Different initiatives by central banks, financial market infrastructure providers and bank consortia contemplate building new proprietary systems based on blockchain and other distributed ledger technologies. They are missing the point. The future of FMIs lies not in replicating existing arrangements with DLT, but in joining together existing and emerging ecosystems.
FMIs, particularly in the payments sector, are typically developed and owned by central banks and other financial services entities. This ensures the specifications, in terms of functionalities and performance, are tailored for the central bank and its users. Such systems can be highly performant but are also insular, which may limit scope for innovation and advanced functionalities.
Proprietary DLT systems face similar challenges. They will likely hold fewer resources, be biased towards a particular user group, sector or geography, and struggle to offer a generally accepted governance structure to scale.
Unified ledgers trade-off
Some central banks are now exploring the development of DLT-based ‘unified ledgers’ – single-platform solutions that bring together tokenised assets and money. The argument is that a single infrastructure is needed to ensure financial market integrity and maximise the technical advantages of one platform. While central banks recognise that there may be a trade-off between a single platform and innovation spurred by competition, they maintain a strong preference for proprietary and private FMIs.
The US administration has taken the opposite approach, effectively banning central bank engagement in digital currencies. It rests inter alia on the premise that it would imply an undue meddling in payments by the public sector. This may critically constrain the role of the central bank as the backbone of the monetary system. As payment systems expand into DLT-platforms, access to central bank money should be equitable across platforms.
Taking an excessively insular approach to financial infrastructure risks shutting off vectors of innovation. Recent critical financial market innovations have originated from outside the financial sector. Tokenisation, blockchain, programmability enabling smart contracts, flash loans, automated market makers among others have proven to offer new and advanced functionalities to enhance financial transactions and address new use cases.
DLT platforms differ fundamentally from most conventional platforms. They are inherently set up to accommodate different types of tokens – enabling the co-existence of asset and money tokens –and offer natively cross-asset and cross-money functionalities. Their programmability enables complex business logic to be embedded into transactions, simplified automation and give rise to new business models. The denationalised character also offers new scope to overcome traditional geographic boundaries more consistent with a truly international trading environment.
DLT’s role in the digital ecosystem
At their core, DLT platforms are about ecosystems. They ensure that financial market actors are immersed in and exposed to developments driven by the heterogenous nature of network participants and use cases. Participating in these systems is to become an integral part of the tokenisation economy.
DLT platforms are especially about the allocation of trust and governance and where transaction validation relies on the network. It seems particularly relevant in an international setting where participants may not want to be bound by the operations of an entity in a particular jurisdiction or subject to incentives that may not be aligned with other parties.
The externalisation of platform governance may represent the biggest advantage of using an external DLT platform. Different unrelated parties may find it easier to agree to the terms of an existing blockchain than to devise common terms themselves. DLT platforms are fund transfer platforms whereby sending and receiving tokens remain subject to the rules of the respective transacting parties.
Using external DLT platforms does not mean giving up controls. Various control levers exist such as token standards and wallets that ensure only intended parties have access and or can perform transactions. Privacy and speed can be addressed through layer 2 applications that ensure adequate conditions for processing financial transactions exist.
Permissioned and permissionless frameworks
An external platform can be permissioned or permissionless. The former seems relevant where a private system can offer preferred functionalities a decentralised system struggles to establish due to coordination failures. Permissioned platforms are private platforms typically operated by a private sector consortium where access is restricted to eligible parties. Few entities will be in a position to install a competitive environment. The latter seems the preferred choice if there is a desire of immediate participation in a certain environment. Different platforms will likely coexist and be required to be interoperable.
Permissionless environments, by contrast, open themselves up to broader resources, a large pool of participants, continuous innovation and considerable cost savings. Where a central bank contemplates building a new payment system, participation in an existing platform may be the more economical approach. This could be of particular relevance for lower income countries that may find it more difficult to offer the best possible platform functionalities.
For central banks, the use of an external DLT platform would be similar to the circulation of banknotes. Central banks issue banknotes, physical tokens, to be handled by the public. Transactions in cash are validated only by the transacting parties and the cash infrastructure is entirely external to the central bank. The central bank makes sure banknotes are difficult to counterfeit and durable but has no control of banknote transactions. The challenge for external DLT networks will similarly ensure digital tokens are secure to use.
The use of external DLT networks offers a treble benefit of ecosystem participation, governance and advanced functionalities. DLT platforms promise a reverse takeover of FMIs, transforming how financial systems operate in open, denationalised, programmable environments. This seems much more aligned with the future of financial markets.
Ousmène Jacques Mandeng is a Visiting Fellow at the London School of Economics and Political Science and a Senior Adviser at Accenture.
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