The Committee on Payments and Market Infrastructures (CPMI) defines interoperability as follows:
“The technical or legal compatibility that enables a system or mechanism to be used in conjunction with other systems or mechanisms.”
When the Distributed Ledger Technology (DLT) community talks about interoperability, they mean that two or more systems can work seamlessly with each other. What they are talking about is enabling cross-chain atomic swaps – swaps in which either both legs happen or neither of them do. Deriving from the Greek ‘atomos’, the word roughly translates to ‘indivisible’. It is indivisibility which ensures both legs of DLT-enabled financial transactions can be actioned, to eliminate settlement risk.
As suggested in the CPMI’s definition of delivery versus payment and payment versus payment, atomicity means that in any transaction, the final transfer on one side occurs if, and only if, the final transfer on the other side happens too. We then say that these two transfers happen atomically – as one.
This is precisely the approach that we take at Fnality.
The value of atomicity in wholesale finance
The primary argument for atomicity is about mitigating settlement risk. Looking back, we can trace its inception as a core tenet of financial language to a relatively small German bank, Herstatt Bank, whose bankruptcy in June 1974 became a global symbol for settlement risk.
Put simply, settlement risk is the risk that a counterparty to a trade does not pay its dues. In an FX swap, its two legs or ’payments’ must be settled successfully for the overall trade to be settled. If, however, the two legs are settled without this atomicity, the counterparties to that trade run the risk that one of the two legs never settles. When this happens, it would leave one counterpart exposed to credit and liquidity risks.
Herstatt Bank created this event in the FX markets in 1974. At the time, Herstatt Bank was heavily active in the Deutsche Mark (DM) and USD FX market. When forced into liquidation by the German regulators, the Bank stopped all payments. The time difference between Germany and the US meant that USD that were supposed to be transferred to the US counterparties of the DM-USD swaps never settled. The missed transfer of the US liquidity left the US counterparties short of their expected funds and scrambling to find liquidity elsewhere. At the same time, the US counterparties incurred credit risk, as they had already paid their DM leg of the swap.
Even 50 years later the implications of the story hold true. Atomicity must be guaranteed for cross-chain swaps in the same way as they are in traditional Financial Markets, if we’re to build an ecosystem where settlement risk is properly mitigated.
The rationale for peer-to-peer atomic swaps
At Fnality, we’re building a Payment System based on the principles of decentralised Financial Market Infrastructure (dFMI), where participants’ payments are ‘peer-to-peer'. The role of the settlement agent is played by the consensus mechanism, leveraging cryptography to solve the double-spending problem.
The Fnality Payment System (FnPS) ensures any participant is only exposed towards its payment counterparty and no one else, as no intermediary exists. The FnPS reduces counterparty and credit risk, benefitting our participants and the wider market. Within each FnPS, this property is guaranteed by the use of Blockchain, which also provides benefits to participants in terms of lower operational risk and higher resiliency.
Building a new approach to atomic settlements
At Fnality, we’ve worked with our Partners and legal entities to create an interoperability protocol that is inspired by extensive research and years of experience in the DLT community. We have hypothesised, iterated and learnt quickly.
We immediately discounted intermediated approaches, as they were incompatible with the dFMI concept. We then analysed what the market had to offer in terms of peer-to-peer cross-chain swaps, especially focusing on understanding the weaknesses and edge cases that could have broken the CPMI definition of PvP and DvP. For example, we looked carefully at the criticalities identified by the Bank of Japan and the European Central Bank in their Joint Stella Reports on PvP and DvP, and at projects such as Jasper-Ubin, from the Bank of Canada and the Monetary Authority of Singapore.
This iterative approach has allowed us to craft our own way, with an approach that fully meets the CPMI definition of PvP and DvP without requiring third-party intermediating of the settlement process. We’ve aimed to be as open as possible and believe in a future where multiple DLT platforms perform cross-chain atomic swaps at scale. Our solution is therefore technology agnostic and can be implemented across different platforms. This openness is key to delivering against our vision of a single pool of liquidity for our participants, to satisfy all their business needs.
Looking to the future
We’re building a new type of financial infrastructure which removes the need for settlement agents for simple payments and for PvP and DvP, thanks to a uniquely interoperable design. This will enable our customers to reduce their counterparty and credit risk greatly.
We are excited to be counting down to the initial operations of our first Fnality Payment System in the UK later this year. But we know it is just the beginning of an exciting journey that will lead us to the development and deployment of new cross-chain, interoperability-based use cases. Together with our customers, we will soon be able to realise the DLT promise of ‘decentralisation at scale’, truly reimagining the global post-trade landscape.