Distributed Ledger Technology in Banking
Blockchain or, more precisely, Distributed Ledger Technology (DLT) is currently one of the hot topics in the banking industry. Its main focus is on clearing and settlement, where DLT can reduce reconcile efforts, address liquidity needs and accelerate processing. Several reports and studies suggest benefits and substantial savings – in particular, when DLT is applied in financial market infrastructures spanning multiple jurisdictions. But there are also a number of open points, not least in the legal and regulatory realms.
Nonetheless some firms are already operating DLT based infrastructures, for example, Ripple. Classic financial institutions mainly have small-scale projects underway, handling digestible volumes with the primary goal to better understand the capability of the technology and its impacts.
DLT touches many areas, including business models, processes, pricing models, governance, as well as legal and regulatory frameworks. But it can also enable initiatives driven by regulators to gain better and near real-time transparency about activities in financial markets. It is expected that parts of the financial market infrastructures will change significantly, as will the roles of important players like Central Securities Depositories (CSDs) and regulators.
Currently, we see a growing number of basic use cases being published. The majority is in clearing and settlement. DLT is compelling where processes are comparably slow, costs are high and margins are still good. Exemplary domains are payments and securities trading. An excellent example is cross-border payments. DLT-based implementations promise faster execution and, at the very least, price transparency to corporate customers and private households.
Automating and integrating additional parts to the process chain using DLT further improves efficiency in a number of ways:
- It can reduce internal efforts in banks significantly, in particular, reconcile efforts
- It speeds up processing times, especially interbank processes with multiple parties involved
- It simplifies and accelerates cross-border bank-internal processes between different legal entities
Here are some of the key aspects that drive distributed ledger design and implementation:
|Key Drivers||Key Questions|
|Participants in a distributed ledger||Is the distributed ledger restricted or non-restricted?
What is the expected number of participants?
Who will operate the nodes of the ledger?
How are participants on- and off-boarded?
Who submits transactions/updates to the ledger?
Who retrieves information from the ledger?
What is the role of regulators?
|Jurisdictions||Which jurisdictions do nodes and participants belong to?|
|Roles played by participants||What are the roles of individual participants (e.g. in regard to data access, transaction submission, transaction validation)?|
|Performance and Scalability||How can transaction peak volumes, throughput, scalability and settlement times be optimised?
Does the design enable high-frequency/high-speed/high-volume capabilities?
Are the service levels comparable to those of current implementations, thus ensuring the stability of the financial market infrastructure?
|Finalization of Transactions||How are transactions such as settlements finalised?
Who is to agree/validate/confirm?
What is the consensus/validation algorithm to finalise a transaction within performance and scalability requirements?
|Reporting||What information needs to be reported to whom?|
|Financial Standards||What are the relevant standards, e.g. ISO20022?
What are required extensions ?
|Fraud and attack scenarios||Does the DLT implementation include algorithms for transaction handling that address the most prominent scenarios, such as double spending and the creation of siblings?
Does it also address use-case-specific scenarios?
Table 1: Key Drivers
Design and Implementation
These key drivers determine the decision to initiate a custom implementation or to select an existing distributed ledger framework. Since these frameworks differ very much in their capabilities, sufficiently detailed use cases and a proper selection process are needed.
As already pointed out, today’s implementations are primarily small-scale. Compared to today’s financial market infrastructures, they process low volumes. Experience and best practices in high-volume processing and operations are yet to emerge on a broader basis. The most frequent optimisation areas in DLT are node interactions and consensus/validation algorithms. The latter very much determine time needed to finalise a transaction.
Beyond these key drivers, the classic topics in the development and implementation of new systems need attention: integration into existing system landscapes and financial market infrastructure, regulatory frameworks and required security measures.
Governance, legal and regulatory
But DLT is also a governance, legal and regulatory topic. It requires new or revised approaches for regulators and key players in the financial market infrastructures. In a continuous dialogue with regulators, implementers sometimes narrow down the scope of their pilot implementations to reduce regulatory complexity in the beginning – scope meaning functionality, jurisdictions, performance and availability in this context. As often discussed, DLT offers possibilities to enhance transparency for regulators and can be used to lower reporting efforts for financial institutions. Standards are needed to leverage such approaches.
Although DLT is already in production, it is still at an early stage for regulated areas and regulated participants. Current regulations, the regulatory structure, and the legal framework need to be reviewed against the use cases. In some areas, DLT might just be used as a new technology to internally implement a given functionality in a different way. Depending on the context, current governance and regulations might be sufficient or require minor adaptions only. One example could be CSDs. Clarifying these aspects will take some time.
In comparison with other industries, it could slow down the pure technology play significantly. In particular, when uses cases lead to more complex setups. Considering, for instance, the setup of a restricted ledger distributed across several jurisdictions, the following key areas require attention:
|Key Areas||Key Considerations|
|Governance of Participants||Participants distributed across several jurisdictions and a fragmented regulatory require governance rules:
Who is accountable for the ledger as a whole, who for individual nodes?
What is the legal and contractual coverage of participants?
|Roles in financial market infrastructures||Impacts on existing roles in financial market infrastructure have to be validated against distributed ledger specific aspects. Activities, like on-boarding of participants, management of nodes and ledger access permissions need to be added. Related to reconciliation, less effort can be expected.|
|Role of regulators||Regulators must cover operational, but also design aspects. The distributed nature requires their involvement in the definition of involved parties, jurisdictions and information access as early as in the design phase. Consensus/validation algorithms might be of interest for regulators.|
|Transparency||Regulators demand increasing transparency of transactions in financial markets. DLT could provide regulators with direct access to distributed ledgers. In a multi-jurisdiction setup, regulators’ needs and access require additional standardisation and legal consideration (such as data protection laws).|
|Existing regulations and directives||EU and other directives, such as the Settlement Finality Directive, require adjustments in a DLT context.|
Table 2: Regulatory
For distributed ledger implementations to become a relevant part of the financial market infrastructures, standards will play an important role. Many standards already exist, like ISO20022. But these standards need to be verified in the context of distributed ledger implementations – If necessary, adjusted or extended.
Standardization is required in the legal, regulatory, functional and technological areas, especially where distributed ledgers span multiple jurisdictions and regulators. Regulatory standards could provide a reliable basis for the design, implementation and operation of distributed ledgers in a multi-national environment, thus accelerating their proliferation significantly. It can be expected, however, that achieving such common standards will be time-consuming and not very straightforward.
From a functional and technological viewpoint, standards have to address integration needs between DLT implementations, which are part of an overall process. Even more importantly, they are indispensable for the integration of DLT implementations with other systems and services required by financial institutions.