Where’s the headphone jack on the latest iPhone? There isn’t one. If you want to use headphones, you need an adaptor. Compatibility is always a consideration when you try to take a big leap forward.
Financial markets have a similar challenge. There is a high degree of recognition and acceptance that blockchain, aka distributed ledger technology (DLT), offers huge potential for simplification of the market infrastructure, and with that some very significant reduction in costs.
For at least five years, the financial markets have been debating how best to leverage blockchain. The argument has gone backwards and forwards between the optimists who can see a once-in-a-lifetime opportunity to abandon costly, error-prone, semi-manual post-trade processes and the pessimists who insist that the transition costs and disruption far outweigh the perceived eventual benefits.
Many institutions and service providers are still struggling to shore up business models and profit margins in the post-crisis environment. Some also fear the scale of change required to shift to a streamlined blockchain-based eco-system could push the road back to sustained profitability even further into the distance.
At Fnality, we’ve grappled with these issues too. In fact, we think of little else. And we see both sides of the argument. The financial markets cannot and should not take a collective leap in the dark in the hope of grasping new efficiencies overnight. But the risks of inaction are very large indeed. In an increasingly digitised economy, the opportunities to slash operating costs and develop new, more customer-centric and dynamic value propositions cannot be ignored.
Fnality and its shareholders understand well the three building blocks of tokenised markets, what we call the holy trinity: tokenised assets, new exchanges or price discovery venues and payment interoperability. We are building the third: USC will be the tokenised payment instrument that supports the trading & settlement of tokenised assets on DLT-based market infrastructures. The aim is to safely support a step-by-step transition from tried and tested market processes and practices to a new paradigm that can profitably support a wider range of issuer and investor needs well into the future.
Using blockchain will require the new technology environment to interact with the existing infrastructure. There are some things that will not change. As the older generation of Star Trek fans will know; “You cannae change the laws of physics”.
Take value dates. There can be few more fundamental concepts in banking than that which governs the point at which cash is exchanged between counterparty, to make good on an agreed transaction or contract. Value dates define when a payment is due and drives the cash management planning of both payer and receiver.
Value dates do not, however, sit comfortably on a blockchain. Indeed, one of the key attractions of moving financial transactions onto blockchain-based platforms is immediacy. Because blockchain does not have a concept of time, if a transaction is submitted and the party delivering has the asset or the means to pay for the cost of the transfer, then the instruction is sent for validation.
There are number of dimensions to the time challenge. The first is the matter of asserting control over when transactions are submitted to a blockchain. New infrastructures will need a means to support ‘queue management’, including at least the capability to monitor the value date and submit transactions no earlier than that date.
Second, whilst we are all waxing lyrical about 24x7 transaction processing, there will still be a need for an end-of-day process to enable institutions to construct and validate their balance sheet. Financial institutions depend on the daily discipline of ‘ledger-to-statement reconciliation’ to identify and resolve discrepancies between what the inside world of the ledger says and what the outside world says on a statement. Even if that outside world is a ledger, or blockchain, that discipline will still be needed.
As we come up to ‘year-end’, on Dec 31st 2019, we can see a clear, practical example. All financial institutions will show on their year-end accounts an asset titled, ‘Cash at Banks’, i.e. the sum of cash held with central banks, with payment systems and with correspondents. The external auditors will be writing to some of those correspondents and payment systems to say: “Please confirm the amount of USD that Bank X held with you as at 31.12.19”.
The devil of course is in the detail. Much remains to be done and many voices need to be heard. For us, the most important issue is ensuring interoperability. A digital financial market ecosystem – consisting tokenised assets, fully-digital market infrastructures and payment in a digital equivalent of central bank money – will need to support three levels of interoperability. Not only must interoperability be achieved between legacy and digital venues and platforms, but also between competing blockchains – to support atomic settlement regardless of the standards and protocols – and between different means of on-chain payment.
As the business case becomes clearer, and the building blocks and underlying technologies mature, momentum for the shift to digitised markets is growing. It’s time to add your voice.
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