In the repetitive cycle of scandals and whining in crypto, it is easy to forget that the technology has the potential to be useful.
The Bank of International Settlements (BIS) recently released an interim report about a Proof of Concept (PoS) for currency trading using smart contracts, distributed ledger technology (DLT), and a synthetic version of the central bank digital currency (CBDC) called wCBDC. These are all concepts borrowed from the so-called decentralized finance (DeFi) ecosystem. [So-called because all DeFi systems are invariably centralized].
Project Mariana Details
In traditional currency trading, market makers provide liquidity by buying or selling to maintain price parity. Project Mariana uses automated market makers (AMMs). AMMs are liquidity pools or smart contracts that use a bonding curve, to set prices for each token in the pool, to maintain parity with the intended peg.
Traders and commercial banks function as liquidity providers in this system. The latter mint wCBDCs and get tokens proportional to the amount of liquidity they provide. In exchange, they earn transaction fees. Traders pay those fees and profit from the price changes for currencies. Bridges are used to transport wCBDCs from domestic networks to international ones. The former are permissioned networks accessible only to CBDCs and no other tokens. The currencies used in the project – EUR, SGD, and CHF – are based in ERC-20 standard.
A Central Bank Show
At the outset, the test once again demonstrates the power of central banks will wield in the future financial landscape. Central banks are responsible for managing smart contracts, relayers, and bridge access. The design of bridges used to connect international and domestic networks is also guided by central bank requirements. They also select the commercial banks allowed to mint wCBDCs and can retrieve tokens from blocked commercial banks. [Cue news about reclaiming stolen funds from a hack].
On a more granular level, there are many questions and concerns. Some of them relate to technology. For example, the specifics of smart contract functioning in the system are still unclear. Smart contracts are efficient because they make it possible to automate tasks by encoding all possible outcomes. In currency trading, it is difficult to envision all possible scenarios and predict their outcomes. There’s also the question of multiple points of failure in the architecture. Bridges, relays, and smart contracts are all susceptible to hacks.
Other concerns are related to risks. The bonding curve adds a layer of unpredictability. The European Rate Mechanism (ERM) in 1999 attempted to manage a floating rate between the German Mark and three other currencies within a fixed band. The experiment did not succeed because it required far too many interest rate interventions by governments to maintain the peg. Large liquidity pools, especially those consisting of an unequal currency pair – an emerging economy against a developed one – could have similar consequences.
The composability of DeFi systems enables pairing of different smart contracts together to build a completely new system. They are considered one of its innovations. But they also amplify the riskiness of a system. Again, illiquid currency pairs can easily become a flashpoint that triggers the collapse of an entire system through a system of interconnections woven together through liquidity pools stacked on top of each other.
There’s also the unanswered question of fees. Ethereum, the chain used for the BIS project, is infamous for high fees. How expensive are currency trading transactions within the context of DeFi?
Of course, it is still very early days for this project and DeFi. So it might be presumptuous to expect answers so soon. One thing is clear from the project’s design, though. The future of finance is neither decentralized nor disintermediated. And central banks will continue to remain the guiding hand in determining the fate of economies.