The Brazilian Central Bank Approach to Tokenization of the Financial System and Our Views About How This Ecosystem Will Evolve

Emerging technologies, such as distributed ledger infrastructures (DLTs) and smart contracts, make room for new business models that seek to meet the population’s demand for native digital means of settlement, such as the instruments and solutions available in the crypto asset ecosystem which are aimed at lowering transaction costs and ultimately bring more financial inclusion.

The evolution of financial systems has been supported by the modernization of the legal framework, the broad and accessible use of secure technology and the focus on offering value to citizens, through innovation in payments, capital markets, lending and banking. 

In this context, central banks and financial regulators are increasingly approaching the vision of a tokenized economy, that can bring efficiencies and lower costs to the sector, through initiatives related to CBDCs, as well as through the proposition of regulatory frameworks and supervision models focused on the private crypto-asset segment. 

Having said that, it is the regulators’ responsibility to foment a safe environment to allow the creation of new business ideas and promote the access to the benefits of this digitized economy to the largest number of people possible. In the past 15 years, the Brazilian Central Bank (BACEN) has been positioning itself as one of the most innovative and tech oriented worldwide, serving as a benchmark for many institutions around the globe. Led by Campos Neto and a team of motivated and forward-thinkers, the BACEN has been transforming the financial system and moving Brazil to a new frontier in recent years. With the advances of technologies and initiatives such as PIX, Open Finance and CBDC (Real Digital), and new licenses and regulations such as IP, SCD, SEP, Receivables Regulation, we now see a more fragmented market and digitally connected population with broader access to financial services. The tokenization of the economy and the connection to DeFi is the tip of the iceberg and one of the most important steps of the Central Bank’s agenda going forward. 

During the event, we are able to experience first-hand what is driving the Central Bank’s agenda towards CBDC and tokenization, seeing some very exciting trends and opportunities. A lot of these discussions are still incipient, but given the speed of innovation, some of them will start affecting everyday’s lives very soon. The main trends, discussions and articles about the topic that were brought during the conference were the following:

• The need of a multidisciplinary set of entities working together: current innovations and proposals on the crypto and digital assets’ spaces demand an accurate and sharp acting from all the players that are involved in it. Technically speaking, there are several layers that need to be disrupted to allow the creation of the tools and rails needed to digitize the current financial structure. However, this will only be possible to do if aligned with a robust legal framework and proposals to address what was previously nonexistent. In parallel to those two aspects, the market and academia should be working in sintony to bring the right incentives and intellectual property to enable those innovations. All the projects that were presented covered in depth, not only the technological points, but also the regulatory and economics aspect behind the proposals.

“Inovação e Economia Digital” | Otávio Ribeiro Damaso – Diretor de Regulação do Banco Central do Brasil & Prof. Robert M. Townsend – Massachusetts Institute of Technology (MIT)

• There is a clear application and latent pain point to be addressed in the field of traditional assets tokenization through the use of CBDC: the Brazilian Real won’t focus initially on retail as many people think. It is clear that the initial use cases are being created towards enabling more efficiencies and cost reductions possibilities in the Brazilian financial market, especially wholesale. The CBDC has a massive potential to create a faster, cheaper and more secure settlement layer between banks and financial institutions and is going to interoperate with other existing rails and DeFi. The buying and selling of CCBs – Cédulas de Crédito Bancário – should be mentioned as one of the processes that can be impacted and improved by a tokenized environment, has its value chain optimized and its issuing cost structure reduced. We see many other asset classes being impacted, which make even more clear that tokenization and CBDC can help to rebuild or improve the whole Brazilian financial market.

Desafios para Implementação de Sistemas CBDC’s interoperáveis: natureza do Real Digital e possibilidades para interoperabilidade | Fernando Mirandez Del Nero Gomes (Pinheiro Neto Advogados)

• Cryptography and the blockchain ecosystem should be seen as a constantly disrupted body: as mentioned in one of the panels during the event, there is no technology, even when we are talking about cryptography, that does not have the possibility of being disrupted. Enigma, for example, a cipher device employed extensively by Nazi Germany during World War II, was supposed to be the unbeatable cryptography means of communication at that time and was cracked by Alan Touring in England. In this way, the incentives to innovation and the creation of a tech-driven ecosystem in the financial sector should be priorities when talking about the implementation of structures to tokenize traditional assets, enable the introduction of CBDCs and disrupt current payments and remittances rails.

“A Multi-Currency Exchange and Contracting Platform” | Federico Grinberg (International Monetary Fund – IMF)

• Current legal frameworks will have to be questioned and new standards created: current legal structures do not contemplate some of the issues and questions that arise when talking about CBDCs and digitalization of traditional financial assets. The more innovations disrupt the current rails, the more questions will appear and new standards will have to be created. Disruptions have been started by the upper layers of the system and are coming down to its roots. Questions around privacy, security and decentralization will take place more and more

Moeda e dívida: Uma cartografia jurídica das moedas em circulação no Brasil | Daniel Fideles Steinberg (Bitso)

Stablecoins – Uma análise jurídico-regulatória a partir de suas funcionalidades | José Luiz Homem de Mello (Pinheiro Neto Advogados)

• After successfully launching and scaling PIX, CBDC is a key short term focus for the central bank today: Pix was first launched in 2020 with some simple core functionalities and has been iterated since then. In only two years of its operations, Pix is responsible for more than 3 billion transactions monthly with roughly 130 million people in Brazil using it using it. As presented by Eronides from CESAR School, PIX is as fast as the lightning network, but a step ahead in terms of user experience, as adoption shows. We see a massive potential for interoperability between those networks, as more applications are built on top of them. The CBDC, on the other hand, is just starting as the infrastructure enabler for interbank payments and remittances, and the regulated on-ramp to the digital assets economy. Financial institutions and technology providers submitted their proposals to the Central Bank last week and a few of them are going to be selected to run the pilots with Real Digital. We’ve seen a variety of use cases being tested such as: Delivery Versus Payment, Tokenization of Financial Assets, Asset Backed Lending, Interbank Deposits Settlement and many others.

Um estudo comparativo de usabilidade entre o Pix e o Lightning Network para pagamentos instantâneos presenciais no varejo | Eronides Felisberto da Silva Neto (CESAR School)

• The blockchain trilemma: security, decentralization and scalability should be core components of the Real Digital project: the Central Bank has chosen Hyperledger Besu as the chain for the Pilot of the project. Alex Buelau, the Co-Founder and CTO of our Portfolio company Parfin presented a very interesting paper showing how the infrastructure could achieve a much higher TPS by using Parchain, an EVP compatible network created by Parfin. Alex also explained how Parchain can  help to solve for privacy between financial institutions, since participants and validators (i.e Banks) can’t see each other’s ledgers and can run their own “sub-chains”. Although incipient, Parchain is already being tested by some of the major financial institutions in the country and presents a great opportunity for Parfin.

“Addressing Privacy Challenges in Permissioned Blockchain Adoption for Financial Institutions and Governments” | Alex Buelau (Parfin.io)

• Smart contracts are not always the most effective solution: Yuri Martins, the CEO of Hathor Labs, presented a paper that discussed the need of using smart contracts in heavily regulated markets. According to him, when you are dealing with a heavy regulated market, where the bylaws are defined and regulations can change every time, it makes sense to have the regulatory and financial framework solved off-chain (through multi-sig), especially because creating a smart contract that is changing every time, goes against one of the core principles of the technology (immutability) and can break the trust of network participants.

“A technical solution to implement financial regulation into secondary markets of tokenized financial assets” | Yan Martins (Hathor Labs)

We at Valor Capital come out of this Conference very impressed by how forward thinking and inclusive the Brazilian Central Bank continues to be, and mesmerized by the level of sophistication of so many people and organizations building tools, frameworks and ideas to deliver a more efficient payment landscape and financial market in Brazil. We remain highly excited about the idea of backing Entrepreneurs who have a mission to help create the next generations of financial technologies, using regulation as an edge, and look forward to continue to back entrepreneurs in the space