How DLT can provide a good global payments solution

The debate continues to rage regarding the potential benefits of blockchain technology and their role in improving the world of international payments.

At the moment, this is a business where many different parties need to reach a consensus in order to route payments, execute currency conversions, and manage liquidity in different jurisdictions. All of these are subject to volatility, change, and regulatory constraints.

The complexity of existing payment networks

One of the big issues that blockchain is capable of solving is the actual complexity of the payments network due to the inherent fragmentation of the financial industry itself. This makes it very impractical for individual banks or financial institutions to deal directly with any other banks in the world.

For example, when a bank receives instructions to make a payment from a client, it needs to first find a correspondent bank that is willing to accept the clients’ funds before terminating the payment locally at the receiving bank. In order to do this, the correspondent bank needs to have a nostro or vostro account with the receiving bank that has enough pre-funded liquidity to complete the payment on the client’s behalf.

The receiving bank has absolutely no way of verifying the incoming transfer from the correspondent bank, rather they correspond to the client that set the moment. That is why a SWIFT message is required from the sender so that the receiving bank is able to understand the purpose of the incoming funds and carry out any AML or due diligence on the payment.

Each party that is involved in this process has a different ledger which means they do not share one, single version of the truth. The communication between these parties is slow and error-prone and can often rely on manual interventions by staff in the bank. In addition to this, someone needs to perform a currency conversion and all parties are responsible for managing liquidity levels at nostro/vostro accounts.

The idea behind blockchain is that it aims to offer the single version of the truth which is missing from the current banking system.

Smart contracts and blockchain

A smart contract-enables blockchain to provide a single ledger and transactional engine where balances can be both maintained and transacted upon this means that payments can exist as a single, common digital object that makes reconciliation totally redundant.

Through the use of smart contracts, all involved parties cannot only register their tokenised payments and funds, but they are able to lay down the rules applying to every step of the payment process. This will significantly eliminate errors and misunderstandings, whilst increasing transparency and audibility. Everything exists on the same ledger with the same smart contracts and there is no risk of tampering or fraud.

Most of these decentralised solutions that are being proposed focus on improving the payment process through digitisation and creating single, digital representations of payments that can enforce transactions on proprietary ledgers. This is a significant improvement on the standard message-driven payment processes we use at the moment.

The problem is that an issue arises when we try to scale such systems, especially when large payments are issued by corporate clients.

Overnight, fast payments have a reliance on pre-funded nostro accounts so everyone knows that the correspondent bank has the funds to terminate the payment. Whilst these accounts then need to be rebalanced over the course of the day, large sums of money need to be moved through the central bank. Once again, this is a cumbersome, slow and error-prone process, especially when compared with real-time transactions that blockchain claims it can deliver.

Digitally native tokens

The idea of having digitally native tokens that can function as a store of value within the ledger where the payments, commercial bank balances and nostro balances are stored is a revolutionary solution. These tokens can then be used to exchange liquidity between liquidity providers and markets within seconds.

This means that it is possible to also implement token based secondary markets for liquidity exchange which then enables liquidity providers to trade with each other much easier and quicker. By using tokens and smart contracts, users can even post unused liquidity in certain jurisdictions as collateral to borrow liquidity in places where it is needed.

These tokens will need to be universal and able to support the liquidity of today’s currency markets which amount to around $7 trillion per day.

The Utility Settlement Coin project comprised of Santander, BS, Deutsche Bank, Bank of New York Mellon and others, are working on an initiative where a tokenised, digital central bank currency will be created to help overcome issues within the process.

These initiatives show a positive approach to the idea and also aim to improve liquidity management for commercial banks and market makers. As the ideas continue to develop and flourish, many believe that they will become a leading enabler of the decentralised, tokenised economy that much of the world is talking about.

 

E&S Group is a leading law firm offering various services with regards to ICOs. Feel free to contact us directly on +356 20103020 or by email at [email protected] to find out how E&S can help you in ‘making things happen’.

For more information click the link.