Skip to content

CBDCs

As blockchain technology gains traction, central bank digital currencies are among the most powerful applications being developed. But these will inevitably fall far short of the ideal for one simple reason: control. In particular, that has implications for composability and privacy, and much else besides.

Central bank digital currencies are no longer a theoretical application of blockchain technology. The list of countries developing CBDCs is growing rapidly, with several now trialling state-backed digital cash.

CDBCs are not built on classic, open blockchain technology. While there are various approaches, they are all based on permissioned ledgers that restrict the role of securing the network and processing transactions to a group of approved entities. They also include a control layer that allows administrators to intervene in transactions, blocking or reversing those they deem invalid.

It's a far cry from the ideals of Bitcoin and the Ergo platform that aims to build on these. But it's only to be expected. The state has a role and a remit, and it's unlikely to give up the control it exercises. Unfortunately, though, two ways holding onto control will mean that CBDCs fall far short of what they could be, meaning they may ultimately cede ground to open platforms like Ergo.

Composability

As we wrote in a recent blog, composability is a core feature of DeFi. It gives applications network effect, instantly adding value by plugging into existing apps user bases and functionality.

Programmable money is a huge development. The current system is clunky and complicated to use, at best. It's impossible to attach detailed conditions to transactions, and have them interact seamlessly with software, as can be done with blockchain and smart contracts.

Imagine the value that we could unlock if CBDCs were programmable, and we could integrate smart cash frictionlessly into new applications – banking interfaces, investment services, stores, social networks, games. The list is endless. But this is hardly likely. The freedom to program money will exist, for many years at least, in the open blockchain space alone.

Privacy

Secondly, we consider privacy to be a core requirement of DeFi. Money is too important to be used as a surveillance tool, but there is no question that this is what it will become as soon as the first CBDCs are rolled out to a large user base.

China is one of the furthest ahead in creating state-backed digital cash. This is a notorious state for its internet censorship and online surveillance of its population. Its human rights record is dire, and in recent days we have learned more about its oppression of the Uighur minority. Moreover, China already uses a social credit system, which grants or denies citizens access to certain services and amenities depending on their social score, with model citizens enjoying greater privileges.

There is, again, no question that a state-backed, traceable CBDC will be used as a tool of surveillance on a scale that is unprecedented in human history. And it will be the same across any nation that implements money within the same framework.

That giant eye on the dollar bill? You have not seen anything yet.

Private, programmable financial services

Ergo has a very different vision for blockchain-based cash and financial services. In the new blockchain paradigm, value is not retained by constraining it, and it is only maximised through open systems that make it as accessible as people want. Money without borders, in both senses: cash that can be programmed, sent and received freely but privately, between any two individuals or organisations – and even blockchains – anywhere in the world.

This is what money needs to be and what Ergo is building.

This is the first in a series of articles speculating on how the fast-emerging DeFi sector might evolve in the coming years.

The DeFi movement, as it currently exists in only a few months old, and blockchain itself has barely existed a decade. We are already beginning to see themes crystallising and the first popular use cases becoming established.

As a DeFi platform that takes positioning for the future seriously, Ergo must have a vision – not only a sense of where things might be heading but the role it should play as these new decentralised financial services consolidate and grow in popularity.

While no one can know the future, least of all in this space, several trends, technologies, products and use cases are emerging, and it seems that these are starting to plot a certain trajectory. Allowing for necessary course correction as time goes on, where might we see DeFi end up in ten years?

Tokens will be the fuel for DeFi, and everything will be tokenised

One of the major themes apparent, long before the yield farming craze brought DeFi to global attention is tokenisation. We already have blockchain tokens representing cryptocurrencies and digital assets, and the first shares and other securities have been issued on the blockchain. The benefits are such that the direction of travel is clear. Sooner or later, everything will end up as tokens.

A regular token will work for regular, fungible (interchangeable) assets. Fiat and cryptocurrencies, shares, bonds, precious metals, ETFs, CBDCs – these will all be freely available on the blockchain.

For other assets, NFTs will proliferate. When you buy a car, house, painting, or another unique item of value, whether digital or physical, the transaction will also include a blockchain token.

These tokenised assets will place trillions of dollars of value on the blockchain that are currently 'stuck' offline, illiquid or impossible to buy or sell outside certain limited circles and circumstances. This pool of tokenised value will represent the fuel of the Defi economy: assets that can be traded frictionlessly, borrowed against and leveraged using decentralised protocols that probably won't look so very different to the ones we use today.

Digital identity will become non-negotiable

Since these assets will be tradeable on centralised and decentralised exchanges, digital identity will also become an increasingly important theme. This will link blockchain addresses with offline identities, enabling individuals and corporations to operate in a compliant way with relevant regulations. It will also allow the automation of tax and accounting processes. To date, digital identity has been an overlooked element of the DeFi ecosystem – likely due to the use of centralised platforms that can conduct KYC as a condition of use. We're fast approaching a point where that is no longer a given, with the growth of new forms of a decentralised exchange and the increase in volumes moving to these platforms.

Stablecoins will become embedded elements of the blockchain

One of the biggest use cases for DeFi – and again one that is often overlooked – is stablecoins. These exist in many forms and rely on a range of approaches: centralised and decentralised, collateralised and algorithmic, fiat-backed, etc.

Whatever your preferred approach or view of stablecoins, they are here to stay. They have found use cases as a store of value, especially for traders, and as a popular form of collateral for yield farming.

They haven't been widely adopted yet as an integral part of blockchain infrastructure. Transaction fees are almost always paid for with the native blockchain token. Not only does this fluctuate in value, but so does the amount required per transaction, depending on both the complexity of the transaction itself and competition for space in the next block. This complexity is not conducive to mainstream adoption. End users are best served by simplicity, with minimal burdens for managing multiple tokens. They will want to pay transaction fees in a stable unit of account and not have to worry about handling the native blockchain token.

The solution? An integrated stablecoin that, to most end-users, is the most important token on the platform.

Two-tier system

As a result of this need, it seems likely that we may start to see a two-tier system evolve more clearly. A blockchain such as Ergo will have a native token, which will serve as the underlying payment currency, just as it occurs now. For the most part, though, these will only be handled by more experienced users. These expert users will maintain the technical and financial infrastructure of the DeFi space. For example, they will mine and use the native token as collateral to create a stablecoin, which we can sell into the market for general use in return for tokenised assets of all kinds.

Regular users will then use the 'native stablecoin' as a standard reserve currency in all their businesses. We will use it to buy other assets; it will be lent to users against other tokenised assets as collateral (houses, cars, real estate and much more); and we can use it to pay transaction fees.

The miners who receive this native stablecoin can hold it to pay for electricity and hardware costs, or they can convert it back to the platform token or other assets – that is up to them.

These are just some of the themes we are starting to see emerging in the DeFi world and how they might develop over time. We'll explore various other ideas in the coming weeks as the space evolves and Ergo launches new technology.

Ergo enables new models of financial interaction, underpinned by smart contracts built on flexible and powerful Sigma protocols but easily accessible to developers.

One of the most exciting things about blockchain is the possibility of making digital agreements without any trusted intermediaries. In the simplest use case, pioneered by Bitcoin, Alice can send a payment directly to Bob, wherever the two are located around the world, with no bank or any trusted third party needed. However, with the functionality of a modern blockchain like Ergo, it is possible to make far more complex and sophisticated financial agreements than simple payments. Take the following example.

Gold-backed tokens

Alice uses ERGs to purchase gold-backed tokens from Bob. Bob stores the gold in a secure vault and uses the blockchain to issue one token for every Troy ounce of gold he has. Alice can then use these tokens freely in different contracts, transferring and trading them under whatever conditions she specifies in the smart contract code. When Alice wants to sell the tokens for physical gold, she can conduct another transaction with Bob, receiving ERG in return at market price.

The point of blockchain contracts is to eliminate the need for trust. While the purchase transaction is now trustless, in this instance, Alice still needs to trust Bob about two things. Firstly, Bob may refuse to swap the gold tokens back to ERG at the correct price when Alice wants to sell. Secondly, Bob may default on his obligations – running away with the gold or misusing the funds he receives and running a fractional reserve.

Extending the contracts

We can create an Oracle or decentralised price feed to address these issues. This uses multiple external data sources to record the price of gold to the blockchain at regular intervals. This price feed will be the reference point for the redemption contract that manages the sale of Alice's gold with Bob (or any other participant). Thus the system automatically enforces the right price when a swap takes place.

The second situation requires a third-party insurer, Charlie, whose service is also hosted on the blockchain with a smart contract. When Alice purchases gold from Bob, she additionally buys an insurance contract from Charlie. The payment can depend on factors including the amount of insurance required and Bob's reputation – again, managed by a decentralized feedback mechanism. Now, if Bob defaults, Alice will automatically receive the value of her gold tokens, with Charlie effectively acting as a buyer of last resort.

Programmable contracts

There are, of course, many other example use cases like this one. We can also extend this use case, adding further economic actors. For example, Charlie may sell shares in his insurance business to Dave and other participants, providing them with a proportion of revenues to ensure he has the capital he needs to cover any liabilities from the outset.

However, even the most complex use case is simpler than general-purpose software that can be used to program any contract. After all, generalised logic must be both far-reaching and secure. Moreover, even a specialised contract comprises many steps, each of which is fairly simple. Thus another requirement for a general-purpose platform is that it should simplify the process of writing contracts, making them as accessible (and safe) as possible. This can be achieved using template agreements with customisable parameters. For example, the insurance contract above could be based on a module with flexible parameters, and this could be used and reused in many different circumstances.

Ergo's approach

This is essentially the approach that Ergo takes, providing superior support for real-world financial agreements. It does this through:

  1. Support for multi-stage contracts (watch details for developers)
  2. A simple high-level language, ErgoScript, enabling clear descriptions of contractual logic
  3. Support for formal verification of contracts for improved security guarantees (Ergo Platform deployed its first formally verified p2p crowdfunding contract just three months after the network launched)
  4. Easy Oracle creation
  5. Native support for complex signature schemes

In short, creating financial contracts on the blockchain isn't just about the functionality you provide; it's about making that functionality safe and accessible and powerful. Ergo achieves this and more.

As the next financial crisis takes hold, it's clear that conventional monetary policy is at its limit. Smart contract platforms like Ergo enable more innovative, targeted implementations of economic stimulation that the conventional banking sector cannot achieve.

Conventional monetary policy is a hammer. It works as far as it goes, but if all you have is a hammer, every problem starts to look like a nail.

When the Global Financial Crisis hit over a decade ago, central banks did what they were used to doing. Cutting interest rates means it's cheaper to borrow money, so more cash in the system can be spent and circulate in the economy – paying for goods and services, finding employment, and allowing life to continue something like normal.

That, at any rate, is the theory. It's what central banks do in recessions to stimulate economic activity. When times are better, they raise interest rates to make it more expensive to borrow money and prevent the economy from overheating (including asset bubbles).

The outer limits

This is a blunt tool, but it works up to a point. In the 2008 crisis, the problem was more severe – so severe that interest rates were slashed to zero. Banks were still afraid to lend because they didn't know the quality of the collateral offered in return, those notorious mortgage-backed securities.

So the central banks undertook a programme of Quantitative Easing (QE). This entailed creating huge amounts of cash that didn't exist before and then purchasing various banks' assets. The idea was that the central bank would take on the risk and the assets. Commercial banks would then use this gift of liquidity to lend to small businesses and individuals, allowing them to continue operating as before.

It didn't work. Little of that newly-created money went to small businesses. Instead, banks used it to shore up their balance sheets and make their finances safer, investing only in low-risk assets rather than risky SMEs. Ultimately, cash filtered through to assets like the stock market and property, making the wealthy even more wealthy while the poorer were priced out of the market.

Helicopter money

Today, as we experience the greatest financial challenge of our lifetimes – greater than even the Global Financial Crisis – central banks are considering even more unorthodox approaches. One of these is 'helicopter money. This involves cash being airdropped directly to citizens, either in tax breaks or as money straight into their bank accounts. America has discussed giving \$1,200 to every adult, and other nations are exploring the same idea.

But there's a problem with this, too.

Just like the banks, ordinary citizens are worried about their finances. So instead of going out and spending (were 'going out is even possible), they pay down their debt. That newly-printed money goes nowhere.

That's as far as central banks can go. But a platform like Ergo can offer different types of money, with different conditions attached via smart contracts, incentivising different behaviour in different circumstances. And that enables a whole different range of monetary policy tools.

'Hot potato' money

Banks seek to maintain an inflation rate of around 2% in normal times. This means money is worthless over time. So instead of saving it all and seeing the value of their savings fall, citizens have the incentive to spend it and circulate it within the economy.

Too much inflation, of course, is a bad thing. Get money printing wrong, and you have hyperinflation like Venezuela or Zimbabwe, and your economy collapses.

But what if we kept inflation low but created a limited amount of a special class of money that had to be used quickly if it was to retain its value at all? We'll call this 'hot potato' money because it has to be passed on fast.

Using blockchain and smart contracts, this would be a simple matter of creating a new token that could be freely transferred and traded, just like any other token. And it could be backed by reserves (held with the central bank, commercial banks or any other entity). But the difference would be that it has to be spent within a month of receiving it, or those tokens are locked, their value is lost to the holder, and the funds that back them are freed up to return to the reserve holder.

So this would be regular money that people had to spend: use it or lose it. If they hoard it, it becomes useless. And we can ensure that it is not used to pay down debt by including conditions that ensure the banking sector cannot use it. Of course, Ergo's Sigma protocols can be used to figure out what has been spent, where, without knowing individual spending habits – enabling even more targeted stimulus.

This idea likely has far-reaching implications – and possibly unintended consequences. What would the result be, for example, of creating different 'classes' of money that were only semi-interchangeable? Would this introduce unwelcome, even dangerous friction?

This and other questions would need to be explored further. Central banks are already experimenting with unconventional monetary policy and fast reaching the road's end. We can continue that experiment with better, more powerful and targeted tools.

Powerful But Safe Contracts

Ethereum is an exceptional platform, but there are things it does not do well. Its Turing-complete smart contracts are powerful but dangerous – as incidents from The DAO to the Parity wallet exploits have proven, with tens of millions of dollars in collateral damage. With complexity comes uncertainty and potentially catastrophic vulnerabilities. Contracts can be expensive to run, and depending on network conditions, may execute unpredictably – or not.

Ergo takes a fundamentally different approach to smart contract development. The team, which has extensive experience with blockchain platforms, frameworks and organisations from Nxt and Waves to Scorex and IOHK, has adopted a declarative model for programming whereby it's always known in advance how much code will cost to run – and, indeed, whether it will run precisely as intended. While that might, on the surface, limit code complexity, it's nevertheless possible to create Turing-complete scripts by iterating processes across multiple blocks. That means Ergo can support versatile dApps that run predictably, with known costs, and don't have any of the dangers of unrestricted functionality.

Sigma protocols

The platform is unashamedly conservative, basing as many features as possible on Bitcoin – after all, Bitcoin is the most battle-tested crypto network in existence. Ergo's UTXO model, PoW mining and finite supply draw on Bitcoin's approaches to consensus and economic incentives.

But Ergo also incorporates cutting-edge research into new cryptographic processes, using Sigma protocols to enable DeFi applications that would be either complex and messy or simply impossible on other platforms. Sigma protocols are a well-known class of zero-knowledge proofs that allow developers to implement very powerful processes very elegantly. For example, what if you want to build a privacy service that allows any one of a dozen different accounts to spend funds from an address – but no one can tell who has made each transfer? Such a 'ring contract' is possible with Ethereum, but it would require a clunky and expensive workaround. With Ergo's Sigma protocols, it's possible to implement this kind of use case and many others quickly, efficiently and – above all – securely. Sigma protocols have not been deployed in such generic form within crypto before. Yet this kind of out-of-the-box functionality is hugely valuable, especially when no other DeFi platform offers it.

Ergo enables new models of financial interaction, underpinned by smart contracts built on flexible and powerful Sigma protocols but easily accessible to developers.

One of the most exciting things about blockchain is the possibility of making digital agreements without any trusted intermediaries. In the simplest use case, pioneered by Bitcoin, Alice can send a payment directly to Bob, wherever the two are located around the world, with no bank or any trusted third party needed. However, with the functionality of a modern blockchain like Ergo, it is possible to make far more complex and sophisticated financial agreements than simple payments. Take the following example.

Gold-backed tokens

Alice uses ERGs to purchase gold-backed tokens from Bob. Bob stores the gold in a secure vault and uses the blockchain to issue one token for every Troy ounce of gold he has. Alice can then use these tokens freely in different contracts, transferring and trading them under whatever conditions she specifies in the smart contract code. When Alice wants to sell the tokens for physical gold, she can conduct another transaction with Bob, receiving ERG in return at market price.

The point of blockchain contracts is to eliminate the need for trust. While the purchase transaction is now trustless, in this instance, Alice still needs to trust Bob about two things. Firstly, Bob may refuse to swap the gold tokens back to ERG at the correct price when Alice wants to sell. Secondly, Bob may default on his obligations – running away with the gold or misusing the funds he receives and running a fractional reserve.

Extending the contracts

We can create an Oracle or decentralised price feed to address these issues. This uses multiple external data sources to record the price of gold to the blockchain at regular intervals. This price feed will be the reference point for the redemption contract that manages the sale of Alice's gold with Bob (or any other participant). Thus the system automatically enforces the right price when a swap takes place.

The second situation requires a third-party insurer, Charlie, whose service is also hosted on the blockchain with a smart contract. When Alice purchases gold from Bob, she additionally buys an insurance contract from Charlie. The payment can depend on factors including the amount of insurance required and Bob's reputation – again, managed by a decentralized feedback mechanism. Now, if Bob defaults, Alice will automatically receive the value of her gold tokens, with Charlie effectively acting as a buyer of last resort.

Programmable contracts

There are, of course, many other example use cases like this one. We can also extend this use case, adding further economic actors. For example, Charlie may sell shares in his insurance business to Dave and other participants, providing them with a proportion of revenues to ensure he has the capital he needs to cover any liabilities from the outset.

However, even the most complex use case is simpler than general-purpose software that can be used to program any contract. After all, generalised logic must be both far-reaching and secure. Moreover, even a specialised contract comprises many steps, each of which is fairly simple. Thus another requirement for a general-purpose platform is that it should simplify the process of writing contracts, making them as accessible (and safe) as possible. This can be achieved using template agreements with customisable parameters. For example, the insurance contract above could be based on a module with flexible parameters, and this could be used and reused in many different circumstances.

Ergo's approach

This is essentially the approach that Ergo takes, providing superior support for real-world financial agreements. It does this through:

  1. Support for multi-stage contracts (watch details for developers)
  2. A simple high-level language, ErgoScript, enabling clear descriptions of contractual logic
  3. Support for formal verification of contracts for improved security guarantees (Ergo Platform deployed its first formally verified p2p crowdfunding contract just three months after the network launched)
  4. Easy Oracle creation
  5. Native support for complex signature schemes

In short, creating financial contracts on the blockchain isn't just about the functionality you provide; it's about making that functionality safe and accessible and powerful. Ergo achieves this and more.

DeFi dApps have overloaded the Ethereum blockchain, causing long delays and soaring transaction fees. Ethereum and many other platforms have researched and implemented fixes to address the lack of capacity. However, all of the solutions are imperfect in one way or another. Larger blocks are the obvious but clumsy fix, resulting in centralisation as fewer miners can afford the bandwidth, storage and CPU cycles to participate. Reducing the number of block validators – another approach to increasing throughput – also necessarily centralises the blockchain. While potentially very promising, sharding has yet to be implemented successfully, and in some proposed implementations, breaks atomic composability because shards cannot communicate seamlessly.

Thus, many ways projects seek to ensure their blockchains are fit for purpose result in greater centralisation or loss of critical functionality.

Marginal gains

Ergo's developers are closely watching developments in the DeFi space, especially some of the proposals that aim to scale blockchains while maintaining security, decentralisation, and atomic composability. In the meantime, much can be done to improve blockchain capacity. The concept of 'marginal gains', often applied in sports, is useful: several small, incremental gains in different areas add up to a substantial compound effect.

For Ergo, several design principles and choices have been taken to realise efficiencies in different areas.

  • Storage rent is akin to 'on-chain garbage collection', reducing blockchain bloat and lowering the long-term costs of mining, improving economic sustainability.
  • NiPoPoWs (non-interactive proof-of-proof-of-works) enable mobile SPV clients and even lite full nodes, again reducing the barriers to maintaining the network and improving decentralisation.
  • A smart contract language that is finite and clear, without the messiness and possible chain bloat of Turing-complete languages and their unintended consequences.
  • Sigma Protocols allow for powerful cryptographic use cases, implemented elegantly and efficiently.

As DeFi emerges as a major use case for blockchain, the stakes could not be higher. Blockchains that are fit for purpose will thrive; those that do not allow the functionality to sustain the required transaction load simply cannot establish a foothold. At the same time, moving too fast and implementing untested technology is equally dangerous.

There are efficiencies to be gained in first-generation blockchains. Ergo continues to prioritise this approach while researching future upgrades.

Ergo Blockchain is Layer 1 Protocol for powerful Decentralized Finance Contracts that builds advanced cryptographic features and radically new DeFi functionality on the rock-solid foundations laid by a decade of blockchain theory and development. The Proof of Work consensus algorithm and underlying UTxO model enable robust scalability and security. Ergo is also partnered with EMURGO, the commercial arm of Cardano, to improve research on blockchain and zero-knowledge ecosystems. To check out some smart contract deployments, see our GitHub repositories here and here.