A new research paper from the U.S. Federal Reserve System, titled “Distributed ledger technology in payments, clearing, and settlement” (see citation below) looks at the rapidly evolving landscape of blockchain (distributed ledger technologies, or DLTs) in the financial services.
The authors note that DLT “is a term that [as of yet]… does not have a single definition”. Thus, the authors “refer to the technology as some combination of components including peer-to-peer networking, distributed data storage, and cryptography that, among other things, can potentially change the way in which the storage, record-keeping, and transfer of a digital asset is done.” While this definition is broader than blockchain definition alone, it is dominated by blockchain (private and public) typologies.
Impetus for research
Per authors, the impetus for this research is that DLT is one core form of financial sector innovation “that has been cited as a means of transforming payment, clearing, and settlement (PCS) processes, including how funds are transferred and how securities, commodities, and derivatives are cleared and settled.” Furthermore, “the driving force behind efforts to develop and deploy DLT in payments, clearing, and settlement is an expectation that the technology could reduce or even eliminate operational and financial inefficiencies, or other frictions, that exist for current methods of storing, recording, and transferring digital assets throughout financial markets.” This, indeed, is the main positive proposition arising from blockchain solutions, but it is not a unique one. Blockchain systems offer provision of greater security of access and records storage, higher degree of integration of various data sources for the purpose of analytics, greater portability of data. These advantages reach beyond pure efficiency (cost savings) arguments and go to the heart of the idea of financial inclusion - opening up access to financial services for those who are currently unbanked, unserved and undocumented.
In line with this, the Fed study points that the proponents “of the technology have claimed that DLT could help foster a more efficient and safe payments system, and may even have the potential to fundamentally change the way in which PCS [payments, clearance and settlement] activities are conducted and the roles that financial institutions and infrastructures currently play.” The Fed is cautious on the latter promises, stating that “although there is much optimism regarding the promise of DLT, the development of such applications for PCS activities is in very early stages, with many industry participants suggesting that real-world applications are years away from full implementation.”
Per Fed research, “U.S. PCS systems process approximately 600 million transactions per day, valued at over $12.6 trillion.” In simple terms, given average transaction cost of ca 2-2.5 percent, the market for PCS support systems is around USD250-310 billion annually in the U.S. alone, implying global markets size of well in excess of USD750 billion.
DLT Potential
Fed researchers summarise key (but not all) potential (currently emerging) benefits of DLT systems in PCS services markets:
- Reduced complexity (especially in multiparty, cross-border transactions)
- Improved end-to-end processing speed and availability of assets and funds
- Decreased need for reconciliation across multiple record-keeping infrastructures
- Increased transparency and immutability in transaction record-keeping
- Improved network resiliency through distributed data management
- Reduced operational and financial risks
One of the more challenging, from the general financial services practitioners’ point of view, benefits of DLT is that it is “essentially asset-agnostic, meaning the technology is potentially capable of providing the storage, record-keeping, and transfer of any type of asset. This asset-agnostic nature of DLT has resulted in a range of possible applications currently being explored for uses in post-trade processes.”
The key to the above is that blockchains ledgers are neutral to the assets that are recorded on them, unlike traditional electronic and physical ledgers that commonly require specific structures for individual types of assets. The advantage of the blockchain is not simply in the fact that you can use the ledger to account for transactions involving multiple and diverse assets, but that you can also more seamlessly integrate data relating to different assets into analytics engines.
Due to higher efficiencies (cost, latency and security), blockchain offers huge potential in one core area of financial services: financial inclusion. As noted by the Fed researchers, “financial inclusion is another challenge both domestically and abroad that some are attempting to address with DLT. Some of the potential benefits of DLT for cross-border payments described above might also be able to help address issues involving cross-border remittances as well as challenges in providing end-users with universal access to a wide range of financial services. Access to financial services can be difficult, particularly for low-income households, because of high account fees, prohibitive costs associated with traveling to a bank. Developers contend DLT may assist financial inclusion by potentially allowing technology firms such as mobile phone providers to provide DLT-based financial services directly to end users at a lower cost than can (or would) traditional financial intermediaries; expanding access to customer groups not served by ordinary banks, and ultimately
reducing costs for retail consumers.”
Lower costs are key to achieving financial inclusion because serving lower income (currently unbanked and unserved) customers in diverse geographical, regulatory and institutional settings requires trading on much lower margins than in traditional financial services, usually delivered to higher income clients. Reducing costs is the key to improving margins, making them sustainable enough for financial services providers to enter lower income segments of the markets.
Incidentally, in addition to lower costs, improving financial inclusion also requires higher security and improved identification of customers. These are necessary to achieve significant gains in efficiencies in collection and distribution of payments (e.g. in micro-insurance or micro-finance). Once again, DLT systems hold huge promise here, including in the areas of creating Digital IDs for lower income clients and for undocumented customers, and in creating verifiable and portable financial fingerprints for such clients.
The Fed paper partially touches this when addressing the gains in information sharing arising from DLT platforms. “According to interviews, the ability of DLT to maintain tamper-resistant records can provide new ways to share information across entities such as independent auditors and supervisors.” Note: this reaches well beyond the scope of supervision and audits, and goes directly to the heart of the existent bottlenecks in information sharing and transmission present in the legacy financial systems, although the Fed study omits this consideration.
“As an example, DLT arrangements could be designed to allow auditors or supervisors “read-only access” to certain parts of the common ledger. This could help service providers in a DLT arrangement and end users meet regulatory reporting requirements more efficiently. Developers contend that being given visibility to a unified, shared ledger could give supervisors confidence in knowing the origins of the asset and the history of transactions across participants. Having a connection as a node in the network, a supervisor would receive transaction data as soon as it is broadcast to the network, which could help streamline regulatory compliance procedures and reduce costs…”
Once again, the Fed research does not see beyond the immediate issues of auditing and supervision. In reality, “read-only” access or “targeted access” can facilitate much easier and less costly underwriting of risks and structuring of contracts, aiding financial inclusion.
Key takeaways
Overall, the Fed paper “has examined how DLT can be used in the area of payments, clearing and settlement and identifies both the opportunities and challenges facing its long-term implementation and adoption.” This clearly specifies a relatively narrow reach of the study that excludes more business-focused aspects of DLTs potential in facilitating product structuring, asset management, data analytics, product underwriting, contracts structuring and other functionalities of huge importance to the financial services.
Per Fed, “in the [narrower] context of payments, DLT has the potential to provide new ways to transfer and record the ownership of digital assets; immutably and securely store information; provide for identity management; and other evolving operations through peer-to-peer networking, access to a distributed but common ledger among participants, and cryptography. Potential use cases in payments, clearing, and settlement include cross-border payments and the post-trade clearing and settlement of securities. These use cases could address operational and financial frictions around existing services.”
As the study notes, “…the industry’s understanding and application of this technology is still in its infancy, and stakeholders are taking a variety of approaches toward its development.” Thus, “…a number of challenges to development and adoption remain, including in how issues around business cases, technological hurdles, legal considerations, and risk management considerations are addressed.” All of which shows two things:
- Firstly, the true potential of DLTs in transforming the financial services is currently impossible to map out due to both the early stages of technological development and the broad range of potential applications. The Fed research mostly focuses on the set of back office applications of DLT, without touching upon the front office applications, and without considering the potentially greater gains from integration of back and front office applications through DLT platforms; and
- Secondly, the key obstacles to the DLT deployment are the legacy services providers and systems - an issue that also worth exploring in more details.
In both, the former and the latter terms, it is heartening to see U.S. regulatory bodies shifting their supervisory and regulatory approaches toward greater openness toward DLT platforms, when contrasted against the legacy financial services platforms.
Mills, David, Kathy Wang, Brendan Malone, Anjana Ravi, Jeff Marquardt, Clinton Chen, Anton Badev, Timothy Brezinski, Linda Fahy, Kimberley Liao, Vanessa Kargenian, Max Ellithorpe, Wendy Ng, and Maria Baird (2016). “Distributed ledger technology in payments, clearing, and settlement,” Finance and Economics Discussion Series 2016-095. Washington: Board of Governors of the Federal Reserve System, https://doi.org/10.17016/FEDS.2016.095.
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