How DeFi will innovate our financial ecosystems (part 6/7)

Stefan Grasmann
14 min readJan 10, 2021

[This is a cross-post. I first published this article on publish0x — always trying out something new]

DeFi lessons for Central Banks

We’ve come a long way: In previous parts of this series we discussed the influence of public Blockchains like Ethereum, their token ecosystems and especially the latest developments in Decentralized Finance (DeFi) upon financial markets. We went down the rabbit hole of DeFi in parts 2 and 3 — saw its shining and dark sides. In part 4 we went up again — investigating what’s in it for users and how to stay in control of one’s DeFi investments. In part 5 we discussed DeFi opportunities for retail banks. But there is even more change coming to the financial ecosystems.

So let’s get visionary!
You guessed right: This will be the fun part of this series.
Fasten your seat belts, please…

What a great picture! Thanks for sharing, Andrea. Photo by Andrea Piacquadio from Pexels

First movers

Innovations in Blockchain and distributed ledger technologies motivated big tech companies like Facebook and states like China to come up with their own blockchain-based digital currency systems: Facebook is expected to launch its own “commercial currencies” under the label Diem (re-branded from Libra) in 2021. China is clearly ahead with its Central Bank Digital Currency (CBDC), already piloting their digital Yuan in several big Chinese cities. While it will get hard for China to rival with the US Dollar’s world dominance short-term, this is obviously part of China’s long-term vision to extend their influence in world trade.

Photo by Miguel Á. Padriñán from Pexels

Meanwhile, the US and Europe are years behind in this innovation. Instead of investing time and money full-speed into their own digital CBDC solutions and make use of their strong local Blockchain ecosystems like Ethereum, Western countries rather lose time arguing with Facebook and the Diem Association (a.k.a. Libra Association) who invent their own payment system based on several single-currency stable coins (each attached to fiat currencies like USD, EUR, GBP, etc.) and their native multi-currency Libra Coin (≋LBR).

Owning the “world currency” has always been an immense competitive advantage for the US — even in “analogous times”. Bring in digital use cases and this advantage will certainly multiply. By the way: When I say ‘digital’ I don’t mean simple digital transactions as we know them from wire transfers of money or SEPA transactions. I rather mean complex and fully automated digital value transfers. The payment use cases in this area are manifold: Imagine “streaming payments” every minute or hour instead of once a month, machine-to-machine payments (IoT) or fully automated micro-rewards for social media or other digital activities. Regardless if we already value use cases like these high enough or dismiss them as “science fiction”, they will be established. And that’s what blockchain-based smart contracts are all about. Again, DeFi shows impressively which kinds of automation are already possible even in the early state of public Blockchains with all their limitations.

Diem association and China each try to take the best parts of these blockchain technologies and create their own “permissioned” financial systems that adhere to their own value systems. Interestingly, they don’t adopt higher level standards like the token ecosystem around the ERC20 standard. They rather adopt lower level aspects like consensus algorithms, Merkle tree data structures and smart contracts as a concept. Staying in control of payments for either political or commercial reasons is certainly a main focus for both. These solutions will be controlled in a centralized fashion —be it a consortium or a government as we can already see in China — on top of a technology that was meant to bring ultimate decentralization. What a pity…

Photo by Nathan J Hilton from Pexels

But not all is lost! Instead of trying to reinvent the wheel, Western countries should rather urge their central and commercial banks to investigate ways to leverage existing infrastructure that matches their pluralistic democratic value systems and is here to stay: Ethereum. And I mean the public one…

Wait a moment. Using Ethereum Mainnet for a Central Bank Digital Currency? With all its obvious limitations?

CBDCs on Ethereum — the cons

Let’s reiterate: Ethereum is known for…

  • being slow with its max 15 transactions / second
  • having high and fluctuating transaction cost
  • being energy inefficient
  • lacking privacy features
Ethereum sometimes still feels like a traffic jam…Photo by Rumman Amin on Unsplash

Why on earth should central banks like ECB or FED bet on something like Ethereum?

A new wave of innovation

Well, because these are just the current attributes we know from Ethereum 1.0. These attributes certainly don’t match the basic requirements for CBDCs, like they currently put strong limitations to DeFi. But that’s also why half of Ethereum’s ecosystem and all its competitors are working tirelessly to solve exactly these problems. There are many signs that performance issues will be sorted out rather sooner than later. And like with most disruptive innovations, we humans tend to over-estimate the speed of disruptive innovations in their beginning — and we underestimate their speed and power once they are really kicking off.

I expect Ethereum and neighboring blockchains like Cosmos and Polkadot to surprise us similarly…

Photo by Jeremy Bishop on Unsplash

Official statements

On the other hand: In Europe, there are considerations and proposals to create a “digital programmable Euro” and what that might mean. Philipp Sandner, one of Germany’s renowned blockchain experts in the financial space, estimates that it won’t be possible to release a solid digital Euro before 2024 (if we build it from scratch). He works with the German Bundesbank and other experts on requirements. In recent posts, Philipp argues that we won’t see the EURO as CBDC before 2026. So, we speak about a timeline of roughly five years — best case. Quite some time for Ethereum to work on its limitations.

You still think I’m crazy? It gets even better: You’d be surprised that I’m not quite alone with the idea that public blockchains might be a way to go for “official currencies”. See, what US treasury Office of the Comptroller of the Currency (OCC) just published in this letter from Jan 4th 2021:
It states OCC’s Brian P. Brooks that “the United States has relied on our innovation sector to deliver real-time payments technologies. Some of those technologies are built and managed by bank consortia and some are based on independent node verification networks such as blockchains”.
He predicts “[…]an era of stablecoin-based financial infrastructure[…]”.
And please digest these sentences: Our letter removes any legal uncertainty about the authority of banks to connect to blockchains as validator nodes and thereby transact stablecoin payments on behalf of customers who are increasingly demanding the speed, efficiency, interoperability, and low cost associated with these products.

Please let me try to translate into layman’s words: American banks, please react to the recent blockchain developments, embrace stablecoins and start running your own validator nodes for public blockchains to become part of the game.

Boom! Photo by Benjamin Lehman from Pexels

Funny coincidence: Embrace (public) blockchains and stablecoins! Remember my suggestions for retail banks in part 5 (which was clearly published before OCC’s letter)? 😎

Photo by Olya Kobruseva from Pexels

Signs of hope

But let’s come back to reality. I wouldn’t come up with crazy ideas if there wasn’t very interesting evidence that it might be a wise decision to have a deep look into public blockchains and their (future) suitability for digital currencies and CBDCs — at least as one promising implementation option that might soon evolve into a suitable foundation. I’ll walk you through the most important current limitations and solution developments one by one:

Scalability & speed

Photo by SpaceX on Unsplash

As most of us might know, Ethereum is working on its v2 for many years and will have to continue in the foreseeable future (read: years). Once delivered to its full extent, Ethereum v2 will solve many of the limitations mentioned above (except privacy). You should have heard of Ethereum’s successful v2 launch December 1st 2020. But that is “just” phase 0 with Ethereum’s new beacon chain, setting the foundation for sharding — enabling Ethereum to run many transactions in parallel shards. This will bring scalability mid-term, but won’t change Ethereum’s performance attributes for now.

So, if Ethereum v2 phase 0 doesn’t help. Why should we care at all?
Well, because scalability improvements for Ethereum 1 is addressed in many parallel projects throughout Ethereum’s vast ecosystem. This development is heavily driven by current DeFi needs:

  • Roll-up technologies are the most important lever to scale Ethereum short-term. Even Vitalik Buterin (Ethereum’s famous co-founder) assumes that roll-up technologies are key and will change or supplement the current work on Ethereum v2. There are mainly two prominent options: Optimistic roll-ups and ZK-rollups will “bundle transactions” off-chain and settle the results “on-chain” — each technology with its own pros and cons. Both will boost performance dramatically. The interesting aspect: DeFi projects are already adopting these technologies because they are in desperate need of increased throughput and lower transaction cost — with players like Synthetix betting on Optimistic Roll-ups, and projects like Curve investigating ZK-Rollups.
  • Additionally, there are side-chain solutions like Matic and xDai that can be used to off-load uncritical transfers of smaller amounts of money or low-cost assets. Have a look at this tweet if you want a comparison.
  • There are scalable blockchains built on top of “Plasma technologies” like OMG with readily available bridges to Ethereum to off-load traffic in certain areas if necessary. OMG already investigate their match for CBDCs.
  • And there are interesting Ethereum “competitors” like Cosmos and Polkadot gaining traction — they are also able to bridge Ethereum assets bidirectionally to their respective Blockchains (more on that later).

Transaction cost

Photo by Karolina Grabowska from Pexels

Transaction costs are a big problem in Ethereum today — no question about that. High costs hurt many use cases in DeFi, they are unacceptable for a CBDC — especially when we talk about transactions with smaller amounts of money.

As described above, transaction cost will be reduced drastically through most scalability solutions, because e.g. (settlement) costs of roll-ups are divided among many different transactions. If a transaction costs 5$ today and we bundle just 1.000 transactions, then we should expect transaction costs of about 0.005$ — I guess that sounds way more reasonable…

Energy efficiency

Photo by Chris LeBoutillier from Pexels

Energy efficiency is clearly an important requirement in these days. Ethereum v2 means the migration from Proof-of-work (using a lot of compute power for security’s sake) to Proof-of-Stake (instead using staked assets for security). This will fundamentally change the energy story of Ethereum to the positive.

And even in the meantime: Bundling of many transactions into roll-ups will considerably lower the energy cost per transaction.


Photo by Chris LeBoutillier from Pexels

Privacy might be the trickiest part for Ethereum. Scalability hurts so much that privacy is currently not the biggest topic for Ethereum research. But there are very promising players at work like Secret Network who just launched their Ethereum-SCRT bridge on mainnet.

You can lock your existing assets like $ETH, $WBTC and stablecoins like $USDT, $DAI and $TUSD to get “secret versions” in return that are hidden from the public (privacy by default), but can be easily made visible to regulators if needed.

Secret Network runs on top of Cosmos and shows the huge progress in interoperability between both chains. I would highly recommend to keep an eye on this promising project!

You see — our current view upon Ethereum limitations will change dramatically in 2021. The picture will look very different end of year. That’s why I think Ethereum shouldn’t be easily disqualified as base infrastructure for CBDCs.

But there is more to it:

CBDCs on Ethereum — the pros

OK, so now that we’ve discussed potential show-stoppers and see the chance that they might be removed rather quickly: What about the advantages of Ethereum as a foundational platform for launching a CBDC?

There are several advantages to consider Ethereum as foundational infrastructure for (retail) CBDCs — let’s call this a CBSC (Central Bank issued Stable Coin):

The ease of controlling “money supply”

Photo by Pixabay from Pexels

Management of token supply through minting and burning tokens is one of the core Ethereum features. Hundreds of blockchain projects have set up all kinds of tokenomics and token supply mechanisms in their smart contracts — including burn functions to reduce circulating token supply — if needed and suitable.

Central banks should have a look at the tokenomics of stable coin projects like Tether, Circle and MakerDAO for inspiration before they implement their own version of money supply. This could certainly be a staged approach to run small pilot programs with reduced money supply to gradually gain experience and see how a CBSC would be received in DeFi and beyond.

The maturity of the platform

Ethereum is now running for 7 years. Imagine how long it would take to bring up a Central Bank’s own blockchain based infrastructure to the necessary maturity. Why reinvent the wheel, when battle-tested infrastructure is readily available? Central banks could certainly start their very first experiments with a permissioned Ethereum instance but the full impact will certainly need the courage to go for its public mainnet — due to its…


Photo by frank mckenna on Unsplash

Wouldn’t it be a great sign if institutions like Central Banks would bet on a permissionless “public good” like Ethereum?

  • Built upon open source software by a broad community.
  • Governed by its very own users’ community.
  • Run by a diverse set of miners and validators.
  • Driven by pluralistic values.

Certainly — central banks need ultimate control over their money supply. But this is a problem for all kinds of implementation of digital money: they need to work and interact seamlessly with existing smart contracts and blockchains like Ethereum. So, why invent something new and interface with this new world instead of building directly on top of it?

Going that way, Central Banks would fuel the ongoing developments instead of urging governments to just “regulate” them from the sideline. These institutions could bring in their own set of requirements to make these systems even better and bring them to the masses. But they certainly would have to think out-of-the-box and in totally new ways. It won’t work to just bring in existing regulations — regulations need to be re-thought from their initial purpose and projected onto this new technology. But that’s a development we see happening anyway

Value Systems

The political impact of a move like this would be huge. The trust in institutions is degrading in many parts of the world. They tend to live in their own world, slowly separating themselves from people’s everyday reality and ultimate needs. I think we need closer interactions between institutions and people, institutions and technology, institutions and markets.

Blockchains and token systems are the ultimate tool to bring these aspects together again. That’s what fascinated me from day one. It’s not just a technology. It’s a technology that weaves markets, values, people, incentives and governance together into one social system.

Institutions like Central Banks should try and use that effect and further improve their relationships to citizens by joining these ecosystems instead of just adopting the tech part for their own purpose.

Bringing it all together

As we saw, Ethereum and the broader ecosystem with its “sister chains” currently evolves rapidly as a system for assets — and money. It already has a lot to offer and is developing forward at an intense speed.

Even more so, there is actual need for fiat-like money in DeFi. It’s already there and accepted for $USD in the form of $DAI, $USDC and $USDT. I expect it soon to arrive for $EUR once MakerDAO decides to invent a $EuroDAI or Synthetic creates a synthetic $sEUR — following suite to Stasis’ promising $EURS. DeFi platforms like Curve-finance will bring them together and create hundreds of millions of liquidity in days rather than weeks. It’s just a matter of time. I’m a 100% sure we’ll see one form or the other of “accepted” Euro in DeFi and on Ethereum in 2021.

That’s why I see Ethereum at the heart of it (at least for now), with sister chains bringing additional characteristics, like we saw with Secret Network for privacy. There’s already a plethora of these sister chains — some based on Cosmos and Polkadot, others based on Solana or Near Protocol. Expect “bridges” between blockchains to become more and more seamless to the user, creating a web of blockchains with attributes optimized for certain use cases. Ethereum in its current state might be best suited as an investment platform for larger amounts of money, Bitcoin serving as its store of value, Secret Network might be the one for B2B, the race for cash-like transactions is still somewhat open to me. But it will certainly be linked to this ecosystem.

Central banks are free to decide whether they want to have a say in the de facto standardization of fiat money in this ecosystem and be part of the game — or if they try to create their own separate “digital money world”. They certainly need to “bridge into it” anyway. So why not build upon it?

It would be so much fun to see central banks experimenting on top of Ethereum!

Here’s how it could probably work:

Step 1: Be part of it (passive)

Start mining Ethereum v1 and stake on Ethereum v2.
Set up your central bank nodes and validators. It’s permissionless.
You don’t need to ask for allowance.

Step 2: Start public experiments (become active)

Investigate ERC20 as the technical foundation of the digital ECB Euro and FED Dollar. Engage with the broader community to get a feeling of what’s possible. Set up playing fields with limited amounts of officially backed currency. See what happens.

Step 3: Learn

Be agile: Inspect and adapt!


In the meantime, I’ve published subsequent parts for this series:

A personal note

I’m well aware of my Western bias which certainly shines through — especially in this article. I was born and raised in Germany. As you’ve noticed, democratic and pluralistic values are rooted deeply in my thinking and hopes for the future. To me, governments and institutions are invented to serve society, economy, the people and ultimately myself — not the other way around. I see the fantastic chance that token-based ecosystems could be the vehicle to spread this kind of thinking again and build a better future.

I don’t want to hurt anyone’s feeling who might think differently.

Disclaimer: This article is not intended to be an investment advice of any sort. Do your own research and search for professional support if you intend to invest in one of the projects mentioned in this article.

You are also welcome to follow me on Twitter or get in touch via LinkedIn (but please tell me your reason to connect and how you found me).



Stefan Grasmann

Blockchain enthusiast. Driving Thought Leadership @zuehlke_group to the next level. Innovator | Strategic Advisor | Networker | Speaker.