Highlights:
- Establish a dividing line between central bank, commercial bank money
- Directed farm lending not meeting targets with branch closures
- Automate the lending application process
- Programmable money ensures money is spent appropriately
- Create a marketplace for banks to bid on loans
In March, Banco Central do Brasil unveiled nine participants in its Real Digital Lift Challenge, a central bank digital currency (CBDC) trial. One of the projects focuses on directed farm lending.
Initially, the lending will be in tokenized commercial bank money, which could later switch to have the tokens backed by CBDC. Michael Wagner, a partner at Oliver Wyman, observed that it is important to test the resilience of programmable money in day-to-day applications before launching a CBDC.
At a big picture level, if the lending is going to switch from commercial bank money to CBDC, what’s the role of the commercial bank? In this case,account services such as facilitating loan requests wouldbe allocated to the banks, preserving the two-tiered banking system.
With directed lending, banks provide loans at lower interest rates to farmers, which are costly to service under the traditional banking system. CDBC funding for these loans would free up bank balance sheets for more profitable lending operations.
“This project is giving the Central Bank of Brazil and the commercial banks some time to practically use a system and technology to determine where that dividing line is (between CBDC and commercial bank money),” said Kelly Mathieson, Chief Client Experience Officer at Digital Asset. “Where can you still preserve the two-tiered banking system and at the same time get more lending into these small and family farmers?”
It’s also exploring a different dividing line relating to privacy. The central bank wants to see all transactions and support privacy. So it will see the transactions but not the individual farmer’s name.
For this use case, there are three partners. Blockchain firm Digital Asset is known for its Damlsmart contracting language, stock exchange work, and, more recently, its push into CBDC. It’s joined by management consultants Oliver Wyman and VERT Capital which securitizes agricultural loans.
What problem is CBDC trying to solve?
Brazil has significant agricultural programs that direct low-cost lending to farmers. The largest program is targeted at the smaller end of the scale, but even though cheap money is on offer, it is underutilized.
The government used to penalize banks that didn’t lend enough to farmers, but that has weakened over the last few years. And banks are closing branches, particularly in less profitable rural areas.
Because applying for an agricultural loan is non-trivial, the reduction in bank branches is having an impact. There are many specific programs for fertilizer, seed and other goods. Often an agronomist needs to get involved in confirming the farm is compliant, increasing the costs of providing the loans.
The big picture solution
Oliver Wyman, Digital Asset and VERT are working on a program to digitalize the process for agricultural lending and reduce the barriers to getting funds to the farmers.
The solution involves multiple aspects:
- digitalizing and automating the lending application process
- programmable money to ensure funds are used as intended
- a marketplace for agricultural lenders.
Using a digital approach, the farmers are guided through the loan application with a series of questions. This can streamline some of the expensive work done by an agronomist. Instead of the agriculture expert spending time drawing up a plan, they certify the validity of the proposal.
Additionally, agronomists frequently help with education which can be delivered digitally. For example, it’s natural for farmers to want to economize on the cost of fertilizer. However, more expensive fertilizer can produce higher quality crops and a better farming yield, which more than pays for itself.
From programmable money tokens to CBDC
In addition to digitalizing the lending process, the solution uses programmable money. It’s not the CBDC itself that’s programmable, but a separate programmable token that in the future could be backed by the CBDC. Programmable money aims to ensure that the loan funds are used as intended. While there’s a relatively low default rate for small farm loans, those non payments are often the result of misuse of proceeds.
“The challenge is that there are no parameters around how the funds can be used,” said Oliver Wyman’s Wagner. “In some cases (not all) individuals are using the loan proceeds to purchase general consumer goods rather than necessary farming equipment, such as fertilizer.”
Programmable money means that the funds can only be spent at approved farm shops, and it’s viable to control the amount spent on fertilizer, seed or other farming items.
In Brazil, a substantial part of the mechanism is already in place to make it possible to monitor how the money is spent. All invoices in Brazil are electronic, which means they can be checked to ensure that the purchased fertilizer or seed is of adequate quantity and quality.
VERT Capital, the third partner in the LIFT Challenge team, securitizes agricultural loans, so they have already integrated with farm shops. However, currently the loans VERT deals with are for the more industrialized mid-tier agriculture businesses, as opposed to the smaller farms.
Using distributed ledger and smart contract workflow with Daml, the tracking of usage based on invoices is combined with programmable money to reduce loan default risk significantly.
“It brings down not only the cost to deliver the loan, so the operational cost, but also the risk cost,” said Wagner. “And certainly also the compliance cost, creating an environment that will create a big uplift to the agricultural segment in Brazil.”
Creating a marketplace
So far, the solution helps farmers apply for loans digitally and monitors that the funds are used for appropriate purposes. The other side of the process is the provision of loans by commercial banks. There will be a marketplace where the banks can bid for the loans.
Digital Asset’s Mathieson drew a parallel between the company’s workflow projects for stock markets and the farm lending solution, which in many ways also has ‘market rules’.
“You want to be able to embed the market rules in the workflow with transparency: the conditions on which lending becomes available by whom, when, to whom and what it can be used for,” said Mathieson.
Circling back, a key central bank objective is to revisit the dividing line between central bank money and commercial bank money. This project involves loan subsidies through directed lending, so a CBDC makes sense. But those loans currently use commercial bank money. So the CBDC needs to make the process cheaper to incentivize banks.
“It is important to look at market-based mechanisms of adoption, where it makes sense for the banks to just give up commercial bank money in favor of CDBC to allow for the smooth introduction of a CDBC,” said Wagner. “Which I think is an important aspect. Because you can sit there and design the perfect system, but the minute you put it live, it adapts to market realities.”
