There has been much debate about the potential benefits of blockchain technology to enhance the planet of payments — particularly international payments.
This is a business where many various parties got to reach consensus to route the payments, perform currency conversions, and deploy and manage liquidity in several jurisdictions, all subject to heterogeneous regulatory constraints.
One of the most issues blockchain can tackle is that the high complexity of payments networks, thanks to the fragmentation of the financial industry itself, which makes it impractical for individual banks to deal directly with all other banks on the earth .
For example, when a bank gets a payment instruction from a client, it must find a correspondent bank that’s willing to require the client’s funds and terminate the payment locally at the receiving bank. And so as to try to to so, the correspondent bank must have a nostro or vostro account with the receiving bank (or with another correspondent bank that has access to the receiving bank, thus adding an additional hoop), ideally with enough pre-funded liquidity to finish the payment on the client’s behalf.
But when this happens, the receiving bank has no thanks to verify that the incoming transfer from the (last) correspondent bank, in fact, corresponds to the first client sending the cash . that’s why a SWIFT message from the sender is required , therefore the receiving bank can understand the aim of the incoming funds, do proper due diligence or anti-money laundering checks on the payment, and inform the receiver of the funds.
All the parties involved have different ledgers, i.e. they are doing not share one version of the reality , and therefore the coordination between of these parties is slow and error-prone, repeatedly counting on manual interventions by back-office teams. Furthermore, someone must perform currency conversion at either end, and different parties got to manage liquidity levels at nostro/vostro accounts, which involves settling against financial institution accounts also .
Blockchain’s big promise is precisely providing that single version of the reality that’s missing within the picture above.
Indeed, a true, smart contract-enabled blockchain provides one ledger and transactional engine where balances are often maintained and transacted upon and where payments can live as single, common digital objects that make messaging and reconciliation unnecessary.
By using smart contracts, different parties can’t only register tokenized funds and payments, but they will also set in stone the principles applying to all or any aspects of the end-to-end payments processes, eliminating errors and misunderstandings, increasing transparency and auditability, and reducing fraud and cyber risk. The result: Everything on an equivalent ledger, with an equivalent smart contracts for all, and with an equivalent computational engine, with no possibility of errors or tampering.
Now, most of the (so-called) decentralised solutions being proposed lately often specialise in improving payments processes either by digitizing the messaging layer described above or, even better, eliminating it by creating single, digital representations of payments which will enforce transactions on proprietary ledgers, connected to at least one another with some kind of inter-ledger protocol. this is often indeed a big improvement on today’s message-driven payments processes.
But a key issue arises when one tries to scale such systems, particularly when large payments issued by corporate clients are at stake: management of liquidity.
Indeed, fast (overnight) payments believe pre-funded nostro accounts, therefore the correspondent bank has the cash at hand to terminate the payment, thus eliminating any settlement risk. And when these nostro accounts got to be rebalanced over the course of the business day, large sums of cash got to be moved through central banks. Again, this is often a slow and error-prone process — a minimum of compared to the real-time transactions, with finality within seconds, promised by permissioned blockchains.
A low velocity of liquidity internationally finishes up docking liquidity at nostros at levels that are above really necessary. this is often an enormous problem thanks to the many opportunity costs of those funds — mounting from tens or many basis points to tens of percentage points in emerging economies.
The possibility of getting digitally native tokens that act as a store useful within an equivalent ledger where payments, full service bank balances and nostro balances are stored represents a fundamental, revolutionary solution to enhance this example . These tokens are often wont to exchange liquidity between liquidity providers and market makers globally in real time.
Through this, it’s possible to implement token-based secondary markets for liquidity exchange, which enable liquidity providers to trade with each other with much less friction and improved transparency and reduce the amount of liquidity deployed in nostro accounts in several places thanks to much higher capital velocity.
With these tokens and therefore the use of smart contracts, participants can even post unused liquidity in certain geographies as collateral to borrow liquidity in places where it’s more urgently needed, in real time.
The key here is making these tokens as universal as possible, and capable of supporting all the liquidity needed today within the currency markets – which amount to quite $7 trillion per day, consistent with the Bank for International Settlements. a big a part of this market is deliverable and thus liquidity-related.
There are proposals to use cryptocurrencies or unbacked crypto-assets to play this role, but this approach suffers from variety of limitations.
The market risk of such assets is sort of difficult to hedge, thanks to significant volatility, and therefore the total liquidity in circulation is small as compared with what’s needed within the market — a market which works quite well with a rather universal and hyper-liquid asset available today, the U.S. dollar.
As a practical alternative, several leading institutions are working towards producing tokenized, digital financial institution money.
Some, just like the Utility Settlement Coin project (which my bank, Santander, is a component of, alongside with UBS, Deutsche Bank, Bank of latest York Mellon and lots of others), do that through intermediate vehicles that hold the backing funds on a real-time gross settlement (RTGS) account. Others, like project UBIN in Singapore or project Khokha in South Africa , recently implemented and demonstrated by ConsenSys, directly implement RTGS accounts on smart contracts.
Either way, these initiatives show a viable approach to improving liquidity management for commercial banks and market makers, with the promise of providing much greater liquidity velocity and transparency, with the potential results of enabling a big reduction in liquidity levels within the entire economic system .
As these initiatives mature and flourish, we believe they’re going to become a key enabler of the decentralized, tokenized economy the planet is so intrigued about.