BIS endorse Distributed Ledger Technology (DLT) for payments clearing and settlement

I’ve just been alerted by friend Gijs Boudewijn to the release of a fascinating white paper by BIS, the Bank for International Settlements (the guys who do Basel stuff and are big cohonez in banking circles).  Their Committee on Payments and Market Infrastructures released Distributed ledger technology in payment, clearing and settlement: an analytical framework last week, and I just read it.  It’s funny, because they are quite fusty-dustry in terminology, as you can tell from the reports title, but the report is intriguing as it’s another endorsement of Distributed Ledgers for payments and finance.

The outline of the paper, which is only 20-odd pages, is as follows:

1. Distributed ledger technology

• Background
• Technical design elements
  • Maintaining information on the ledger
  • Updating the ledger
  • Process flow
• Institutional design elements
  • Operation of the arrangement
  • Access to the arrangement (unrestricted or restricted)
• Potential configurations and trade-offs

2. Analytical framework

• Understanding the arrangement
  • What is the functionality and nature of the arrangement?
  • What are the key factors for effective implementation?
• Potential implications for efficiency
  • Speed of end-to-end processing
  • Cost of processing
  • Speed and transparency in reconciliation
  • Cost of credit and liquidity management
  • Efficiency gains from automated contract tools
• Potential implications for safety
  • Operational and security risk
  • Settlement issues
  • Legal risk
  • Governance
  • Data management and protection
• Potential broader financial market implications
  • Connectivity issues and standards development
  • Financial market architecture
  • Broader financial market risks

To give you a flavour of the paper, here’s the introduction:

Distributed ledger technology (DLT) is viewed by many as having the potential to disrupt payment, clearing, settlement and related activities. DLT, including blockchain technology, draws upon both well-established and newer technologies to operate a set of synchronised ledgers managed by one or more entities. In many markets, financial market infrastructures (FMIs) are entrusted by their participants with updating and preserving the integrity of a central ledger and, in some cases, managing certain risks on behalf of participants. DLT could reduce the traditional reliance on a central ledger managed by a trusted entity for holding and transferring funds and other financial assets.

DLT may radically change how assets are maintained and stored, obligations are discharged, contracts are enforced, and risks are managed. Proponents of the technology highlight its ability to transform financial services and markets by: (i) reducing complexity; (ii) improving end-to-end processing speed and thus availability of assets and funds; (iii) decreasing the need for reconciliation across multiple record-keeping infrastructures; (iv) increasing transparency and immutability in transaction record keeping; (v) improving network resilience through distributed data management; and (vi) reducing operational and financial risks.1 DLT may also enhance market transparency if information contained on the ledger is shared broadly with participants, authorities and other stakeholders.

The use of DLT, however, does not come without risks. In most instances, the risks associated with payment, clearing and settlement activities are the same irrespective of whether the activity occurs on a single central ledger or a synchronised distributed ledger. That said, DLT may pose new or different risks, including: (i) potential uncertainty about operational and security issues arising from the technology; (ii) the lack of interoperability with existing processes and infrastructures; (iii) ambiguity relating to settlement finality; (iv) questions regarding the soundness of the legal underpinning for DLT implementations; (v) the absence of an effective and robust governance framework; and (vi) issues related to data integrity, immutability and privacy. DLT is an evolving technology that has not yet been proven sufficiently robust for wide scale implementation.

This report aims to provide an analytical framework for central banks and other authorities to review and analyse DLT arrangements – in the conceptual, experimental or implementation phases – with the objective of understanding the use cases, and identifying opportunities and risks. Market participants may also find the report useful. The framework focuses on the potential implications for efficiency and safety, and for financial markets more broadly. The framework is directed primarily at arrangements that involve restricted ledgers (access to which is for approved users only), reflecting the main types of arrangement currently being developed in the financial sector, which are of particular interest to the relevant authorities.

I also received another paper from a friend, Kathleen Tyson of Granularity, on same subject.  This was produced by Kathleen with RISE Financial and, for those interested, this one's thesis is:

DVP on DLT: Linking cash and securities for Delivery vs Payment settlement in distributed ledger arrangements

Distributed Ledger Technology (DLT), also known as ‘blockchain’ (ed: this is incorrect, DLT is NOT THE SAME as blockchain), is redefining the interaction models between diverse market stakeholders. It has great potential to enhance the performance and security of today’s highly centralised market infrastructure. The core proposition of DLT for securities custody and settlement is that investor ownership of assets and control of transactions across the settlement cycle can be securely and immutably recorded using a de-centralised ledger so that investors have better control and visibility of asset uses, rights, revenues, and transfers. This can reduce investor and intermediary risk of fraud, loss or abuse of trust.

In addition to changing the way securities can be owned and transferred, it is increasingly recognised that DLT can bring significant benefits to global capital markets operations by improving efficiency, security, transparency and resiliency. While the efficiency and risk management of centralised market operations have been greatly improved by collaboration as documented in the CPMI-IOSCO Principles for Financial Markets Infrastructures (PFMIs),1 better fail and dispute management and risk management are still achievable through technology for secure de-centralised DLT custody and settlement. The BIS Committee on Payments and Market Infrastructures has recognised the potential of DLT to deliver better market infrastructures and has provided an analytical framework for supervisors evaluating DLT arrangements.

In this paper we aim to explain some of the benefits of DLT migration and the challenges that need to be overcome during the transition. We then show how existing securities and cash can be moved into DLT arrangements for delivery versus payment (DVP) transaction settlement. DVP is a fundamental requirement as it eliminates the principal risk that either counterparty to a trade or financing transaction could lose the full value of cash or securities while either leg of the trade or transaction remains unsettled. PFMI 12: Exchange of-value settlement systems states that a Securities Settlement System ‘should eliminate principal risk by ensuring that final settlement of one obligation occurs if and only if the final settlement of the linked obligation also occurs, regardless of whether the system settles on a gross or net basis and when finality occurs.’ We provide models for meeting this obligation by interfacing legacy centralised securities settlement infrastructure with DLT platforms. The paper concludes with a set of recommendations for financial market infrastructures aimed at guiding a successful migration strategy.