There has been much debate about the potential benefits of blockchain technology to improve the world of payments — particularly international payments.
This is a business where many different parties need to reach consensus to route the payments, perform currency conversions, and deploy and manage liquidity in different jurisdictions, all subject to heterogeneous regulatory constraints.
One of the main issues blockchain can tackle is the high complexity of payments networks, due to the fragmentation of the financial industry itself, which makes it impractical for individual banks to deal directly with all other banks on the planet.
For example, when a bank gets a payment instruction from a client, it needs to find a correspondent bank that is willing to take the client’s funds and terminate the payment locally at the receiving bank. And in order to do so, the correspondent bank needs to 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 extra hoop), ideally with enough pre-funded liquidity to complete the payment on the client’s behalf.
But when this happens, the receiving bank has no way to verify that the incoming transfer from the (last) correspondent bank, in fact, corresponds to the original client sending the money. That is why a SWIFT message from the sender is needed, so the receiving bank can understand the purpose 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 do not share a single version of the truth, and the coordination between all these parties is slow and error-prone, many times relying on manual interventions by back-office teams. Furthermore, someone needs to perform currency conversion at either end, and different parties need to manage liquidity levels at nostro/vostro accounts, which involves settling against central bank accounts as well.
Blockchain’s big promise is precisely providing that single version of the truth that is missing in the picture above.
Indeed, a true, smart contract-enabled blockchain provides a single ledger and transactional engine where balances can be 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 not only register tokenized funds and payments, but they can also set in stone the rules applying to all 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 the same ledger, with the same smart contracts for all, and with the same computational engine, with no possibility of errors or tampering.
Now, most of the (so-called) decentralised solutions being proposed these days often focus on improving payments processes either by digitizing the messaging layer described above or, even better, eliminating it by creating single, digital representations of payments that can enforce transactions on proprietary ledgers, connected to one another with some sort of inter-ledger protocol. This is indeed a significant 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 rely on pre-funded nostro accounts, so the correspondent bank has the cash at hand to terminate the payment, thus eliminating any settlement risk. And when these nostro accounts need to be rebalanced over the course of the business day, large sums of money need to be moved through central banks. Again, this is a slow and error-prone process — at least compared to the real-time transactions, with finality within seconds, promised by permissioned blockchains.
A low velocity of liquidity internationally ends up tying up liquidity at nostros at levels that are higher than really necessary. This is a big problem due to the significant opportunity costs of these funds — mounting from tens or hundreds of basis points to tens of percentage points in emerging economies.
The possibility of having digitally native tokens that act as a store of value within the same ledger where payments, commercial bank balances and nostro balances are stored represents a fundamental, revolutionary solution to improve this situation. These tokens can be used to exchange liquidity between liquidity providers and market makers globally in real time.
Through this, it is possible to implement token-based secondary markets for liquidity exchange, which enable liquidity providers to trade with one another with much less friction and improved transparency and reduce the levels of liquidity deployed in nostro accounts in different places due to much higher capital velocity.
With these tokens and the use of smart contracts, participants can even post unused liquidity in certain geographies as collateral to borrow liquidity in places where it is 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 in the currency markets – which amount to more than $7 trillion per day, according to the Bank for International Settlements. A significant part of this market is deliverable and therefore liquidity-related.
There are proposals to use cryptocurrencies or unbacked crypto-assets to play this role, but this approach suffers from a number of limitations.
The market risk of such assets is quite difficult to hedge, due to significant volatility, and the total liquidity in circulation is tiny in comparison with what is needed in the market — a market which works quite well with a rather universal and hyper-liquid asset available today, the U.S. dollar.
As a pragmatic alternative, several leading institutions are working towards producing tokenized, digital central bank money.
Some, like the Utility Settlement Coin project (which my bank, Santander, is part of, alongside with UBS, Deutsche Bank, Bank of New York Mellon and many others), do this 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 result of enabling a significant reduction in liquidity levels within the whole financial system.
As these initiatives mature and flourish, we believe they will become a key enabler of the decentralized, tokenized economy the world is so intrigued about.