the usage of money, there is also no way for policy makers to access a full, detailed report of the current market, only an inaccurate report of a market three months ago. Furthermore, one of the most important factors of trade is left heavily influenced by the political and personal bias of a country, which over time will damage investor and business confidence. However, with CBDC traceability and other real-time data (like satellite light images of harbours and cities, or credit card spending), governments could be able to produce real-time indices. Whilst a high-frequency real-time index like the WEI exists already, with the increasing importance of decentralised finance in the future, the importance of having data on the active "DeFi" trade is significant⁴. Therefore, that is another example of why central banks are trying to have fintech like DLT in place for the potential issuing of CBDC.

With the ability of "nowcasting" and potential algorithmic fine-tuning of interest rates, this will benefit normal consumers and an economy's growth. As markets and normal consumers can enjoy monetary policy that is relatively less influenced by politics or bias than that of a monetary policy making institution like the Fed that we have now, industry can receive more targeted subsidies in real time and higher control of the economic cycle can be achieved.

Question: The Paradox of a centralised "DeFi"

Higher efficiency, a stable currency and platform for trade, and better policy making are all considered potential benefits of CBDC. Yet at what cost? Whilst there isn't a straight answer to it, there is definitely concern about the autonomy of "DeFi". Decentralised Finance is defined as a financial system that has no central point or centre of power. If the currency that "DeFi" is trading in gives authority and power to an institution to control, doesn't it go against the aim of "DeFi"? A core benefit of "DeFi" is making the market more solely dependent on demand and supply, with little to no influence from government, yet with CBDC it could be argued that it brings all of us back to centralised finance. If CBDC becomes a reality, there is an indication that authorities can even control what an individual is purchasing, and perhaps even an introduction of programmable money and spending constraints.

Ultimately, the future is unpredictable. There exists enormous potential and benefit in using CBDC to allow sustained growth in decentralised finance, but at what cost? The future of whether we should have a centralised "DeFi" system is up to the market and government to decide. Yet one point is clear: the benefits of CBDCs have to be built on careful political and economic consideration from government and a stable system of politics and trade. 16% of our market will be tokenised and traded in "DeFi" in 2035 and more will come; it will be a future that hides enormous potential and moral questions at the same time.