DTCC report lays out CBDC challenges

Multilateral settlement and asset encumbrance mechanisms are core functional requirements for post-trade settlement, according to a white paper from the Depository Trust & Clearing Corporation (DTCC).

The white paper, entitled ‘Exploring Post-Trade Security Settlement with a US Central Bank Digital Currency’, outlines wholesale central bank digital currency (CBDC) settlement network connectivity and design choices and potential business outcomes. Published at the end of November, in collaboration with the Digital Dollar Project (DDP) and with support from Accenture, it also highlights further opportunities around CBDC settlement. The DDP is a non-profit organisation devoted to catalysing research and exploration of the potential advantages and challenges of a US CBDC.

The DTCC began the pilot in April. It included participation from leading market participant firms including Bank of America, Citi, Nomura, Northern Trust, State Street, Virtu Financial and Wells Fargo, exploring how a CBDC might operate in the US clearing and settlement infrastructure leveraging distributed ledger technology (DLT). The white paper outlines key findings from the pilot (formerly known as Project Lithium), the first private sector initiative to explore how tokenised securities and a wholesale CBDC could operate within the US settlement infrastructure leveraging DLT. 

Pilot participants provided feedback on the DDP and DTCC pilot through a series of workshops. The design included an architecture that connected two distinct asset networks to enable secure, resilient and efficient security settlement leveraging CBDCs. The pilot also assessed network governance, creating mechanisms for a network administrator to resolve transactional issues while otherwise remaining in observation mode, ensuring that assets were settled on both networks, minimising communication dependencies between parties, and eliminating counterparty risk at the time of settlement.

In terms of CBDCs, the white paper concludes multilateral settlement and asset encumbrance mechanisms are core functional requirements for post-trade settlement. Broader access to a digital Federal Reserve payments system could present new opportunities within the settlement bank model and drive innovation in traditional industry responsibilities.

Based on the pilot results and feedback from industry participants, a CBDC network offers the potential to achieve operational efficiencies and enhance transparency and reporting capabilities, it concludes.

Among the business implications, the white paper reports that a CBDC could enhance operational efficiencies, allowing DTCC to streamline settlement processes.

A DLT-based cash settlement infrastructure, in which the Federal Reserve is the owner and operator of the network, can provide transparency and reporting benefits as an alternative model that replaces and simplifies reporting to DTCC and the Federal Reserve, the white paper says.

CBDC settlement supports a flexible settlement architecture that can benefit industry participants, and could provide funding and risk benefits and trade-offs for the industry, according to the report.

Getting onboard

Central banks and regulators have increasingly expressed interest in the development of CBDCs, with many in the early stages of research and development. Jennifer O’Rourke, director of innovation strategy and design at DTCC, says: “Given this context, our pilot was conducted in conjunction with the DDP with support from Accenture to better understand the potential implications of using CBDC in the delivery versus payment (DvP) settlement process.” 

Post-trade settlement in the US is significantly different from settlement in foreign markets and carries a distinct set of requirements, Ms O’Rourke stresses. Should digital assets and currencies based on DLT become adopted, it is important for US market participants to understand their implications on the settlement lifecycle, she says.

In terms of network connectivity and design, the white paper found that when settlement of securities and cash occur on separate and distinct networks, orchestration between the networks is required to ensure settlement. The pilot’s orchestration model between the two distinct networks reduced counterparty risk at the time of settlement and provided settlement guarantees. “Moving forward, this approach may provide a governance model for future implementations,” says Ms O’Rourke.

The findings of this initiative will be used to help inform the design considerations around supporting a digital dollar, she says. “DTCC looks forward to applying these learnings, as appropriate, to future efforts if and when a CBDC is adopted,” she adds.

A number of findings uncovered during the pilot are intended to help inform private sector participants and policy-makers of the advantages, requirements and implications of this new technology paradigm.

For example, the pilot showed that broader access to a digital Federal Reserve payments system could present new opportunities within the settlement bank model and drive innovation in traditional industry responsibilities.

“The pilot outcomes also highlighted that, to ensure settlement in the instances where settlement of securities and cash occur on separate and distinct networks, orchestration between the networks is key. The pilot’s orchestration model between the two distinct networks reduced counterparty risk at the time of settlement and provided settlement guarantees. Moving forward, this approach may provide a governance model for future implementations,” Ms O’Rourke says.

Based on the pilot results and feedback from industry participants, a CBDC network could offer operational efficiencies and commercial benefits, as well as enhance transparency and reporting capabilities, she adds.

Obstacles ahead

There are still obstacles to industry adoption of CDBC settlement. Industry debate around the use of CBDC is in its early stages, and a number of questions remain, says Ms O’Rourke. “Future initiatives should challenge and refine the findings of this pilot to design a CBDC network that can support a variety of nuanced use cases,” she says. “As an example, future exploration should seek to quantify the benefits of incorporating a CBDC into the settlement process.” 

Potential business benefits to CBDC settlement will depend on industry adoption, according to the white paper. Ecosystem adoption rates and requirements should be studied to better understand the business value proposition, it says.

Such studies should compare CBDC settlement models with existing settlement models to accurately measure risk and funding impacts on participants, says Ms O’Rourke, and they should also explore margin requirements, impacts to risk controls, or the ability to go into intraday deficits. “Experimentation should seek to measure how shock resistant a CBDC network would be under periods of high volatility or liquidation,” she adds.

It should also be assumed that, if developed, a CBDC network would likely exist alongside traditional networks as well as private industry digital asset networks, she says: “Further research is required to explore integration requirements for co-existing networks and how a CBDC network could change the relationship between industry participants and their settlement banks.”

As the US dollar is an integral part of the US and global economy, a digital dollar should be carefully explored in consultation with key stakeholders in both the public and private sectors. The pilot with DTCC was a practical exploration of the use of simulated CBDC and DLT for DvP settlement in the US wholesale financial markets through direct engagement with market participants, according to the white paper. 

“The findings from this pilot serve as crucial information to inform worldwide CBDC developments and conversations that are rapidly increasing across sectors,” DDP executive director Jennifer Lassiter said in a statement. “Understanding the impact of CBDC technology on this critical aspect of financial market infrastructure is imperative to the evolution of US markets and will inform further CBDC research and experimentation globally.”

In a statement, David Treat, senior managing director and global metaverse co-lead at Accenture, said: “Accenture is pleased to have supported DTCC and DDP in their efforts to explore the value of digital currency and tokenisation in the evolution of our capital markets. DTCC’s experience, leadership and innovation paired with the DDP’s diverse community of experts and stakeholders is a powerful combination that will help shape the impact that digital currency will have on the transformation of financial infrastructure.”

As a potential digital alternative to cash, a US CBDC should be carefully explored in consultation with key stakeholders across the public and private sectors, according to Jennifer Peve, DTCC managing director, head of strategy and business development. DTCC’s pilot with DDP assessed the use of a simulated CBDC and DLT for DvP settlement in the US wholesale markets by directly involving market participants, she says. “The results of the pilot can help inform market participants and US policy-makers about the many requirements related to this new technology and currency paradigm,” she adds.