The potential of blockchain to transform traditional banking processes has generated much enthusiasm over the past year. Deutsche Bank’s Paula Roels, head of market infrastructure and industry initiatives, and Bradley Lonnen, market management, institutional cash management, look at the current state of play around adoption, and blockchain’s applicability to correspondent banking.

The amount of activity seen around blockchain, or distributed ledger technology (DLT), in the first six months of 2016 has demonstrated that it is not simply a passing fad. Not only have a number of pilots and prototypes for non-financial products been launched in the retail space, but also the first real test cases have evolved in the broader financial services ecosystem. In Australia, for example, the Australian Securities Exchange is actively evaluating how to replace its current database platform with a blockchain-based distributed ledger.

In addition, there are other noteworthy examples of real-life use cases entirely outside the finance and commerce sectors. For example, the Estonian government has recently announced its health records are to be secured by blockchain. Unsurprisingly, investment is increasing. The World Economic Forum estimates that by 2019, banks’ annual spent on blockchain technology will amount to $400m.

What is blockchain? 

Blockchain refers to one type of distributed ledger. Basically, it is a ledger of digital records or transactions that is accessible to all computers running the same protocol. The Bitcoin protocol, for example, results in each transaction being given a unique cryptographic number or ‘hash’, which is then included with others in a ‘block’ of similar transactions; and each completed block is also hashed in sequence with others to form a chronological ‘blockchain’. 

However, it would be foolish for banks to consider DLT as the panacea for everything. True, they are currently facing multiple challenges including fluctuating economic conditions, rising cyber threats, new entrants and shifting customer expectations, as well as increasing regulation and costs pertaining to IT legacy systems. In fact, it may well be the latter point that is driving the banks’ enthusiasm to explore DLT’s potential. 

The case for DLT

But just how applicable is this technology to the correspondent banking model? Advocates argue that DLT – rather than a specific type of blockchain – can potentially be positively applied to correspondent banking, as it would allow a process or an asset to be shared more securely and efficiently, with full certainty of its validity between several parties.

Take, for example, cross-border payments, which currently can take up to three to five days to process end to end. Applying DLT on a ‘permissioned’ ledger basis would reduce that process to minutes. Proponents highlight that implementing the technology would lead to increased transparency, reduction in errors and greater transaction automation, leading to a decrease in cost and, ultimately, fees for the end user.

Benefits could also be realised by using DLT to address rising costs and operational risk issues, as well as improve efficiency in compliance with know your customer and due-diligence requirements. Additionally, regulatory oversight would be improved, as all transactions are traceable. Better visibility and traceability would therefore help eliminate – or at least significantly reduce – money laundering.

Outstanding questions

But for all its potential, many questions still remain at this stage. A main factor shaping a future model of correspondent banking built on DLT is the creation of digital central bank book money (settlement and clearing only).

Yves Mersch, a member of the European Central Bank’s executive board, raised this issue in a recent speech, where he stressed that DLT will not be able to operate successfully without central banks. He pointed out that the key question resulting from a market infrastructure move to DLT is how central bank money is put into the ledger or, more specifically, which entities can access the central bank money on the specific ledger. Should that access be restricted to banks and market infrastructure providers, such as central securities depositories, or extended to central counterparties and automated clearing houses?

How DLT works 

Distributed ledgers are decentralised in order to eliminate the need for a central authority or intermediary to process, validate or authenticate transactions. Each record is time/date-stamped and given a unique cryptographic signature designed to ensure the ledger’s authenticity and integrity. All participants view the whole ledger, which provides a complete history that is verifiable and auditable. The cryptographic technology means it is possible to both compress data and maintain confidentiality of the content and participants in each transaction. Only someone with the correct ‘key’ can access the details associated with a specific record.

Taking the scenario to the full extreme, Mr Mersch even imagined a situation whereby a central bank offers a DLT network that is open to all individuals. Citizens would have the choice to hold commercial bank deposits with banks or digital currency at the central bank.

But that scenario in itself results in further questions. These include what functions would be embedded in a central bank deposit account? How would this affect the bank’s ability to offer loans? How would the monetary transmission mechanism – and the economy at large – work if the basic business model of many banks could potentially be impaired? While Mr Mersch did not answer these questions directly, he certainly raised awareness around the complicated intricacies of a potential move to DLT.

Of course, other considerations also need to be factored in. There are still questions pending as to the scalability of DLT, with thousands of transactions processed every second. Furthermore, there remains the issue of interoperability, not only between different DLT systems but also between DLT and legacy systems. The upfront necessary investments may also prove to be a barrier to adoption, as undoubtedly some market participants will not want to move to DLT until a standard develops.

Finally, there is the central question of regulatory oversight. The fact that regulators across the world accept Swift as the principal mechanism for cross-border payments and see it as a recognised standards setter means the consortium could play an important role for widespread DLT adoption – but how this will play out remains to be seen.

Potential outcome

Although discussions around DLT have seen a recent surge in prominence, the technology is still far from being considered mainstream. In any case, the key to successful implementation depends on the willingness of industry participants, including banks, financial technology companies, market infrastructure providers, central banks and regulators to collaborate. A go-it-alone approach is simply not feasible.

DLT adoption will vary based on geographies, regulatory environment and implementation complexity – for example, cost implications when new and existing technology co-exist for a period. It remains to be seen which product and process areas will start to unfold first based on concrete use cases, none of which are public today. Today banks are testing proofs of concept and the first commercial products are expected at some point in the next 18 months. Most industry experts believe that full adoption of DLT may be three to five years off.

But even then it may well be that the Swift network remains the most effective vehicle for particular transactions, particularly in the correspondent banking space, whereas DLT may prove to be more effective for other types of transactions. It will most likely take another five to 10 years before the technology becomes pervasive. 

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