blockchain teaser

Use of independent computers to record and synchronise transactions rather than keeping data centralised has big implications. 

12-04-2019-16-02-56-356

Distributed ledger technology (DLT), of which blockchain technology is a variant, has the potential to fundamentally transform modern financial markets.

The world’s largest financial institutions are seeking to leverage the use of DLT in order to streamline complex financial processes, save costs and improve transparency and security.

Furthermore, numerous central banks in developed and developing economics are engaged in research and experimentation with central bank digital currencies, with some even considering the possibility of launching digital base money.

DLT was first used for the transfer of Bitcoin and other digital currencies. In essence, a distributed ledger is a record of information shared across a network.

Distributed ledgers allow parties to transfer, store and record digital assets or digital representations of assets through a peer-to-peer (P2P) network of computers. The technology allows some or all of the users of the network to share the responsibility for database management and validate transactions without relying on a trusted central authority.

Distributed ledgers combine certain innovative features, which support the transfer process and record keeping. P2P networking and distributed data storage allow participants to share a single ledger providing them with a shared history of all transactions.

Shareholders of a company would have a complete view of the record of ownership of the securities and would be able to instantaneously identify any ownership changes.

Moreover, the extensive use of cryptographic techniques provides a secure way to store assets and validate transactions, while consensus algorithms allow the confirmation and addition of transactions to the ledger. Another technology that can be combined with and leverage the potential of DLT is smart contract technology, which enables the self-execution and self-enforcement of contractual clauses.

Securities and trading

In securities markets, the technology can be applied at various stages of the trading cycle across numerous asset classes. In particular, the issuance and trading of securities on a distributed ledger can facilitate the recording and tracking of the ownership of securities, thereby improving transparency.

For instance, shareholders of a company would have a complete view of the record of ownership of the securities and would be able to instantaneously identify any ownership changes.

What is more, by promoting direct ownership of securities by end investors, distributed ledger technology has the potential to dispense with the current Byzantine indirect holding system for securities.

Under the contemporary system, investors’ securities are held indirectly through a chain of intermediaries resulting in a dilution of investor rights and excessive rents for the intermediaries involved in the process.

The adoption of DLT could lead to faster clearing and settlement by reducing the need for the involvement of multiple intermediaries and streamlining reconciliation processes. The compression of the settlement cycle could result in the minimisation of counterparty credit risk, increase in liquidity and more efficient collateral management. DLT could even eliminate counterparty risk and remove the need for clearing, if clearing and settlement are combined in a single step and become instantaneous.

Central banking possibilities

In the realm of central banking, the emergence of DLT has spurred central banks’ interest in examining the case for launching central bank digital currencies (CBDCs).

CBDC already exists in the form of deposits at the central bank held by commercial banks. Recent discussion revolves around retail CBDC, which would allow non-bank institutions, including households, to access central bank balance sheets by directly opening accounts at the central bank instead of depositing their funds at a traditional banking institution.

A diverse set of motivations is driving central banks’ interest in retail CBDC, including the declining use of cash and the emergence of private cryptocurrencies, whose mass adoption could potentially challenge monetary sovereignty.

According to proponents of the retail CBDCs, they would promote financial inclusion, improve cross-border payments and lead to greater payment diversity. Furthermore, they would eliminate bank runs, ending thereby the explicit and implicit guarantees offered to the banking sector, such as deposit insurance, lender of last resort facilities and bailouts.

Moreover, the transmission of monetary policy would be greatly simplified, since the central bank would be able to manipulate accountholder balances directly. A CBDC could also facilitate the implementation of negative interest rates and helicopter drops.

Nevertheless, the launch of digital base money carries significant financial stability risks. The loss of deposit funding might result in the reliance of banks on riskier wholesale funding and the curtailment of their lending activities. A CBDC might also encourage runs in central bank money.

Considerable hurdles

Overall, DLT promises to radically alter securities markets and central banking. Nevertheless, the widespread adoption of the technology faces considerable hurdles, including the challenge of replacing existing legacy systems and changing incumbent business processes.

Mass adoption requires addressing interoperability issues across the different distributed ledger networks and between distributed ledger networks and legacy systems.

Finally, concerns have been expressed regarding the scalability of the technology and whether it can be scalable to high-volume markets.

Despite these potential roadblocks, the development of DLT and its widespread adoption looks set to accelerate, in line with wider digitisation trends precipitated by Covid-19.

Alexandros Seretakis is an assistant professor in law at Trinity College Dublin.

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