Does CBDC Threaten the Existence of DeFi?

‍Implementation of central bank digital currencies (CBDCs)

CBDC (digital money) could be developed in a few ways. Using a centralized approach, the central bank keeps a record of all transactions and balances in ledgers - which could be a blockchain. Using a decentralized approach, the central bank defines a set of rules and requirements for the execution of transactions with CBDC, which are then recorded by users or financial intermediaries.

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What problems do CBDCs solve according to central banks? Let's highlight the main ones:

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Convenience and accessibility of financial services

When making bank transfers, users can often face long-duration financial transactions or reverse transactions with hidden fees. CBDC transactions could be settled in real-time, even if the parties involved are located in different countries. This would be a significant improvement over the current state of cross-border payments, which can take days or even weeks to be settled.

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Safer and more secure payments

The transition to a fully electronic economy, which means the migration to CBDC, will give central banks full access to all transactions in the ledger, which together with privacy-enhancing technologies will ensure anonymity throughout the entire payment process, and the auditing will be done only in pre-determined cases related to money laundering, counterterrorism financing, and tax evasion. 

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Cost-effectiveness

According to the data from Mastercard, countries have to spend nearly 1.5% of GDP on cash services. The transition to a new digital fiat system will significantly reduce unnecessary expenses.

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Eliminating competitors

Implementation of CBDCs could have an impact on competition between existing payment systems, participants of available payment systems, and CBDC payment systems, as well as competition within the CBDC ecosystem. Private entities responsible for issuing cryptocurrencies are serious rivals (if not threats) to government regulators. The first ones, endanger the stability of the traditional financial system and consequently, raise concerns among regulators.

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Despite, trying to solve the aforementioned problems, CBDC being a digital payment system stays vulnerable to some cybersecurity threats, including account and data theft, double spending, counterfeiting, or quantum computing according to the document issued by the World Economic Forum.

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What is DeFi?

Decentralized finance is a way of organizing finances when a person gets access to services without the participation of third-party intermediaries, such as banks, brokers, etc. For the implementation of DeFi, decentralized apps based on blockchain, are created. In other words, to lend, borrow, or exchange your money, you need to use specialized apps bypassing different financial organizations. All transactions are made via smart contracts, and all the finances are controlled only by yourself.

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Key principles of DeFi in crypto

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No intermediaries when making transactions

Taking as an example DeFi lending platforms, they allow users to lend and borrow money without a need for a bank, which can save money on interest rates and fees. Lack of intermediaries is one of the key benefits of DeFi, which makes the financial system more transparent and gives users more control over their finances.

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Self Governance

Decentralized autonomous organizations (DAOs) are organizations that are built on top of blockchain technology and use smart contracts to automate their operations. The main feature of DAO is that users don't have to trust another user, they just can check the DAO code, which is transparent and can be verified by anyone.

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Composability

A key feature of DeFi composability is that it allows different decentralized protocols to be interconnected and used together in new and innovative ways. Thus, developers can create new financial products and services for users, who then can use them to do the things they couldn't do before.

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DeFi, despite its advantages in terms of transparency of transactions and giving users full control over their money, is built on smart contracts, which are vulnerable to exploitation due to the novelty of its technology.

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Possible interconnections between CBDC and DeFi 

CBDC and DeFi are two emerging technologies that have the potential to revolutionize finances. CBDC being a digital version of fiat currencies and DeFi being a financial system can fruitfully work together. 

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Liquidity. CBDC could be used to provide liquidity to DeFi markets, which are often illiquid, this way, users will be able to buy crypto with fiat currency without using the services of intermediaries and to trade assets without any problems.

Scalability. With the growth of popularity and the number of transactions, CBDC will need to increase its throughput, which can be done by using Polygon.

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DeFi applications can use CBDC's to get more liquidity, while CBDC's can use DeFi protocols to increase their popularity. So, to answer the thesis of the article, CBDC does not threaten the existence of DeFi, but for them to work together, there is still a lot of work to be done in terms of security and regulatory inaccuracies.

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