Security and trust are essential to the global financial system’s plumbing and capital market infrastructures. The trade of stocks, bonds, derivatives and other financial instruments is pegged at nearly $3,000tn in transaction value each year. However, ensuring trust between banks, brokerages, custodians and clearing houses using multiple ledgers requires all actors to have full confidence in the market infrastructure. The financial sector was once abuzz with the potential for distributed ledger technology or blockchain to profoundly change the architecture of global financial services and capital markets.
In particular, major wholesale and investment banking activities were allegedly about to be transformed. At the fore, central banks were exploring methods to adopt DLT for wholesale and interbank operations for trade and settlement. The technology promised to make infrastructures more efficient, productive and resilient. The most prominent of these initiatives were the Monetary Authority of Singapore’s Project Ubin and the Bank of Canada’s Jasper. More recently, central bank efforts have shifted towards DLT-based retail central bank digital currency.
Concurrently, the private sector has developed more specific use cases for blockchain and DLT. Legacy manual operations and the need for data reconciliation between different parties mean that many financial transactions processes are costly and ineffective.
Promising applications of blockchain and DLT include the automation of fixed-income bond markets, the ability to digitally represent and tokenise financial instruments, assets and securities, as well as optimising the post-trade clearing and settlement lifecycle within financial markets. Several financial intermediaries are exploring the possibilities, including commercial banks, stock exchanges, and even at times in collaboration with central banks.
Blockchain systems could facilitate the issuance of primary securities such as corporate bonds. Currently, issuance and payment of cashflows are largely tracked and performed manually. The immutable nature of blockchain transactions can help automate certain procedures in the bond life cycle via pre-determined smart contracts. For instance, issuance of bond proceeds can be done on a parametric basis, which is instantaneously activated once specific trigger conditions are met.
In 2018, the World Bank issued bond-i, the first public bond created and managed via DLT. The Commonwealth Bank of Australia, which managed the two-year blockchain bond, raised $80m in its first issuance. There is likely to be similar issuance in the future.
For banks, the tokenisation of securities could significantly reduce global trade costs. A tokenised economy offers the potential for a more efficient system with frictionless creation, buying and selling of tokens. This could lower costs and make the financial industry faster and more accessible, unlocking trillions of dollars in illiquid assets and vastly increasing the volumes of trades.
In an effort to keep pace, some central banks are aligning their research into wholesale CBDC with these use cases. In November, the Reserve Bank of Australia began collaborating with commercial banks to explore the viability of wholesale CBDC. It intends to enable the funding, settlement and repayment of tokenised syndicated loans using an Ethereum-based DLT platform.
In the coming years, traditional players will have the opportunity to meet the demands of a token economy by providing a platform for storing tokens, or assuming the role of a trusted intermediary if a decentralised solution is not enough. In the near term, there is a need for appropriate regulation, and for it to be aligned across jurisdictions.
Banks see clearing and settlement as another important use case. A shared ledger could expedite the clearing and settlement of assets where large and complex multiparty transactions occur regularly. Stock exchanges and other financial institutions dealing in frequent, high-volume exchanges of securities and derivatives have experimented with blockchain platforms in their settlement process.
In 2017, Goldman Sachs was granted a patent for SETLcoin, a transaction settlement system based on blockchain. The Nasdaq stock exchange successfully completed the first blockchain-based securities transaction platform via Linq in 2015.
Current real-time gross settlement systems have limited operation hours. Continuous Linked Settlement, a platform operating as an international multi-currency clearing system on a payment-versus-payment settlement mechanism, is limited by the fact that transactions can only occur in specific time windows, such as when two countries’ central bank RTGS systems are running concurrently.
Using DLT would allow for continuous PvP and delivery-versus-payment settlement globally. The reduction of intermediaries such as correspondent banks or central agencies can help minimise charges incurred along the payment chain. Currently, transaction settlement relies on financial intermediaries and service providers.
As a result, post-trade processes require a considerable amount of reconciliation. A peer-to peer model reduces the need to update and reconcile multiple accounts in the post-trade cycle. Enabling direct transmission of information and assets between parties could optimise the operational costs of cross-border payments, as any lack of standardisation can be minimised.
However, the industry cautions that this is still in the early stages. There are many policy issues to address. This application of DLT would significantly de-risk payment settlement, although it would probably create pressures in other places, such as liquidity management. This is one other area in which banks expect significant progress over the next five years, conditional on productive engagement with regulators and other policy-makers.
The private sector is starting to take a more realistic view of blockchain’s potential, and has a better grasp of implementation issues. The public and private sectors have many common goals, with major benefits for both sides if they are able to overcome certain blocks.
There is growing consensus among leading central banks that wholesale CBDC could make the financial sector more effective and innovative. A range of sandbox experiments and pilots is set to emerge, involving private sector consortia, central banks and securities exchanges.
Bhavin Patel is Senior Economist and Head of Fintech Research and Brandon Chye is Economist at OMFIF.