Distributed ledger technology: hype or history in the making?
Distributed ledger technology (DLT) has become a “hot” topic. It has drawn the attention not only of financial institutions but also of central banks. Some are looking into the possibilities of DLT from a more theoretical and research angle, while others have set up test labs to assess how it could be used to develop solutions for inefficiencies in the financial industry. Indeed, there were few financial conferences in the past year or so where it did not feature on the agenda. A sober look at some of the hype around DLT is urgently needed: is it a panacea for the ailments of the financial industry, or merely a flash in the pan, soon to be forgotten? Is it hype, or history in the making?
What is distributed ledger technology?
A distributed ledger is essentially a record of information, or database, that is shared across a network. It may be an open, publicly accessible database or access may be restricted to a specified group of users. From a technical perspective it can be used, for example, to record transactions across different locations (see In focus paper). In terms of impact, it has the potential to advantage some actors, by lowering back-office costs and collateral or capital requirements. At the same time, it may possibly disintermediate or even make redundant some market actors that do not provide core functions. In an extreme scenario, it could completely transform the financial system as we know it. But this is all hypothesis at this stage.
Why does it matter to the ECB?
In the field of market infrastructure, the Eurosystem has three key roles: as owner and operator of TARGET2 and TARGET2-Securities (T2S); as overseer, to make sure that the financial market infrastructure operates in line with the applicable standards and guidelines; and as a catalyst, to support the industry in developing its own initiatives. The Eurosystem is well placed to do this given its extensive knowledge and understanding of the financial market and its pan-European reach.
It is essential that – as the financial market landscape changes – the Eurosystem monitors these changes closely to assess whether it needs to adjust the services it offers or its oversight framework. In addition, as more market players work on DLT-based solutions, the need for the Eurosystem to play a catalyst role increases to avoid new market fragmentation and ensure that there is no negative impact on financial market integration.
The ECB has set up a workstream to analyse technological innovation in the financial sector. It covers the practical aspects, such as the possible use of DLT for our market infrastructure, as well as more research-oriented activities which touch on, for example, the implications of the issuance of central bank digital money. As part of this work, the ECB has identified three scenarios for DLT in the post-trade space.
In the first scenario, different groups of market players adopt different DLT solutions to improve their internal efficiency. In the second scenario, which is called an “evolution”, core players adopt market-wide distributed ledgers. T2S adopting DLT would be a concrete example of such a theoretical scenario. In the third, more extreme scenario, which is called a “revolution”, all post-trade processes of the issuers and the investors are performed on DLT in a peer-to-peer environment with limited room for financial intermediaries and market infrastructures (see occasional paper entitled “Distributed ledger technologies in securities post-trading” for more info).
Although the technology may have the potential to revolutionise securities and payments, a lot of questions still need to be answered, including what the right governance model is, and who is accountable in a DLT environment. So, even though DLT is not mature enough to be considered a viable alternative to the market infrastructure offered by the Eurosystem, it certainly merits analysis and reflection.
Welcoming new task force on DLT
It is of utmost importance to the Eurosystem that DLT, if used, is used in a way which will promote a level playing field and not introduce new fragmentation to the financial system. With this in mind, the ECB stands ready to assess innovations and to help the market collaborate by playing a catalyst role. Specifically, a task force is now established under the T2S Governance. Its main objective is to assess the potential impact of DLT on T2S as well as on the wider post-trade harmonisation agenda. The work of the task force will be complete by the end of 2017 and regular updates will be published on www.t2s.eu