Distributed ledger technology (DLT), such as bitcoin and ethereum, is changing how we think about transactions. These decentralized networks use cryptography to record information securely across many computers simultaneously. This allows people to transact directly without relying on intermediaries like banks or clearing houses.
Traditional payments systems rely on a centralized authority and hierarchy to generate the trust needed to transfer value. Money moves around the world via a complex system of checks and balances. Banks take deposits, lend out funds, store cash, handle wire transfers and provide other financial services. They also act as a trusted third party to ensure that both parties fulfill their obligations.
When money passes between participants, typically in the form of digital payments sent over the internet, a central counterparty tracks and supervises the transaction to prevent fraud. Participants must go to the counterparty’s site to confirm the payment and reconcile their accounts.
With DLTs, trust comes from the processes themselves rather than from the status or reputation of particular participants. Instead of relying on a single authority, each node in the network keeps a copy of the entire history of all transactions, ensuring no one person or group controls the ledger. This makes it easier to track and verify every step of a transaction.
The most common application of DLTs is to manage cryptocurrencies. Bitcoin is the best known example, but there are others including Ethereum, Ripple, Stellar and Monero. Each cryptocurrency is unique because it implements different rules for managing the ledger. For instance, some require proof of identity, while others do not. Some allow anonymous transactions, while others require everyone to register with a government-issued ID.
A surge in two waves
The next few years are likely to see a surge in innovation around distributed ledger technology (DLT), according to research conducted by Accenture and published today. DLTs offer potential beneﬁts such as transparency, security, cost savings and increased speed. But while many people believe that DLTs will displace traditional payment methods, the reality is likely to be different. We think there will be two waves of adoption – one driven by the needs of cross-border payments and another driven by the use of central banks’ fintech initiatives.
In the ﬁrste wave, financial institutions will focus on situations where there are clear opportunities for improvement, concrete rewards for innovators and no dominant central counterparty. These include improving existing processes, developing new products and services and building out infrastructure. This is a market that is already well established; however, it is still growing rapidly and presents a large opportunity for growth.
We expect the second wave to start later in the decade with the advent of central bank-backed digital ﬁat currency schemes. At present, central banks are experimenting with blockchain technologies, including those underpinning cryptocurrencies like bitcoin. They are looking at how DLTs could help improve the settlement process, reduce costs and increase efficiency. As these experiments mature, we expect to see a wider range of applications emerge.
Cutting through the tangle of international correspondent banking
International financial institutions (IFIs) are responsible for clearing and settling trillions of dollars worth of payments every day. Their networks of correspondent banks are used for cross-border transfers. But the process is slow and cumbersome; it takes days to settle a single transfer, and it requires multiple parties to sign off on each step.
Figure 3: International correspondent banking
Source: Bank for International Settlements
In contrast, blockchain technology offers a solution to some of the problems inherent in traditional correspondent banking. A distributed database, blockchain provides a secure record of all transactions. This removes the need for third-party intermediaries and enables faster settlement times.
Blockchain-based systems also allow IFIs to cut out the middleman and make direct connections among their members. For example, RippleNet uses XRP tokens to connect banks and ﬂexible money market funds. In addition, because the network operates peer-to-peer, there is no need for central authorities to manage the infrastructure.
Blockchains aren’t just useful for large-scale payments. Smaller payments can also be handled via smart contracts, where one party sends money to another without human intervention. Smart contracts are self-executing agreements stored on a shared ledger.
The potential beneﬁts of blockchain technology are far reaching. In fact, the BIS estimates that the cost savings from adopting a decentralized model could amount to $15 billion per annum.
Hard choices for banks
The recent wave of blockchain hype has drawn attention away from the real promise of distributed ledger technologies (DLTs). While DLT has been touted as a panacea for everything from cross-border payments to clearing and settlement, there are some fundamental questions about how well it works in practice and what the implications are for incumbent players like commercial banks.
As the dust settles, it seems likely that one thing is true across most industries: DLT is here to stay. But while many large institutions are talking up the potential benefits of DLT, few seem willing to commit to making it happen.
In fact, many of the largest financial institutions around the world are actively exploring ways to use DLT. In addition to the obvious applications, such as cross-border payments, DLT could help reduce costs for international trade finance, improve the efficiency of securities settlements, provide greater transparency into complex derivatives contracts and enable secure data sharing among disparate stakeholders.
But even though DLT offers great promise, no one knows exactly how it might play out. This uncertainty creates challenges for traditional banking organizations, which must decide whether to embrace the technology or continue down their existing paths.
For example, while the blockchain concept itself is simple enough, actually implementing DLT requires significant investments in both hardware and software. And while DLT proponents claim that the technology is scalable, in reality, scaling a network involves building out infrastructure and hiring specialists to manage it.
Many banks are already investing heavily in DLT research, but the pace of change is quickening. As DLT becomes increasingly mainstream, the pressure is on to make sure that banks do not miss out on the opportunity to exploit the technology.
Trade ﬁnance: a tougher nut to crack
The global trade ﬁnancing industry is one of the most important sectors in the world economy. But it is also notoriously difficult to understand, let alone manage. This is partly due to the complexity of the underlying processes, such as clearing and settlement, but also because there are few reliable data sources.
A recent report by McKinsey & Company highlights some of the challenges facing the industry today. In particular, it notes that trade ﬁnances generate around US$23bn in annual revenues globally, but that this represents just 10% of total bank lending. They also note that the industry faces significant frictions – including poor customer experience, high costs, low transparency and regulatory uncertainty – which make it hard to compete against traditional correspondent banking.
However, the authors argue that blockchain technology offers great promise. As well as improving efficiency and reducing friction, it could help facilitate cross-border payments, increasing liquidity and enabling greater transparency.
Domestic payments, just over the horizon
Central bankers around the world are increasingly interested in the concept of a national digital currency. In recent months, several prominent central bank governors have voiced support for the idea. At the same time, many central banks are exploring the possibility of issuing their own digital currencies. For example, the People’s Bank of Chinahas launched a pilot project that allows customers to pay for goods and services in yuan via WeChat Pay. And the Bank of Englandis working on developing a “central bank digital currency.”
The attraction for central banks and governments includes more direct control over the implementation of monetary policy, better monitoring of financial transactions and the potential for automated taxation. But the devil, of course, is in the details. A digital ﬁatcurrency would require significant changes to existing banking infrastructure and regulatory frameworks.
Restricted to interbank deals only, effectively taking away the role of real-time gross settlement system (RTGS), a digital ﬁct currency would have limited impact on the global economy. However, once made available to the public and combined with low-cost payment solutions, it could radically change how people interact with ﬁnance.