Fed Comments on the Challenges Facing Blockchain Technologies in Financial Services

At last week’s SFIG Las Vegas 2017 conference, there were several lively discussions about the application of blockchain or “distributed ledger” technologies to structured finance, with many industry participants suggesting that there are many applications suitable for consideration.  Interesting enough, Federal Reserve Governor Jerome Powell was at Yale University last Friday March 3rd to make a speech about the future of finance and the capital markets.  One of the topics that Governor Powell covered was the challenges that the financial industry faces in implementing these Distributed Ledger Technologies or “DLTs”.

Here is an excerpt from his March 3rd presentation wherein he highlights five significant challenges facing the industry:

Distributed Ledger Technologies

“Let’s turn to another type of new technology that may have important implications for the payments and financial systems: distributed ledger technology, or DLT. Bitcoin helped bring this technology to public attention. Using blockchain technology–which employs a form of DLT–and an open architecture, Bitcoin allows for the transfer of value (bitcoins) between participants connected to its ecosystem without reliance on banks or other trusted intermediaries. This feature has led some to predict that DLT will in the long run render parts of the banking and payments system obsolete, as the intermediation of funds through the banking system will become unnecessary.

Faced with these dramatic predictions, we have seen banks and market infrastructures collaborate with technology firms to explore the use and further development of DLT. In 2016, there was widespread experimentation. Efforts by financial institutions often focused on evaluating the technology, identifying potential uses, and conducting proofs of concept. Prominent examples included the use of distributed ledgers to store transactional data and records in tamper-proof ways, as well as the use of the technology as a primary means to hold and transfer money or assets. By the end of 2016, a few major U.S. clearing organizations had announced plans to use distributed ledger technology in limited ways.

As we have followed developments over the past year, a few lessons have come into better focus.6 First, in contrast to Bitcoin’s open architecture, work by the financial industry has focused on the development of “permissioned” systems, which establish criteria to determine who is permitted access to particular systems, ledgers, functions, or information. In the near term, this approach seems more likely than fully open systems to provide the needed governance and management to address operational, security, and financial risks. Indeed, access is typically permissioned in situations that require the protection of systems and information in the financial and other industries. Even in permissioned systems, some key issues will remain, including whether finality of settlement is to be determined by a central trusted party or by a majority of participants, and whether participants are able to view information on other parties’ transactions. Some argue that movement away from open systems undermines the potential efficiency and the spirit of DLT. At least for now, in payment, clearing, and settlement, safety and confidence must also weigh in the balance.

Second, firms are still grappling with the business case for upgrading and streamlining payment, clearing, settlement, and related functions with DLT. Promoters of DLT offer a vision of streamlined processes that lead to faster processing, reduced reconciliation, and lower long-run operating costs. Some argue that in certain markets, faster and more predictable processing will also reduce the capital and liquidity costs of operations. But upgrades are often costly, lengthy, and risky, particularly if the technology is still being proven, as is the case for DLT. Network effects can also affect adoption, since multiple firms may all need to adopt a particular implementation of DLT in order to justify its use in a specific market.

Third, technical issues remain. Practical issues such as whether a particular version of DLT will work for the intended purpose are still being explored. Issues of reliability, scalability, and security remain very important. Beyond these issues, standardization and interoperability across different versions of DLT will need to be addressed to allow technology integration and avoid market fragmentation. In general, industry members and technology providers recognize these important issues and have taken initial steps to address problems. It will be important to keep these challenges firmly in mind as we move beyond experimentation and into the development and deployment of new products and processes.

Fourth, governance and risk management will be critical. For individual firms or clearing houses that adopt DLT as an internal technology upgrade, the governance and risk-management processes are likely to be internalized within existing organizations and be akin to other technology upgrades. However, if new networks of bilateral payment, clearing, and settlement are established, the new technology may involve tightly coupled protocols and operations. The safety of the overall design will depend on a highly interdependent framework. If automated risk management, smart contracts, and similar tools are deployed across a network, cascades of rapid and hard-to-control obligations and liquidity flows could propagate across a network and the financial system in response to events. This interdependence will likely call for creative organizational thinking to address the need for governance and strong risk management.

Finally, the legal foundations supporting DLT will need attention. Deployments of DLT will involve firms, perhaps in different jurisdictions, with systems that record and transfer information and assets under existing legal frameworks. Which bodies of law apply to the particular firms, assets, and activities will determine the associated rights and responsibilities when transfers are made, cleared, and settled. For example, whether and how banking, payments, securities, or commodities laws apply in a given context are likely to be important in designing systems and services and understanding their properties. And, as with any new technology, things may go wrong. We will need a thorough analysis of how DLT fits into current legal frameworks and what gaps need to be filled by contractual agreements or new laws and regulations. A robust legal basis that provides certainty across relevant jurisdictions is essential for building strong governance, risk management, and operations.”

About markferraris
Managing Principal Orchard Street Partners LLC

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