Technological innovation has, in many ways, transformed our lives. Existing industries, such as retail, publishing and music, have changed beyond recognition and new ones, such as virtual reality and artificial intelligence, have emerged thanks to technological breakthroughs. Will the financial industry be the next to be transformed by new technologies?
Why does the ECB have a stake in market infrastructure?
Market infrastructure is the backbone of the financial system. It needs to be efficient and innovative to support the fast-paced technical developments that impact our world. However, it is also crucial that it remains safe and resilient to maintain trust in the financial system. The ECB therefore continuously explores new ways to enhance the market infrastructure both as an operator and overseer and as a catalyst of financial market integration in Europe.
Technological innovation is transforming financial services as we know them today.
Technological innovation on the horizon
With this in mind, the ECB closely monitors developments related to the market infrastructure which could potentially impact the stability of the financial ecosystem.
It carefully examines the various innovative technological solutions popping up in the financial industry, often referred to as fintech. Among them, distributed ledger technology, or DLT, has received the most attention to date.
Introduction to DLT
A distributed ledger is a record of information, or database, that is shared across a network. The best-known type of distributed ledger is “blockchain”. The name comes from the fact that some DLT solutions store all individual transactions in groups, or blocks, which are attached to each other in chronological order to create a chain. This long chain is put together using a complex algorithm which ensures the security and integrity of the data.
Access to a distributed ledger can be unrestricted, i.e. any party could become a participant, or restricted to a specified group of users. Members of the network may have access either to the entire ledger or only to part of it. Depending on the permission rights, members can add data which are then disseminated to other members of the network. Allowing only authorised entities to make updates could be a useful way to protect the network from malevolent users or external attackers trying to disrupt its functioning.
Financial institutions are exploring the potential of DLT to optimise their internal processes.
The potential of DLT
DLT has the potential to offer an alternative technical solution for storing data in a decentralised way. This could bring many advantages, for example permitting automatic updates of records, which would optimise the reconciliation process and thus lower back-office costs, and shortening the settlement cycle, thereby reducing collateral and capital requirements.
In addition, it could potentially lower market liquidity needs and possibly reduce or even eliminate the involvement of some market actors.
The impact of DLT will depend on the extent to which it is embraced by the market. If individual market participants use DLT mainly to improve their internal efficiency, the effect on the financial ecosystem will be more limited than in a scenario where a group of core market participants adopt the new technology. A more revolutionary scenario is a peer-to-peer world without any financial intermediaries.
Why does DLT matter to the ECB?
DLT is a relatively new technology. This makes it difficult to assess the magnitude of its impact on the financial ecosystem from today’s perspective. If we narrow down the scope to market infrastructure, the new technologies could affect the ECB’s activities in the context of its roles as:
- Operator of the payment system TARGET2 and the securities settlement platform TARGET2-Securities (T2S);
- Catalyst supporting the financial industry as it moves towards deeper integration of the capital markets in the EU;
- Overseer ensuring that market infrastructures operate in line with the applicable standards and guidelines.
DLT cannot at this stage be considered as an option for the Eurosystem’s market infrastructure.
Should the Eurosystem’s market infrastructures run on DLT?
The ECB is open to considering new ways to enhance its market infrastructure. However, any technology-based innovation would have to meet high requirements in terms of safety and efficiency.
There are also a number of functional, operational, governance and legal aspects that need to be carefully weighed before considering the mass adoption of new technologies. At this stage of its development, DLT is not mature enough and therefore cannot be used in the Eurosystem’s market infrastructure. As DLT-based solutions are constantly evolving, the ECB will continue to monitor developments in this field and explore practical uses for DLT.
The ECB is collaborating with the market to ensure that the emerging DLT-based solutions do not hamper market integration by creating new fragmentation.
How can we ensure that innovation triggers further integration?
Another important aspect to be considered is the interoperability of post-trade processes across institutions and markets adopting new technologies. The various emerging DLT-based solutions could in theory lead to renewed fragmentation. These consequences should be avoided as they run counter to EU-wide efforts to achieve deeper integration of financial markets.
As an EU institution, the ECB has put European market integration high on its agenda. It encourages the development and implementation of common standards and business practices across all EU markets. With respect to new technologies, the ECB can add value by steering cooperation among all stakeholders and coordinating their efforts to standardise and ensure the interoperability of DLT-based solutions.
A step in that direction has been taken through the creation of a DLT task force bringing together market experts on financial innovation and cyber security. Its objective is to avoid any negative consequences of technological innovation regarding the harmonisation and integration of post-trade markets in Europe and to explore the potential of DLT to help remove some of the remaining barriers to a fully integrated post-trade market in Europe.
The ECB is committed to supporting innovation and exploring the potential for new technologies to improve the financial ecosystem.
Can DLT meet high safety and efficiency standards?
The ECB’s objectives of safety and efficiency have been translated into specific requirements that are essential for the smooth functioning of market infrastructures. In its capacity as overseer, the ECB – together with the national central banks of the Eurosystem – promotes the safety and efficiency of payment, clearing and settlement systems as well as payment instruments.
The rise of new technologies raises questions about their safe usage. As an overseer, the Eurosystem needs to arrive at a common understanding of how the adoption of DLT could potentially affect overseen entities and their business models. Moreover, the emergence of new market actors requires reflection on issues such as how to ensure a level playing field for newcomers and long-established players. Against a background of increased cyber threats, it is also important to ensure a high level of protection for the users of these new services.
There is no doubt that technological innovation has the potential to profoundly impact the financial market we know today. But any new technology-based market infrastructure service needs to be mature enough to meet high requirements in terms of safety and efficiency. Against this background, the ECB cannot, at this stage, consider basing its market infrastructure on a DLT solution.
The ECB will continue to explore, analyse and test new technologies. In doing so we will ensure that tomorrow’s market infrastructure not only is efficient and innovative but also remains safe and resilient. To this end, it has, for example, launched a joint research project with the Bank of Japan to study the possible use of DLT for market infrastructure services. This international collaboration aims to bring greater clarity regarding the impact of new technologies on the global financial ecosystem, as well as to ensure that central banks are adequately prepared.