Stablecoins, central banks and the new era of credit creation

And how DeFi will sit alongside Central Bank Digital Currencies

To state the obvious, money creation drives fluctuations in financial markets. Just look at the market attention Federal Chairman Jay Powell creates following every Fed meeting, as an example.

Let’s take another step back into the economics of it all. It’s true that central banks have the ability to print money, but banks have the ability to create money (by extending credit). It’s therefore not money creation that is the lifeblood of an economy – it’s credit creation. In other words, the extension of loans; connecting those who need money now to those who don’t and are seeking yield.

The rapid growth of stablecoins on Ethereum and other chains has encouraged many financial authorities to draw up plans for a “Central Bank Digital Currency” (CBDC). While no CBDC has yet gained serious traction, the key question has shifted from “why” to “how” (and “when”).

While the political will is forming in central banks around the world, policy makers are struggling to grasp the monetary implications of a digital currency. What would it mean for credit extension in a world of CBDCs if everyone ends up holding an account with the central bank? What money-like instruments would investors then hold?

The answer could well lie in stablecoins. Their increasing variety in DeFi and developments in supporting financial activity will equate to a new model of money and credit creation – one where DeFi has a critical central role. 

China tries to get ahead

ECB President Christine Lagarde has made some smart comments about a digital Euro, but for now almost all eyes are on China and the U.S.

China’s Digital Currency Electronic Payment (DCEP) has passed the research phase and has already been rolled out in a few pilot cities. But two key questions remain:

  1. Will the DCEP be freely convertible with other currencies?

  2. Is the DCEP a material upgrade from the existing digital payment infrastructure, around WeChat and Alipay?

China has not followed through on promises to open its capital account, so it’s hard to imagine a digital RMB accessible around the world. And realistically, it's not going to be able to compete as a global currency if it’s not freely convertible.

While the payment infrastructure of the U.S. seems stuck in the 1970s, China has already made the leap to a digital-payments world. Perhaps the increased use of DCEP will unleash a new wave of financial products with smart contracts and programmable assets. For now though, DCEP seems to have been embraced primarily by state-owned banks and financial regulators in Beijing. From this perspective, it looks like the DCEP is more of a political move to wrestle power away from Tencent/Alibaba.

Americans look for a middle ground

Initially, the U.S. was less enthusiastic about a digital dollar, but China’s progress has fostered political support from a fear of being left behind. This culminated in an announcement from Jay Powell in May, of an upcoming Fed research report on digital currencies expected to be released this summer.

Unlike China, there are privacy concerns across the political spectrum in the U.S., so the digital dollar may have some type of anonymity built in for smaller transactions, similar to cash. 

No one knows what Fedcoin would look like in practice. Yet the key feature of any digital currency is some type of digital wallet that can hold, send or receive payments. These functions are primarily served by banks now, but would there be a need for Bank of America if anyone can have an account with the Fed?

Fed Governor Lael Brainard noted in a speech last month at Consensus:

Some research indicates that the introduction of a CBDC might raise the risk of a flight out of deposits at weak banks in favor of CBDC holdings at moments of financial stress. Other research indicates that the increase in competition could result in more attractive terms on transactions accounts and an overall increase in banking system deposits. Banks play a critical role in credit intermediation and monetary policy transmission, as well as in payments. Thus, the design of any CBDC would need to include safeguards to protect against disintermediation of banks and to preserve monetary policy transmission more broadly.

Brainard continues:

Consumers and businesses don't generally consider whether the money they are using is a liability of the central bank, as with cash, or of a commercial bank, as with bank deposits.

The introduction and uptake of CBDCs leads to a completely different banking model and a new, more direct monetary policy. Among bankers, there is nervous concern they will lose their deposit base to a digital wallet. With open access to base-level interest rates, yield would be earned entirely from returns through credit extension.

Bankers are right to worry about their deposit base, but are there other methods of “credit intermediation and monetary policy transmission” than traditional physical banks?

A DeFi model

In the future, CBDCs will be wrapped in stablecoins that offer more yield opportunities along with higher risk, similar to how investors deposit USDC in MakerDAO’s peg stability module (PSM) to mint Dai because it tends to have higher yields than USDC. 

Moving further up the risk ladder, Dai also has the Dai Savings Rate (DSR), which pays a yield to any Dai locked in the smart contract; funds can be deposited/withdrawn every block. Compound has a secondary lending market for Dai, where depositors earn interest from Dai borrowers, plus it passes along yield from the DSR by automatically depositing Dai that is not lent out in the DSR. Dai depositors get a token (cDai) that represents a claim on their deposited Dai with interest accruing from the DSR and Dai borrowers on Compound.

Other stablecoin projects are focusing on capital efficiency, aiming to achieve $1 value with as little collateral as possible. These are risky experiments, but that risk can be compensated for with a higher yield. The growing number of stablecoins has created an interconnected ecosystem. New stablecoins benefit from Curve pools with other stablecoins to bootstrap liquidity, while stablecoins like alUSD are built on top of Dai’s future yield.

While there will never be any physical banks in DeFi, loans will still be extended and not all will be to overcollateralized borrowers. Instead, “banks” that issue loans to risky borrowers will live on top of DeFi lending protocols. You are already starting to see this with Aave’s credit delegation, where uncollateralized loans can be issued. These banks will deposit a CBDC or a wrapped version (or any asset) as collateral in Compound, Maker or Aave and charge a small fee on top of the protocol’s interest rates based on the creditworthiness of the borrower. 

The interactions between these stablecoins, especially how collateral is moved and rebalanced, preview a new credit market, one where money creation may still be the purview of central banks, while credit creation is driven by DeFi.

Leading vs. following

In the current dialogue on digital currencies, a condescending tone of “the adults are here now” is being taken by some mainstream media outlets towards the cryptocurrency space. Something along the lines of: “great work on the blockchain thing, but we’ll take it from here.” In reality, they fail to recognize where the innovation in blockchain and cryptocurrencies lies. 

And in discussions on CBDCs you hear “payments” often yet “smart contracts” almost never. Fast payments may have been exciting in the past, but when it comes to digital money and DeFi, things are now moving several steps ahead. 

It’s hard to speculate without any specifics from the leading central banks, but regardless of what CBDCs will look like, none will undo the role of, and need for public blockchains. Any central bank that successfully launches a CBDC will have introduced their entire country to digital currency and digital wallets, doing the hard, last-mile work for public blockchains. 

DeFi, meanwhile, will continue to be attractive in the age of CBDCs because it offers greater yield opportunities and more productive use of assets. CBDCs will enable fast payments, but can Uniswap run on the same network as CBDCs? 

The most likely scenario is one where CBDC infrastructure and DeFi will sit side by side; countries may even use Ethereum to issue and manage their CBDC. 

And as a result, in the digital money world, central banks will still print money but DeFi will be how credit is created.

Odds and Ends

  • Link

  • Yield, a fixed-rate lending protocol, raises $10m, led by Paradigm Link

  • Compound Treasury launches, targeting businesses & institutions Link

  • Perpetual Protocol launches v2 Link

  • Open source DeFi liquidation bot from fall 2020 Link

  • Opyn now offers partially collateralized options Link

Thoughts and Prognostications

That’s it! Feedback appreciated. Just hit reply. Written in a previously hot, but now rainy, Brooklyn. It’s been a busy June! Excited to watch all the MEV content this weekend…

Dose of DeFi is written by Chris Powers. Opinions expressed are my own. I spend most of my time contributing to DXdao*. All content is for informational purposes and is not intended as investment advice.