Quick and Proper Global Payments: Digital Assets

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Correspondent Banking reinvented with blockchain technology

The first part of this paper gave an introduction into the inefficiencies of correspondent banking in the context of global payments in contrast to the Blockchain approach. While Blockchain technology has the potential to revolutionize the global payments landscape, certain key prerequisites need to be in place to ensure feasibility in the short to mid-term. This part will close in on each of these prerequisites – finality, trust and transparency, local as well as global liquidity and settlement – and examine how they can support economic activity on a Blockchain.

Global Finality, never unwind

Finality of transactions, i.e. the certainty at any given point in time, that a settled payment is irrevocable and unconditional, is essential for conducting business. When two parties are transacting with each other and a monetary transaction is made, the receiver needs to be sure that the payment received from the sender cannot be taken or nulled away. For accounting, bookkeeping and legal purposes, they also need to know exactly when the transaction is settled.

The consensus mechanism of a distributed ledger technology can be used to achieve this. This mechanism describes the set of rules, also called algorithms, which govern the way a network agrees to the validity of a transaction.

Some consensus algorithms allow temporary chain forking, which happens when a Blockchain splits into two different branches, with different transactions considered settled. Upon resolution only one of the branches will be considered valid. This will effectively revoke the validation of a transaction on the other branch, thereby unwinding a previously validated payment. As a result, the immutability of such a Blockchain is not absolute.

The possibility that a transaction which seemed to have been settled turns out unsettled after a fork in the chain disqualifies some Blockchains from being used for high value payment settlement.

In order to mitigate this issue, a widespread practice to alleviate these risks is to wait for a number of consecutive blocks so it is less likely that the part of the chain observed will become untangled. This approach reflects the probabilistic asymptotic finality. It basically means that the finality of a transaction correlates to the number of its subsequent blocks; the longer the branch, the more probable the survival of the transaction. In such a system, finality can only be approximated, it is never absolute. A high probability of finality might be sufficient for conducting general business. Legal and regulatory standards in payments however, demand more accuracy. For example, in the case of insolvency, knowing the exact time a transaction is settled is essential to determining how it needs to be considered.

The consensus protocol of a global payment system has to determine at which point in time a transaction is completely settled, probabilistic asymptotic finality, i.e. eventual consistency is not enough.

Some Blockchain technologies do provide immutability and finality of transactions on the level described by defining a consensus protocol with a different approach for dealing with exceptions such as diverging events on the chain. Instead of forking, the progress of the network is stopped until all participating nodes reach a consensus. The network itself reaches an agreement on which participants are trustworthy [1]. As a last resort, risking downtime is preferable to losing finality and consistency of the system.

Another option to avoid temporary chain forking is by using so-called “validating nodes”. In this scenario, consensus over the validity of transactions is reached when the majority of validating nodes come to an agreement. Before launching such a node, participants first need to disclose their identity and register with the network provider [2]. By only allowing identifiable and well-known entities to validate transactions, a network provider can ensure integrity on the payment network.

Ultimately the underlying Blockchain technology needs to fulfil the requirements of proper accounting and serve as a trust anchor when recording payments, especially when applied to high value transfers where a single transaction could be worth millions.

Connecting with trust and transparency

In order to build a reputable global payment solution, fostering trust in the system is imperative to success. However, how can a global payment solution ensure trust and transparency?

One way to achieve this is to leverage already existing payment principles and integrating into established policies, instead of competing against or even ignoring them. With this approach, solutions can build upon existing structures and practices, while offering new functionalities and benefits. This would also lead to reduced go-to-market barriers and costs for the solution. Due to the familiarity of the setup, banking institutions would be more willing to participate in the novel solution.

A key aspect in this endeavor is being compliant with local regulatory standards. Systems with participants operating in the EU need to ensure that all laws and all regulations set forth by the European Banking Authority are observed. These rules aim at ensuring that payments across the EU are secure and efficient [3]. One elementary step is ensuring all network participants handling money transfer operations are appropriately licensed. This of course entails full Anti-Money Laundering and Know Your Customer compliance with supporting features being established on the payment solution as well.

A permissioned Blockchain can be leveraged to ensure that access to a global payment system is restricted. By allowing only licensed operators to participate in payment execution, the supervision of these participants is already governed by local rules and regulations. Prospective participants from outside Europe also need to be compliant with their local banking and money transfer regulations in order to gain access to the network. Conducting due diligence activities on all prospective participants and issuers is an essential instrument in this process – to be overseen by the governance of the network.

Different financial institutions globally are subject to different local regulatory regimens; therefore, they need to be in control of who they are interacting with. This means that before any two participants can transact with each other, they will need to know and recognize the counterparty, i.e. be on each other’s “white list”. Whitelisting represents a bilateral agreement which governs the way the involved participants conduct business with each other. Who will be whitelisted by whom is dependent on each participant’s regulatory requirements as well as business strategy and needs. Basically, whitelisting ensures that every participant is always in control of who they are dealing with. A potential Blockchain solution needs to take this into account and support enforcement of whitelisting.

Such business agreements can be established between all participants and service providers. Knowing who is receiving and sending funds represents an essential part of dealing with money laundering and terrorist financing.

Additionally, while transacting on a global payments network, there must be no doubt about the fees charged by service providers. This empowers participants to make better decisions regarding which services to use. Transparency of fees also reduces the costs of communication and gathering relevant information, which in turn, leads to lower transaction costs.

Ultimately, restricting access to an exclusive group and implementing Know Your Counterparty measures, like whitelisting are suitable tools which foster trust and facilitate transparency on a global payment solution.

Liquidity – any time, any currency

In order for a global payment system to work smoothly, access to liquidity for any currency needs to be ensured at all times. At the end of a payment, the beneficiary usually needs to receive liquidity in their local currency. The beneficiary’s financial institution in turn, needs to ensure that they have enough funds to pay out. In the current global payment scheme, this leads to liquidity being trapped in isolated systems: only the liquidity available now in the target currency can be paid out in the next instant. In order to minimize costs and risks involved with this issue, flexibility in handling settlement assets within a global payment system is essential. While conducting business, the participants of a network need to be able to choose how much liquidity they hold in any settlement asset and be able to stock up and down at any time, i.e. 24/7 as well as instantly as required by the market.

A global system for cross-border and cross-currency payment facilitation with multiple settlement assets appears to be the solution. The processing of global payments on a large scale needs to be as frictionless as possible with minimum risk.

In order to contain the risk and cost of trapped liquidity, an efficient means of exchange between different settlement assets is required. Blockchain needs to enable atomic payment vs payment transactions even for small amounts as well as efficient creation and destruction of settlement assets.

As fiat currencies are still by far the dominant way to pay out, it is imperative for liquidity to be easily switched between on-chain and off-chain, i.e. conventional accounts or cash. A transaction settled in crypto currency or any asset different from the target still has to be converted into the target currency. Among the main issues when settling in crypto currency however, is volatility from the related exposure to market risk, even if settled within near real-time. When a transaction is triggered in crypto currency, the value of the transaction may increase or decrease before the transaction is settled. The value difference makes it difficult to predict exactly how much liquidity is needed for the transaction. When you fix all exchange rates before settlement, whoever is providing the quote will price the volatility in the respective spreads. Ultimately, liquidity is linked to the current price and supply of the underlying crypto currency. The receiving financial institution also may not want to hold a crypto currency with fluctuating values. Additionally, liquidity in the target currency needs to be ensured.

A favorable alternative to crypto currency is settlement in fiat-based digital assets. Instead of crypto currency, a digital representation of the participating real-world assets can be used. At the end of a transaction, a digital currency will be converted into the equal amount of fiat, assuming conventional pay out of the recipient. This puts the market risk on the same level as the underlying real-world assets.

As all digital assets are held on the Blockchain supporting the payment system, all participants have 24/7 access to liquidity – globally and in any currency represented.

Settling the score globally

As in any cross-currency payment, addressing the questions about the settlement asset is inevitable. Bank customers as well as banking institutions operate with fiat at the start and end point of the transaction. In the global foreign exchange market however, not every currency pair is traded. As a result, bridging between fiat currencies is crucial to successfully implement global payments, on Blockchain or not.

Outside of Blockchain in the traditional fiat-based foreign exchange market, when there is no direct link between two currencies, the USD is typically used as a “settlement bridge”. In the example of a money transfer between German and Nigerian banks, assuming the German bank has no reserves in NGN (Nigerian Naira) , it would first exchange EUR to USD and then from USD to NGN.

Similarly, transactions on Blockchain require digital assets to serve as bridge assets between two fiat currencies. As previously discussed, crypto currencies are not ideal for use as a settlement asset due to their high volatility and market risks. This is where digital representations of fiat currencies, i.e. stablecoins or specifically tokenized funds, come into play. Stablecoins in this sense are digital assets representing a claim against the issuer in the value of the underlying fiat, e.g. EUR [4]. Thus, stablecoins enable the use of fiat currency digitally on a chain.

For ease of adoption, including practical aspects from reporting to financial accounting and compliance, the use of tokenized funds as defined in the European Central Bank’s white paper released in August 2019 [4] seems the fastest way forward. Other forms of stablecoins can technically follow suit, once the legalities and aforementioned aspects have been clarified and harmonized globally. Tokenized funds can be exchanged on a fixed basis to its underlying fiat currency, backed by the issuer and/or held as a collateral at a custodian, possibly even a central bank.

Tokenized funds combine the advantages of fiat and crypto currencies, i.e. the capability to exchange fiat value on a Blockchain-based network in near real-time to create a new rail for global, instantaneous transactions. Since the value of tokenized funds is pegged to the underlying fiat currency, users benefit from the flexibility of crypto while maintaining the stability of fiat.

Central banks across the globe are showing growing interest in issuing tokenized funds. When issued by a Central Bank, tokenized funds are called Central Bank Digital Currency (CBDC) [5]. Such CBDCs, once available, would be the preferred means of settlement as they are a claim against a central bank as opposed to a private issuer of tokenized funds.

Since one of the main roles of central banks is to stabilize the currency using different monetary policies and instruments, CBDCs issued on a Blockchain would have the potential to become the ultimate, most stable settlement asset [4].

The issuance of CBDC on a Blockchain-based global payments system would represent a leap to digitalized payment rails while eliminating limitations of a traditional approach.

But regardless of the digital assets used – crypto currency, CBDCs or other stablecoins – participants of a global payments network can always settle their scores globally, i.e. in seconds, 24/7 and independent of a correspondent bank’s operations.

The third part of this paper will focus on how to bring all of these together in order to propose a comprehensive solution for global payments using Blockchain technology.

Authors

Sources

[1]       https://www.stellar.org/papers/stellar-consensus-protocol
[2]       https://xrpl.org/blog/2015/validator-registry.html
[3]       https://eba.europa.eu/regulation-and-policy/payment-services-and-electronic-money
[4]       https://www.ecb.europa.eu/pub/pdf/scpops/ecb.op230~d57946be3b.en.pdf
[5]       https://www.bis.org/publ/bppdf/bispap107.pdf