The role of blockchain in banking - Future prospects for cross-border payments - OMFIF
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The role of blockchain in banking Future prospects for cross-border payments
Contents 3 Preface Section 1: The blockchain solution 4 What is blockchain 5 The industry approach 16 Regulation Section 2: Outlook 21 Future trends for blockchain in banking 24 Technology considerations for future implementation 25 Regulatory and governance challenges remain 27 Conclusion 29 Appendix
OMFIF.ORG 3
Preface
I n this consultation paper, OMFIF and CCBU investigate the
effects of blockchain and distributed ledger technology on
financial institutions’ business models.
The study focuses on the motivations underpinning financial
institutions’ decision to adopt blockchain, their participation
in consortia – groups of companies collaborating to develop
common objectives and standards for blockchain and DLT –
and the critical practices and lessons they have learned so far.
It is based on in-depth interviews with representatives of major
global banks and financial technology companies. The people
we spoke to are innovation officers and managers responsible
for deploying practical blockchain and DLT use cases in
areas like cross-border payments, trade finance and foreign
exchange settlement. OMFIF and CCBU engaged with experts
representing other diverse perspectives and sectors, including
fintech and technology providers from the blockchain and DLT
industry. Analysis of financial technology regulation and public
policy papers complements our research.
Contributors’ insights are reflected throughout this paper and
summarised faithfully to give an overview of blockchain and DLT
in the financial industry, as well as the opportunities and risks
that major global banks face by innovating in this field.
4 BLOCKCHAIN BANKING
Section 1:
The blockchain solution
Major banks and financial institutions are realising that
blockchain technology could vastly improve the efficiency
of their processes – particularly in cross-border payments
– and reduce costs. Many have joined forces to research
new applications, though regulatory barriers remain.
Blockchain: functions
and limitations
Distributed ledger technologies – collectively the development of the world’s first peer-to-peer
known as blockchains or blockchain-based cryptocurrencies. Its best-known application is
platforms – have moved from the margins of public bitcoin, the cryptocurrency developed by Satoshi
interest to being touted as paradigm-changing Nakamoto in 2008. Bitcoin employs blockchain
technologies. At their core, blockchain and DLT technology to allow, in principle, any anonymous
are novel systems to digitally manage data in a individual or entity to perform transactions without
decentralised manner, transforming how individuals, a trusted third party. Other subsequent public
companies and institutions can transact and trade blockchains such as ethereum are based on
with each other. Mainstream interest in blockchain similar principles. However, bitcoin’s lack of wider
arose after the 2008 financial crisis in tandem with integration with technological infrastructures
and its uncertain position in existing regulatory
frameworks have hampered mass adoption of
blockchain.
Large businesses and governments are
increasingly interested in exploring the potential
merits of blockchain and DLT. In contrast to bitcoin’s
open architecture, the development of enterprise-
grade blockchains in the financial industry and other
economic sectors has focused on permissioned
systems. Federated blockchain models offer
the most promise as potential enterprise-grade
systems within financial services and other
industries.
Smaller settings require fewer nodes to generate
consensus, and therefore do not need nearly
as much computational capacity to secure the
network, allowing for greater scalability. Unlike
public blockchains, there is no need to incentivise
validators – those responsible for verifying
transactions within a blockchain – to compete
with hashing power for cryptocurrency rewards, as
maintaining network security is a shared interest. In
effect, the financial sector is prioritising blockchain
models that can offer security and scalability rather
than decentralisation, see Fig. 1.1.
OMFIF.ORG 5
Fig. 1.1 Financial sector favours permission-based consortium model
Three types of blockchain systems
Public blockchain Consortium blockchain Private blockchain
Managing One central institution holds all
All participants (decentralisation) Participants in the consortium
entity the authority
Rules can be changed easily Rules could be changed easily
It is very difficult to change the
Governance through the agreement among according to the decision made
rule that has been made
consortium members by the central institution
Transaction Difficult to expand the network, Easy to expand the network and Very easy to expand the network
speed and transaction speed is slow transaction speed is fast and transaction speed is fast
Only authorised users can Only authorised users may
Data access Everyone can access it
access it access it
Identifiability Pseudo-anonymous Identifiable Identifiable
Proof of transaction is known
Proof of transaction is decided by through authentication, and
Transaction Proof of transaction is made by
algorithms such as PoW and PoS, transaction verification and block
Proof and cannot be known in advance generation are made according to
central institution
the rules agreed in advance
R3, Hyperledger Fabric, Quorum, Linq, a stock exchange platform
Examples Bitcoin
Ethereum for Nasdaq unlisted companies
Source: Financial Services
Commission (2016)
The industry approach
After the initial hype, industry proponents have work together on a common solution using a
adopted a more pragmatic approach: decentralised database. For one major bank, ‘Many
advantages of blockchain, such as immutability,
• Focus on pain points in existing businesses, from are useful but really the core tenet is the idea of
the perspective of efficiency and cost-savings. decentralised data that allows many countries and
This is a departure from blockchain’s early days, competitors to work and co-invest on a common
when it was touted as a generator of digital platform. Everyone keeps their own data and only
transformation and a new revenue driver. permission certain data to each other when they
• Contrasting technology and fintech start-ups. want to interact and trade.’
• Form or participate in a technology consortium. While novel use cases (or business cases) for
With blockchain technology still in its nascent blockchain are still emerging, some of the common
phase, being part of a consortium is a more cost- areas it has been applied to in the financial
effective way to share information, learn about industry include know-your-customer procedures,
the underlying technology, grow the community trade finance and primary security issuance. The
to garner network effects, and nurture an internal technology suits various core banking functions
innovation culture. and back-office scenarios such as payments,
clearing and settlement, see Fig 1.3.
Maximising benefits, limiting risks The industry has identified five main pain
The properties of blockchain are especially points that DLT could address: security, speed,
suited to maximising mutual benefits and transparency and traceability, risk and cost
limiting business risks from collaboration and management.
co-investment. Blockchain enables banks to The centralised nature of legacy financial
6 BLOCKCHAIN BANKING
systems makes them vulnerable to single points
Fig 1.2 Cross-
Spotlight:
of failure. For example, a single-point attack on an
border payments intermediary responsible for payments, clearing
dominates use or settlement could suspend services to the entire
cases
BCTrade
system, leading to widespread outages among
Blockchain use payments services. By creating a distributed
cases, 2019 market network, a DLT-based system could eliminate these
share, % single points.
Source: Institutional Speed remains an issue in legacy systems. From identifying these inefficiencies and
Deposits Corporation 2019
Authentication, verification and data-sharing pain points, the industry has developed
are usually manually undertaken by different a number of blockchain use cases. One
Regulatory intermediaries. For example, in trade finance, prominent use case is trade finance.
compliance
7
a shipment of goods could be delayed due to Facilitating the movement of physical goods
multiple checks by intermediaries and numerous and commodities is burdensome, with paper
communication points. processes such as issuing letters of credit,
Assets or goods Multiple platforms and different data recording bills of lading and invoices used to reduce
management methods could cause fraud or audit issues if there payment and delivery risks. DLT can speed up
9
are multiple versions of the truth, or errors in the transaction settlement time (which currently
way information is stored. At its core, blockchain takes days), increase transparency between
is a ledger offering visibility into the entire lifespan all parties of a trade and free up capital that
of a transaction or value exchange within a bank’s would otherwise be used to pre-fund trade
Lot lineage or operations. It can reduce the need for expensive finance transactions. For example, China
provencance and time-consuming third-party verifications along Construction Bank launched BCTrade, a
10
a payment process or funds transfer. Documents blockchain trading platform, of which 60
can be linked and accessible through blockchain financial institutions are members. So far,
and reviewed and approved in real time, reducing 3,000 users from banks, manufacturers and
the time it takes to initiate the shipment of a good import and export trading firms, have used
Trade finance or delivery of an asset. the platform to transact more than Rmb440bn
and post-trade Current banking models require a trusted in forfeiting, domestic letters of credit,
or transaction third-party intermediary to remove the credit risk international factoring and re-factoring and
settlements between two parties in a transaction. Credit risk is logistics finance.
10 present when one leg of the transaction is made
first, such as the delivery of goods or an asset or
cash payment, meaning there is no guarantee that
the second leg of the transaction will occur. DLT hours’ of central bank payments systems by
platforms allow the recording of transactions of decentralising infrastructure, were identified as key
Cross-border any arbitrary asset – money, equities, bonds, over- objectives early on.
payments and the-counter derivatives – as well as cash, allowing
settlements multiple, simultaneous changes to the ledger. Industry focused on cross-border payments
16
This would mean that the concept of delivery v. The banks surveyed are largely concerned about
payment – where one asset changes hands only pain points in cross-border payments, particularly
if the other asset does as well – can be achieved high costs and inefficient processes. Respondents
simultaneously, with no ambiguity as to which feel that DLT would provide the tools to surmount
leg occurred first. This extends to invoices and these issues. A 2019 Institutional Deposits
payments – two parties can know the status of an Corporation study on blockchain spending found
invoice at any time, and the payment can settle at that cross-border payments was the use case
the exact moment the invoice is marked as paid, receiving the most annual investment at $453m,
with both parties having visibility of this change equivalent to 16% of market share, see Fig 1.2.
of status. This could mean that transactions Proponents of blockchain maintain that
recorded on DLT could on aggregate be cheaper DLT offers several advantages over current
than transactions recorded across multiple siloed payments technology. These include facilitating
accounts, and remove the credit risk. near-frictionless settlement at any time, global
interoperability, high security, and ultimately, quicker
Greatest return and lower-cost transactions. To understand the
Respondents say the greatest return from rationale and use cases for blockchain technologies
blockchain was its use for cross-border payments. in cross-border payments, the next section
Banks identify several pain points causing examines the incumbent methods for international
inefficiencies, costs and risk to daily operations. transactions and their principal limitations and
Most of those surveyed expect faster payments, disadvantages.
especially across borders, to be the most important The cross-border payments system relies heavily
Others use case. One respondent notes that blockchain on correspondent banking networks facilitated
48
could help solve some of the most cumbersome by financial intermediaries at multiple levels. A
issues in payments systems. Cross-border correspondent bank will have either a nostro or
payments, as well as extending the ‘opening vostro account with a counterpart bank in another 
OMFIF.ORG 7
Fig 1.3: Regulatory concerns across applications
Prominent industry use cases of DLT
Typical Blockchain and Strategic General regulatory
financial actors DLT use cases innovation motives attitude
Back-office Banks and fintech • JP Morgan Interbank • Digital transformation • Regulatory concerns
(settlement, firms, incumbent Information Network in strategic but over legality
reconciliation, service providers e.g. methodical manner and contractual
messaging etc.) Swift • Settlement Clearing • Insulate incumbent enforceability of
Systems e.g. positions from future transactions and
Citi-Nasdaq Blockchain disruption settlement finality
• Optimise operations • Driving base-layer
• Intra-bank foreign interoperability and
and lower costs on
exchange settlement common technical
existing payment rails
e.g. HSBC FX standards
Everywhere • Streamlining inter and
Network intra-bank workflows
• Partner with existing
market leaders to
quickly deploy new
technologies at scale
Compliance Banks and fintech • Streamlining trade • All of the above • Regulatory concerns
procedures (KYC, firms, incumbent finance processes • Potential for market over security and
AML, CFT etc.), service providers e.g. such as letters of credit, disruption to a privacy related to
documentation, Swift bills of lading, invoicing limited extent as digital identities and
information-sharing e.g. We.Trade interoperability/ data storage
• Customer compliance, standardisation can • Entry of new
KYC and collateral expand opportunities intermediary actors
management e.g. for service providers involved in compliance
CLS-IBM • Need to enhance
LedgerConnect regulatory capacity to
engage and integrate
new technologies
into supervisory/audit
processes
Means of payment Typically fintech firms, Retail remittances, B2B • Challenge/ • Ambiguity over legal
(account v. token- now big tech and some payment solutions complement status of payments
based) banks on limited basis. e.g. Ripple’s XRP, mainstream financial and nature of assets
Facebook’s Libra, Visa system infrastructures • Transparency issues
B2B, Santander One • Broaden financial for taxation and
Pay FX inclusion among compliance
peripheral markets and
• Anti-trust concerns
institutions
over competition
and governance
within new payment
infrastructures
• Unsuitability as a
means of payment due
to volatility concerns
Central bank digital Central banks PboC DCEP, Riksbank • Enhance consumer • Unknown implications
currencies e-krona, among others protection, for conduct of
to issue retail CBDC • Financial system monetary policy and
stability and resilience financial stability
• Respond to private-
sector innovation
Source: OMFIF analysis
8 BLOCKCHAIN BANKING
Fig 1.4
Correspondent
banking model
Bank A sends euro
amount to euro Bank D
account of Bank D
in Germany
Correspondent In Germany
Bank A relationship
US Fed wire
Sepa payment
payment system
system
Sw
if t if t
Sw
Bank B Bank C
In US, having In Brussels
relationship with bank
Source: InfoSys, C in Brussels
OMFIF analysis
country. A nostro is the account of a local bank generally more cumbersome and expensive
held by a correspondent bank in another country, than domestic payments due to the number of
in its foreign currency. A vostro is the account of a financial intermediaries involved in the process.
foreign correspondent bank, held by a local bank Smaller financial institutions that have not
in its domestic currency. This reciprocal system of established correspondent relationships with
accounts facilitates foreign exchange transactions foreign counterparts may be disadvantaged. One
and the flow of funds between countries. respondent says, ‘Getting another bank to use our
Swift’s network allows participants to exchange system is a difficult discussion to have and can be
electronic transaction messages detailing a non-starter [in cross-border partnerships]. Swift is
instructions for cross-border payments. However, the only workable example of third parties hosting a
it provides neither clearing nor settlement. network that anyone can join, but it is not a platform
Correspondent banks participating in a transaction that extends to corporates. It’s really just bank-to-
must still process the messages individually on their bank messaging, so again it falls short.’
back-end and subsequently settle any transactions Shrinkage and consolidation in the number of
through foreign exchange markets, see Fig. 1.4. correspondent banking channels have reinforced
Consequently, cross-border payments are higher costs associated with cross-border payments
as institutions seek to reduce their risk exposures,
see Fig 1.5. A 2018 World Bank report on the decline
Fig 1.5 100 of correspondent banking noted that this trend
International of de-risking tends to disproportionately affect
decline in financial institutions in small, developing countries
correspondent 90 at the periphery of cross-border payment corridors.
banking Circumventing this costly system is widely
Number of active 80 regarded as the main motivation for applying DLT to
correspondent cross-border payments, as there are real efficiency
banks by region, gains to be achieved.
Indexed 2011=100 70
Alleviating pain points
60 As highlighted, cross-border payments tend to
2011 2012 2013 2014 2015 2016 2017 2018 be riddled with inefficiencies and transaction
costs. Interbank settlements require a minimum
level of pre-existing trust between intermediaries.
Africa Americas (excl. North America)
Establishing and verifying trust generates tangible
transaction and compliance costs for financial
Asia Eastern Europe
institutions in terms of money, time and uncertainty.
A recent McKinsey Global Institute study on cross-
Source: Bank Europe (excl. Eastern Europe)
for International border payments found that the bulk of costs
Settlements and (nearly 35%) in existing international transactions
OMFIF analysis Oceania Northern America methods are related to nostro-vostro liquidity and
OMFIF.ORG 9
reconciliation due to a lack of real time data and – by avoiding having to channel foreign exchange
differences in end-to-end payment processes, see through a cumbersome network of pre-funded
‘What we were Fig 1.6. legacy banks.
looking to do Blockchain-based cross-border payments offer Similarly, balances can be duly maintained
was put a ledger several advantages in streamlining verification in real-time, eliminating the need for a central
in between and reconciliation procedures. Blockchain-based clearing house such as a central bank. One bank
different entities, transactions diminish the role of any intermediaries, shares that DLT is valuable as ‘getting rid of the
central institutions, and correspondents in the single point of failure by decentralised validation
to update the
cross-border payment process. Transactions can and synchronisation reduces systematic risk’.
life-cycle of the be executed directly between the parties who have Synchronising payments could allow blockchain
transaction and entered into a bilateral agreement on the platform, and DLT to mitigate settlement risk along a
have a single thereby reducing the need for interpersonal payments chain. Thus, blockchain technologies
version of truth trust between transacting parties. This lack of could streamline processing times, improve risk
between the centralisation, and the nature of immutable and management processes, cut back-office costs
different entities secure transactions, present benefits in terms of involved in reconciling data across organisations
and systems.’ efficiency, transparency, security and cost. and reduce overall friction in the system.
The reduction of intermediaries such as
correspondent banks or central agencies can help Shift to tokenisation
minimise charges incurred along the payment chain. Importantly, these benefits could be the basis
Currently, transaction settlement relies on financial for tokenisation – that is fundamentally shifting
intermediaries and service providers. As a result, from account-based to token-based payments
post-trade processes require a considerable amount systems. The lengthy and costly infrastructure
of reconciliation. A peer-to peer model reduces the for intermediaries, compliance and verification
need to update and reconcile multiple accounts in procedures are essential to conduct transfers
the post-trade cycle. Enabling direct transmission of claims upon payments recorded within an
of information and assets between parties could account. DLT-based transactions could allow for
optimise the operational costs of cross-border the authenticity and value of exchanged payment
30
payments, as any lack of standardisation can be objects (tokens) to be verified independently,
minimised, see Fig.1.7. A 2017 Accenture study precluding the need for messaging, clearing and
estimated that full-scale blockchain adoption settlement systems.
among global investment banks could reduce Many respondents emphasise that while there
Full-scale reconciliation and other infrastructure costs by are feasible alternative solutions to cross-border
blockchain 30% on average, an amount ranging from $8bn- payments (e.g. Swift gpi), blockchain and DLT
adoption $12bn. One respondent says, ‘The main pain have proven to be catalysts to push the financial
among global points stem from intermediaries doing away with industry’s outdated infrastructure to the cusp of
investment old correspondent banks, central banks’ opening technological upgrading.
hours slowing settlement finality, and preventing The question of momentum and timeline is
banks could
new risks like market risk, which can arise from important . Large financial institutions tend to be
reduce cryptocurrencies, or credit risk. If a commercial conservative in their approach to DLT – before
reconciliation bank issues the coin or stable coin, this can lead to delving head-first into new endeavours, banks
and other credit or legal risk.’ Our respondents note that this want to make sure that the technology is right and
infrastructure is the most important way in which DLT in cross- that they can secure full regulatory approval. Most
costs by 30% border payments can achieve key cost savings of those surveyed say that the nature and depth
Fig 1.6 High
costs in
international 2
payments 3
related to
13 6
15
nostro-vostro
7
liquidity and
2
reconciliation Nostro-vostro Claims and
liquidity Treasury operations
5
Cost breakdown
for international Foreign Compliance
3
exchange costs
payments
transactions Payments Overhead
operations
Network
management
Source: McKinsey Global
Payments Map 2019
10 BLOCKCHAIN BANKING
Fig 1.7 What
benefits does
blockchain bring Bank A
Blockchain
in, when leveraged
got cross border
money transfer
Money transfer from Bank D
Bank A to Bank D Bank A In Germany
through blockchain Fed wire
eliminating the 3rd payment system
party as highlighted
Swift
Correspondent
Bank C
Bank B
In USA, having relationship In Brussels
Source: Infosys, OMFIF
relationship with bank
analysis C in Brussels
of regulatory engagement will determine which to-back office infrastructures. Another bank
innovations become predominant and their pace of respondent elaborates: ‘Along the way, with better
‘Along the way, adoption. As one bank notes, ‘Getting the regulators understanding and more knowledge of blockchain,
with better on board… with regards to DLT should be priority these banks create their own use cases and move
understanding number one.’ to bigger projects. They see blockchain as an
and more opportunity to create new competitive advantages
knowledge Deepening industry disruption over other banks’.
The payments industry is keenly aware of the pain In increasing order of potential disruption,
of blockchain,
points in cross-border payment processes, with blockchain and DLT innovations might alter back-
these banks office processes, compliance and means of
various institutions taking different measures
create their own to solve them. A key question is whether or not payments. To the extent that DLT could lower back-
use cases and technological innovation in this sector will be office costs and increase efficiency in compliance,
move to bigger gradual and evolutionary, or more radical and these innovations could facilitate an orderly
projects. They potentially disruptive. transition where incumbent financial institutions
see blockchain Although the benefits of blockchain and DLT were gradually deploy new technologies. However, other
as an opportunity traditionally perceived as opportunities confined to products or business services derived from DLT,
to create new back-office efficiency gains and optimising intra- such as a token-based payments system, could
bank compliance workflows, front-offices are now bypass existing intermediaries and stimulate more
competitive
also seeing the benefits. Recent developments disruptive shifts in market structures.
advantages over
in the technology and payments landscape are
other banks.’ impelling innovation at a deeper, strategic level Contrasting bank and fintech activities
among banks. Blockchain and DLT services are Traditional financial institutions have a vast
becoming important differentiating factors affecting customer base and deep pockets, but legacy
end-user experiences. systems hold them back. Put simply, it is a battle
Before 2017, DLT was viewed from an innovation between innovation and distribution, and it remains
perspective. The narrative from 2017 onwards to be seen whether financial technology firms will
was driven by business (mainly efficiency), achieve distribution before banks innovate fully. The
and to a lesser extent, revenue. Institutions are future of the banking industry depends on its ability
now approaching DLT more strategically, with to leverage the power of customer insight, advanced
Facebook planning to launch its cryptocurrency, analytics and digital technology to provide services
Libra, and the People’s Bank of China working that help today’s tech-savvy customers manage
on its Digital Currency Electronic Payment. their finances and better manage their daily lives.
With major commercial and central banks In general, small fintech companies’ activities
innovating in comprehensive DLT platforms, the span all three of these areas. Yet there is also a
industry as a whole may be forced to consider tendency for new entrants to be more radical and
to what degree they should replace front- ambitious in their innovation approach to cross- OMFIF.ORG 11
Fig 1.8 Banks commit to methodical digital transformation
Blockchain networks to address cross-border pain points
Large global banks Medium-sized Fintech: cryptos Central banks
commercial banks
Example/ JPM. Lead, build, partner Signature Bank. Learn, Ripple. Partner with MAS’s Project Ubin.
approach and invest partner with fintech banks and financial Learn, monitor,
(Tassat) institutions. incremental
Business Digital transformation: Compliant, digitalisation; Innovation, scalability, Consumer protection,
/ policy Strategic but new solutions; keep crypto economy system stability and
imperatives methodically; compliant, existing customers and efficiency
leadership, market grow market.
share, control and
protect incumbency
Angle Efficiency, cost-saving, Agile, solve real Young population, built Shadow banking
liquidity management problem, more open to from bottom-up for and other leaks in
and capital efficiency. alternatives; marketing payment; alternative to the banking system,
‘pain points’ tool for new business. Swift informal economy
and non-banked
Initial focus Intra-bank info-sharing Compliance, full stack Solutions to non-bank RTGS fintech,
and workflow within solution, B2B, intra-bank FIs, B2C mass market crypto, sandbox,
own network interoperability
Use cases Compliance apps in IIN; Treasury services Retail remittance, SME Digital money
Treasury services for (cross-border payment, payments solutions,
corporate customers cash management,
and capital markets asset transfer)
Tokenisation None for IIN; new apps Private token backed by XRP, public-traded over Distributed through
availability and for capital market bank deposits, digital exchanges, controlled commercial bank
characteristics through ‘JPM Coin’, cash, digital wallet, by Ripple wallet; on central
which pegged to virtual account; within ledger.
the dollar; within IIN the network
network
Governance/ Quorum Private Ethereum Decentralised Ripple Quorum, R3,
Platform network alternative DLT, even
non-blockchain
Deployment Internal, within Live, private/ Live, daily transaction Pass the PoC stage;
stage, volume consortium permissioned network volume: hundreds of cross-border, and
of banks and their millions. (phase 5) explore
corporate customers, commercial viability
billions per month with banks and
private sector
Regulatory Information- First blockchain-based Not regulated, not a Behind the learning
status sharing piece is live; bank payment solution MSB; only technology curve
conservative approach approved by a US bank provider
Source: OMFIF
regulator
analysis, CCBU12 BLOCKCHAIN BANKING
border payments, see Fig.1.8. Commenting on the
Spotlight: Interbank
general strategic thrust of small fintech firms, one
blockchain technology provider does not expect
an overhaul of the financial markets infrastructure,
Information Network
given the investments into existing technologies,
thus opting for ‘integration with existing [payment]
rails such as Swift and applications such as Murex,
Omgeo, Aladdin’. This approach is, however, atypical
according to the firm. Most other blockchains being
Launched as a pilot in 2017, JPMorgan’s Interbank Information independently developed by fintech companies take
Network aims to develop a meaningful group of bank users a ‘neoliberal approach’ intended to supplant existing
focused on harnessing emerging technologies such as financial market infrastructures.
blockchain to better address the complexities and pain points in
cross-border payments. Initially, JPMorgan tested moving money Playing it safe
within internal entities and was successful. Since then, the bank In comparison, banks’ engagement with cross-
has stepped back from real-money transfers, and focused on border innovation has hitherto been largely confined
one pain point, information-sharing. to analytics and digital technology. Banks prefer
With an extensive network of 397 banks, IIN involves a to play it safe through regulatory dialogue, rather
mutually accessible ledger built on JPMorgan's private than seeking to establish a competitive advantage
blockchain, Quorum. It allows permissioned banks to exchange by staying ahead of the ‘tech curve’ and engaging
information about compliance checks and other exceptions in riskier bets on new blockchain applications.
preventing completed payments. However, they are disadvantaged vis-à-vis new
Within the IIN platform, for JP Morgan’s customers and ‘challenger’ and ‘neo’ banks or smaller fintech firms
potentially for other financial institutions, ‘Resolve’ emerged as that enjoy a lighter regulatory burden and more
one of the first use cases to address a compliance pain point: manoeuvrability in testing new solutions, thus
60% of Office of Foreign Assets Control (a financial intelligence potentially establishing first-mover advantages.
and enforcement agency within the US Treasury Department) Some banks are prioritising ‘co-development’
inquiries relate to client data as simple as date of birth, name with outside fintech start-ups. This greater agility
and address. ‘Resolve’ enables the real-time sharing of client notwithstanding, new fintech firms seeking to
data, cutting processing times to minutes from up to 16 days. In overhaul financial market infrastructures face
future, JPMorgan may expand the network for internal payments another constraint. To be as competitive as banks,
and real money transfers, between different entities within the they must construct a connectivity base from
group. Other developments may include bond issuance, real-time scratch. Small firms acting independently are
security settlement and repo collateral management. JPM Coin likely to lack sufficient institutional commitment
could facilitate such transfers and settlements. and regulatory alignment to drive more disruptive
changes via DLT.
Banks do not tend to have the same appetite for
radical, disruptive innovation as smaller companies.
However, collaborative activities executed via
consortia may help introduce more extensive
Fig 1.9 Eliminating information efficiencies industry changes in cross-border payments.
For one technology provider, systematically
revamping cross-border processes to remove
Current model IIN Vision ‘residual friction in the transparency of fees’ would
entail a combination of technological innovation
and commitment from banks. Another fintech
Manual Faster turnaround respondent concurs, adding that ‘support and
financial commitment from bank leadership is the
key to the success of a blockchain project’. For
this reason, banks have sought out methods of
Costly Reduced costs capitalising on their scale and incumbent positions
by collectively pooling innovation resources to best
situate themselves within this new and volatile
space. One of the preferred methods in this vein is
the use of consortia.
Slow Direct communication
Co-operating with leading consortia
Half of respondents, in particular those from
banks, identify consortia as their preferred way of
Inefficient Secure network implementing an enterprise blockchain solution
for cross-border payments. In the words of one
respondent, ‘You can only achieve success and gain
Source: OMFIF analysis, CCBU interest from all the different parties if you start
with sufficient core coverage, and that’s why youOMFIF.ORG 13
data, the level of input and control each participant
Spotlight: Ripple
will have, as well as how to assess consortium
performance and growth potential.
Consortia considerations
When joining an established permissioned
Rather than compete with large banking companies, Ripple plans platform, a bank becomes either a ‘follower’ or
to partner with leading financial institutions and provide them a ‘leader’ in that consortium. This is ultimately
with a blockchain solution. decided by the consortium’s governance structure.
Instead of converting dollars into other currencies, which A bank is unlikely to join as an outright leader,
entails exchange rate costs, processing fees and slow unless it holds a large enough stake within the
transaction times, one bank can transfer, for example, $5m worth group. Most respondents are members of multiple
of XRP to another bank’s Ripple portfolio, which can then be consortia, and are leaders in one consortium and
converted into local currency. followers in the others.
Ripple is seeking to position itself as an alternative to Swift. Its For banks, the decision to join consortia is based
software controls the relevant banks’ funds and updates each on a number of key characteristics. First, they
party’s accounting books. The settlement process is completed seek to balance wide membership with quality
in seconds. participants. That is why they join different groups–
By consolidating liquidity to service international payments ‘it hasn’t been a pick one winner approach, it’s been
from many, disjointed, international nostro accounts into one more backing a few horses,’ as one respondent
XRP pool, respondent banks allocate less total liquidity to service puts it – and look to involve different parties in
the same volume of global payments. The bank only has to their consortia to get a broad range of views and
hold its domestic currency and maintain one account with XRP, adequate coverage. In the case of the latter, banks
with only enough XRP to service its largest expected payment cite geographical coverage as a specific concern.
obligation. The process minimises the number of intermediaries The aim of this is to ensure that eventually, the
and their markup on spreads. strength of a consortium’s network will allow a
leading member bank to persuade other players to
remain part of their ‘ecosystem’.
Finding common ground on the specific factors
of a consortium’s operating model may include
establishing common ground on:
need to participate in a consortium.’
Large banks could leverage the technology • Business, technology, and regulatory risks
‘You can only to create their own solutions or consortium. • Legal entity structures and liability attribution
achieve success They operate at great scale and within extensive • Intellectual property management, funding, use
and gain interest networks. As such, they are prime candidates to case development
from all the build the blockchain technology – either on their • Technical considerations such as platform design
different parties own or by partnering with a fintech firm – that • Data management, privacy and ownership
if you start will help them maximise efficiency and revenue • Dispute resolution
with sufficient opportunities. • Service-level agreements indicating resource input
One fintech respondent explains that smaller and required levels of participation
core coverage,
banks, or those with less understanding of the
and that’s why technology, may find it useful to join a consortium. In practice, banks must consider their specific
you need to This way, they can have a voice in the industry, objectives when joining a consortium and whether
participate in a exchange information on cutting-edge technology it is the optimal fit for them. A bank may use
consortium.’ and application development, and a marketing membership as an opportunity to learn and see how
platform. to approach the technology, and structure projects
In addition, a distributed ledger system would from a resourcing perspective. But as one bank
benefit from network effects, and a permissioned respondent suggests, the core of the use cases
consortium could allow banks to better leverage this in their respective consortium were Europe- and
network for cross-border payments. The blockchain UK-focused, far from the bank’s regional priority,
can allow for the updating of sensitive customer and meaning there was little opportunity to participate
transactional information between members, with in many of the consortium’s projects. In some
the use of unique identifiers, while smart contracts circumstances, membership fees could be used
ensure only ‘need-to-know’ participants can view to access research portals or resourcing a bank’s
certain transactional information. internal teams to develop their own expertise.
If a bank decides to start a consortium, it must
determine which type best suits its requirements. The reality of multiple consortia
Consortia therefore vary on the level of access, data There is a clear consensus among surveyed banks
sharing, and governance. that membership in different consortia – with
Designing an acceptable and competitive different use cases and roles in each – is a good
governance structure requires developing and thing, in moderation. Yet the lack of an agreed
agreeing on consensus mechanisms, tokenisation, set of universal standards makes the issue of
access and permissions, and hosting of nodes. interoperability difficult. For example, ISO2022 is
Consortium members can determine how to share the standard used for transaction messages in14 BLOCKCHAIN BANKING
cross-border payments. For a legacy system to Working on standards and protocols
work with a newly implemented DLT-based system, Standardisation is still in its early stage. The
‘You can’t go it would have to be able to interpret and transform International Standards Organisation is working
it alone with these transaction messages, and record them on on a series of blockchain and DLT standards,
blockchain, that the ledger. The system must be able to execute a ISO/TC 307, which aim to address architecture,
would not be transaction from its end and export it so that older taxonomy and ontology. The ISO plans to develop
productive. The systems – based on ISO2022 – can accept and a terminology standard in 2020. However, due to
whole point is authenticate the payment order. Solving this data lack of definitions for some critical aspects, these
getting the whole transfer between blockchain and legacy systems, don’t yet have timeframes. These include security,
value chain on and between two different blockchain-based privacy, identity and interoperability. PingAn, a
systems, will solve the issue of interoperability. Chinese insurance, banking and financial services
one network or
For banks, working across multiple consortia company, publishes technical standards for cross-
a collection of could help solve this quandary, as different border trade. Other entities such as the Institute
meshes.’ networks can connect and share data. In the words of Electrical and Electronics Engineers Standards
of one respondent, ‘by joining multiple networks, and the China Electronic Standardisation Institute
you solve the interoperability’ through a ‘cross- have published standards and protocols relating to
participation’ model. Consortia fuel network effects, blockchain.
allowing a group to grow and gain influence in the R3 and Hyperledger are leading private efforts
long run. The incentives of joining a consortium, to establish standards. However, Ethereum
therefore, are geared towards ‘co-opetition’ rather organisations such as the Enterprise Ethereum
than competition. Alliance and the ISO argue for more global and
One of the drawbacks of Swift is that it is public standardisation methods, to maximise
membership based, therefore its services are interoperability and take full advantage of
limited. In contrast, the blockchain consortia networking effects.
business model is not necessarily geared towards Working groups aim to identify blockchain
consolidation. A single group is unlikely to gain standards and build code bases and proofs of
critical mass, meaning future standards reflect a concepts, and are a useful way to pinpoint new
wider group of banks and fintech firms, instead issues. However, outcomes vary between groups.
of being built around one dominant bank. Rather, Joining a large working group is valuable
there is a tendency towards interoperability that for establishing standards in the long run, but
reflects the changing nature of interaction between processes can be slow. Smaller groups allow
consortium members. players to reach a consensus faster, but risk
The global banking and commerce sectors are becoming obsolete if a more widely adopted
unlikely to form a single blockchain network. One standard emerges. Banks usually mitigate this risk
bank respondent suggested that being part of by joining multiple groups, large and small. That is
multiple consortia could alleviate interoperability what BNP Paribas did, for example, in addition to
problems arising from fragmentation across investing in fintech firms. The bank’s objective was
payments and transaction rails. Cross-participation to define standards and develop a proposal for a
would enable data to be moved from one platform specific blockchain application.
to another, without the need for networks to Banks typically need to see clarity in the models,
communicate. goals and use cases of a particular consortium
Another bank respondent said a rulebook on before agreeing to participate. As one respondent
settlement finality was a key asset in their foreign notes, ‘while fewer is definitely better,’ there are
exchange cross-border network, as it gives ‘going to be many ecosystems’. As such, many
them ‘comfort on how we would interoperate banks surveyed agree, there is a need for clear
or permission people onto our ledger.’ However, terms and conditions across networks. For
‘ultimately, many systems will use ledgers, and example, there are clear intellectual property
the technology for each of these DLTs may well be considerations between different consortia
slightly different. There is never going to be one blockchains. Hyperledger has an explicit IP clause,
unified way of doing it.’ while it is unclear where R3’s lies. If there are layers
of applications built on top of existing blockchains,
Blockchain platforms there will also be different layers of intellectual
‘Ultimately, many Implementation is more complex if a bank decides property. Such instances require more detailed
systems will use to build its blockchain framework and network, clarifications.
ledgers, and the therefore banks tend not to opt for this approach.
technology for Several blockchain platforms offer benefits
each of these in terms of infrastructure, network, solution and
DLTs may well be services. The three main providers are R3’s
slightly different. Corda, IBM’s Hyperledger Fabric and Ethereum-
based Quorum. They sit on the protocol layer
There is never
of the blockchain tech stack (which consists of
going to be one application, service, protocol and infrastructure)
unified way of and define essential rules of permission, consensus
doing it.’ and framework.OMFIF.ORG 15
Fig 1.10 Comparing blockchain platforms
Each platform presents different benefits
R3 Corda Quorum Hyperledger Fabric
Industry focus Financial services Cross-industry Cross-industry
Ethereum developers and JP
Governance R3 Consortium Linux foundation
Morgan Chase
Isolated and multi-tenant by
Ledger type Permissioned Permissioned
design
Isolated and multi-tenant by
Multi-tenancy Not available Supported using side-channels
design
Smart contract functionality
Yes, built with Kotlin (Java) Yes, built with Solidity Yes, built with Golang (Java)
and programming language
Pluggable framework, Raft
Pluggable framework, parties Pluggable framework, but not
consensus, and Istanbul
Consensus to a transaction are involved in necessary for all nodes to
byzantine fault tolerant
decision-making participate
consensus
Approximately 550 Approximately 600 More than 2,000 transactions
Throughput
transactions per second transactions per second per second16 BLOCKCHAIN BANKING
Regulation
DLT-based cross-border payments could offer banks ambiguities over territoriality and liability.
considerable cost-savings and efficiency gains, Second, automated, autonomous processes are a
‘The future but this area is rife with competition from nascent key attribute of blockchain networks, with features
of the bank fintech firms. These challengers face a smaller such as smart contracts used to automate contract
depends on regulatory burden than well-established, systemically execution on-chain, for example. While automated
the bank important banks, granting them greater flexibility decision-making on DLTs is generally transparent,
meeting all in devising effective cross-border solutions. One there are still questions around legal liability in the
the regulatory respondent suggests that fulfilling DLT’s potential in case of these processes, though this is less of an
approvals and financial services revolves around regulation: ‘The issue on permissioned networks where there is a
requirements future of the bank depends on the bank meeting ‘central’ administrator.
all the regulatory approvals and requirements Third, ledger permanence is another key feature
with regards
with regards to KYC and AML.’ These regulatory of blockchain ecosystems, which explicitly use
to KYC and
requirements are a key part of the payments playing cryptography to ensure that distributed records
AML.’ field. The most important obstacle to date is a are tamper-proof. This is an essential feature of
lack of harmonisation across jurisdictions and the decentralised networks and one which clashes
absence of global standards. with several existing environments, including
US banks for example, as depository institutions, the European Union’s General Data Protection
require a banking license and are subject to Regulation. The right to be forgotten and the right
regulations from the Federal Reserve, Office of the to rectification are key elements of the GDPR which
Comptroller of the Currency and federal states in conflict with the immutability of a DLT system.
which they operate. Payments service providers Fourth, maintaining and participating in
and money service businesses are regulated by blockchain governance requires an incentive
the US Treasury’s FinCEN unit. Any novel operation mechanism. Cryptocurrencies usually provide this
will have to fit into existing regulatory frameworks. incentive quantitatively, for example by deriving
Fintech firms are technology solution providers, and additional coins as a form of payment. However,
therefore are not formally regulated. However, any in permissioned blockchain systems, non-financial
solution they develop for banks must comply with qualitative incentives for member participation are
regulations. derived from the alignment of participants’ common
objective, such as the ability to transact near-
The industry’s regulatory predicament costless across borders.
‘The future is to align towards regulatory Finally, decentralised networks owe much of their
requirements, so getting regulators on board with appeal to their privacy and anonymity features,
every step that we take with regards to DLT should which are incompatible with anti-money laundering
be our top priority. There is a need to comply with and KYC rules, among others. One respondent
the rules and gain approval from all the different shares that systematically shifting to a new
central banks. There will be the 80-20 rule – when payments infrastructure using DLT could prove
showing central banks a blockchain platform, they difficult as ‘banks have built up their compliance
will agree on most things, but will inevitably deviate checks, in AML, KYC and reporting requirements
on the details.’ for supervisors around the nostro-vostro system’.
Some of the key features of DLT are at odds with For instance, one valued-added regulatory and
existing regulatory approaches in competition, compliance service that Swift provides to banks –
intellectual property and consumer law. According to and recently corporate entities – is a KYC registry.
the International Telecommunications Union, there These issues play out largely at the domestic
are five main issues: distribution, autonomy, tamper level. For respondents, the main problem is the
evidence, incentive mechanisms, and transparency. fragmentation of regulation across different
First, given the decentralised nature of distributed borders and jurisdictions, a crucial quandary given
ledgers, it is difficult to apply existing regulatory the central use case of cross-border payments.
approaches to blockchain technologies. For one, Except for the EU’s GDPR, there is little by way of
legal systems are largely national, and may struggle supranational or international regulation of DLTs.
to adequately regulate nodes across different The Bank for International Settlements’ Principles
jurisdictions. It is unclear how legal responsibility for Financial Market Infrastructures seek to cover
would be attributed in this context. Furthermore, the global payments landscape.
DLTs may pose challenges related to cross-border However, it would be difficult to apply these as a
data sharing and data localisation, which may regulatory framework for enterprise cross-border
fall under disjointed regulatory authorities. Multi- payments solutions. The BIS has produced an
party enterprise blockchains are subject to legal analytical framework through which to examineOMFIF.ORG 17
blockchain design in the context of the PFMI,
but in doing so has mostly sketched trade-offs
US regulatory
and important considerations vis-à-vis existing
financial market infrastructures. It has not provided
concrete legal guidance or explicit guidelines. For
considerations
instance, on the question of settlement finality,
the BIS writes, ‘For DLT arrangements, settlement
finality may not be as clear. In arrangements that
rely on a consensus algorithm to effect settlement
finality, there may not necessarily be a single point The US agencies working on cryptocurrency regulations are
of settlement finality. Further, the applicable legal the Securities and Exchange Commission, the Federal Trade
framework may not expressly support finality in Commission, and the Department of the Treasury, through both
such cases.’ Banks we surveyed agree that the the Internal Revenue Service and the Federal Crimes Enforcement
BIS’s PFMI provide guidance but no clear global Network.
standards. Nevertheless, they still expect to abide There are no formal regulations at the Federal level. Approaches
by the principles: ‘New market infrastructures are mixed at the state level. Some states have passed favourable
are likely to be expected to comply with the regulations which exempt cryptocurrencies from state securities
Committee on Payments and Market Infrastructures laws, monetary transmission statutes and other regulatory
and International Organisation of Securities requirements. These include Wyoming, Colorado, Georgia, Arizona
Commissions PFMI standards, and the legislation and Ohio. Other states such as New York have passed more
in local jurisdictions which implement these restrictive laws, prompting a number of cryptocurrency-based
standards.’ That being said, one technology provider companies to exit the market.
admits, ‘A lot of work needs to go into aspects such The sale of a cryptocurrency is regulated if it constitutes the sale
as data standardisation to prevent fragmenting the of a security under state or federal law, or money transmission
market. This, by itself, is tedious and contentious – under state law. The sale falls under FinCEN regulations if done as
the implementation of ISO20022, for example, is still part of a money services business under federal law.
dragging’. If the token or cryptocurrency is deemed to be a security, it falls
under the securities regulation of the SEC. Similarly, under the
Slow progress in solving regulatory Bank Secrecy Act, FinCEN regulates money service businesses.
divergence According to FinCEN, ‘An administrator or exchanger that (i)
Market participants we spoke to suggest that accepts and transmits a convertible virtual currency or (ii) buys
international bodies may have to take the lead in or sells convertible virtual currency for any reason is a money
transmitter under FinCEN’s regulations, unless a limitation to or
developing these blockchain regulatory standards.
exemption from the definition applies in person’.
National central banks, such as the Bank of England,
According to Global Legal Insights, MSBs that are monetary
frequently rely on these fora to shape and inform
transmitters under FinCEN regulations will have to develop,
their approach. One respondent compares regulation
implement and maintain a written programme that is reasonably
of DLT to post-crisis swaps regulation produced
designed to prevent the MSB from being used to facilitate money
by the G20, yet notes that even then, interpretation
laundering or terrorist financing. Specifically, the company must
and implementation of the international standards
incorporate written policies, procedures and internal controls
resulted in ‘massive divergence’.
reasonably designed to assure ongoing compliance; designate
‘There needs to be coordination beyond that…
an individual compliance officer responsible for assuring day-
in order to get into the detail and address some today compliance with the programme and Bank Secrecy Act
of the interpretive issues to make sure parties are requirements; provide appropriate training for personnel, which
aligned not only on the outcomes, but also on the includes training in the detection of suspicious transactions; and
interpretive issues in order to reduce the friction that provide independent review to monitor and maintain an adequate
emerges through implementation and execution’. programme.
As a result, it is necessary to use international With a stablecoin, similar considerations must be taken. The
organisations not only to develop detailed guidelines SEC notes that labelling a digital asset a ‘stablecoin’ does not
but also to ensure parties are aligned on interpretive affect its regulatory status. Instead, it depends on a facts-and-
and implementation issues, to reduce longer-term circumstances analysis of the economic reality, meaning securities
frictions. At the same time, several respondents are regulation could apply. If a stablecoin exhibits the properties of a
optimistic about the prospects for interoperability deposit (e.g. if it is issued in exchange for $1 and is redeemable
and cross-border regulatory harmonisation, with for $1), this will trigger bank regulatory licensing requirements.
one noting that ‘it’s going very well,’ and that global Stablecoins are also likely to constitute spot commodities, subject
member banks in their enterprise blockchain to the anti-fraud and anti-manipulation authority of the Commodity
solution are ‘very excited about what we can do on Futures Trading Commission. Lastly, an administrator or exchanger
this.’ of convertible virtual currencies (either has an equivalent value in
While cross-jurisdictional ambiguities and real currency or acts as a substitute for real currency) must register
incompatibilities will remain a common element with FinCEN as an MSB. At the state level, a stablecoin issuer or
in blockchain regulation, the trend towards formal exchange may be required to obtain a money transmitter license in
consortia is reducing this ambiguity. Internal the states in which it operates.
blockchain governance within a consortium You can also read
