On 5th December, the Federal Reserve released its much-awaited research paper on distributed ledgers.
The paper, “Distributed Ledger Technology in Payments, Clearing and Settlement", came two months after Federal Reserve governor Lael Brainard remarked at the Institute of International Finance that the US central bank was "paying close attention" to the technology.
The product of the input of 30 financial industry stakeholders, including government officials, experts from traditional finance and FinTech institutions and members of the industry consortia – the paper explored the possibilities of distributed ledger integration in the financial industry, including the legal and governance challenges facing the development of any future proofs-of-concept.
"As part of its core objective to foster the safety and efficiency of the payment system and to promote financial stability, the Federal Reserve has a public policy interest in understanding and monitoring the development of innovations that could affect the structural design and functioning of financial markets.”
Some may argue, however, that the publication of this paper is not necessarily the call of action anticipated following Brainard’s speech and Federal Reserve chairwoman Janet Yellen’s remarks before the House of Representatives’ Financial Services Committee.
Yellen said that blockchain technology “could have very significant implications for the payments system” and that the Fed wants “to foster innovation”.
The perception for some is that the Fed may be playing its cards close to the chest in regards to holding off on proposing definitive action and recommendations regarding distributed ledger innovation or – worse – may not have a hand to play at all.
"I do not think this report is particularly significant," said David Yermack, chair of the Finance Department at New York University’s Leonard N Stern School of Business, to CoinDesk.
The "very general introduction to the structure of payment systems and the potential uses of distributed ledgers", he continued, "barely mentions any role for the government, other than the need to consider whether new regulations will be required to fit the potential uses of the technology."
"I think the report is a useful reference but hardly a roadmap for how the industry might evolve,” Yermack added.
A key consideration in the paper is the question of the payments, clearing and settlement regarding cross-border transactions. The current mechanism for transferring funds across international borders is a series of bank-to-bank credit or debit transactions, with varying fees being applied by each bank along the series.
With banks not necessarily responding to messages from creditors promptly, settlement for cross-border payments could take as long as five days.
The paper suggests that distributed ledgers can help to alleviate the friction caused by the credit chain, with the possibility of an open-source interoperability standard like the Interledger Protocol (ILP) spurring adoption of blockchains for international payments.
There is also the hope that the use of distributed ledgers can help combat the problem of increasing numbers of fraudulent cross-border transactions.
In one case, $81m was stolen from the Central Bank of Bangladesh through false payment requests connected to various Filipino casinos.
The theft – the largest of a series of bank-level intrusion into the SWIFT network, the world’s largest interbank messaging service – illustrated a very uneasy truth about cross-border payments: there is no known way to secure them using current techniques and methods.
While the banks victimized in these thefts all shared deficiencies in their local security, the notion that these thefts can occur unchallenged raises serious concerns about the creditworthiness and stability of the system as a whole.
The paper takes the position that a distributed ledger – by making transaction histories and current states of ownership of assets readily available across all nodes of the network – can quickly make real-time auditing possible at a peer level, improving the transparency and security of the nodes.
“DLT is essentially asset-agnostic, meaning the technology is potentially capable of providing the storage, recordkeeping, and transfer of any type of asset,” reads the research paper. “This asset-agnostic nature of DLT has resulted in a range of possible applications currently being explored for uses in post-trade processes.”
Not everyone, however, is convinced that distributed ledgers can alleviate the friction caused by cross-border payments.
“My thought on this is that they’re trying to fit a square peg in a round hole,” Spencer Bogart, research analyst for equity research with Needham & Company, told CoinDesk.
“By digging in to explore how ‘blockchain’ or ‘DLT’ might improve efficiency in PCS systems that they may uncover some real inefficiencies that can be addressed — but I highly doubt that ‘blockchain’ or ‘DLT’ is the solution,” he said.
The "critical elements" needed for a blockchain to function (such as proof-of-work security, decentralization and immutability) are not "desirable features for these systems", Bogart suggested, adding:
"In the process of exploration, they may find that their database technology is out of date and could be improved and, if so, that’s all fine and should certainly be embraced but it’s standard progress — it’s not the sexy, cutting-edge, mass-efficiency producing technology that people get excited about.”
Understanding the Fed’s motivation
This, of course, is not a position shared by all. Ryan Zagone is the director or regulatory relations at Ripple, which facilitated the development of the Interledger Protocol.
In conversation with CoinDesk, Zagone pointed out that the research paper could be the first step in the formation of a guidance position the Fed could take to help lead innovation in cross-border payments.
“By taking a moment to assess the implications of using this technology – both in the sense of what we can achieve, but also what are the risks and realities of using this technology for our payments – this paper presents a thoughtful look at the state of the cross-border payment system,” Zagone said.
“There are real inefficiencies with cross-border payments and there is – as the Fed has pointed out – room to improve domestic systems,” he continued. “So, this is a broad look toward what is needed to improve the system today.”
Calls for improvements
Ripple is a member of the Federal Reserve’s Faster Payments Task Force, which is charged with finding solutions for the agenda laid out in the 2015 position paper “Strategies for Improving the U.S. Payment System.”
Contained within its agenda are calls for implementation of faster, safer payment capabilities in the US, reduction of fraud and security risks to the payment system, improvement in end-to-end efficiency for cross-border and domestic payments, and enhancement of the National Settlement Service and interbank settlement for check payments.
Composed of stakeholders from government agencies, major financial and retail operations and affiliated non-profit entities, the task force represents the Federal Reserve’s commitment to promote change to the payment system from within the private sphere.
“The Federal Reserve will act as leader, convener and catalyst as appropriate and will commit its resources to supporting these initiatives,” the task force paper reads. “... It would not consider expanding its service provider role unless it determines that doing so is necessary to bring about significant improvements to the payment system and that actions of the private sector alone will likely not achieve the desired outcomes for speed, efficiency and safety in a timely manner.”
Ripple’s Interledger Protocol permits blockchains to automatically route and deliver messages and payments between each other without the need of complicated coding.
The potential of this is that two accounts on different distributed ledgers can connect to each other without the need to vet the connection first.
As the transmitted payment is secured using a ledger-provided escrow, this eliminates the need of a third-party ledger, ensures the receipt of either a cryptographically-signed receipt or the rejected escrow to the sender and removes the need for any mutually-agreed transfer arrangement.
While it can be debated ad nauseam whether the Fed is doing enough to deliver on its promise of promoting innovation of blockchain technology or even if such technology could effectively be implemented wide-scale, the paper – taken with other blockchain innovation measures taken recently, such as the creation of the Illinois Blockchain Initiative – suggests an evolution in the conversation of cryptographic-enabled finances from the theoretical to the concrete.
"This working paper presents as a rigorously researched, lucid, thorough, and comprehensive place to begin in the development of a guiding document for the future,” said Perianne Boring, president and founder of The Chamber of Digital Commerce, in conversation with CoinDesk.
“This paper certainly could signal a move toward a national policy to encourage incorporation of blockchain technologies."
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