Many people believe that distributed ledger technologies (DLTs) will replace the role of the financial intermediaries in the post-trade world. The European Central Bank (ECB), however, adopts a more cautious approach.
Bullmann says: “DLT enables shared databases and trust is embedded through cryptographic proof. This means that on a blank sheet of paper you can sketch a revolution of the financial eco-system, which moves away from what we have today, namely trusted parties operating centralised ledgers, to a partially or fully decentralised ledger with trust built in. One can even design a DLT world, which puts into question the fundamentals of the economic system.” But such reflections, says Bullmann, are at this stage rather theoretical in nature.
Perhaps this is why the focus has shifted to more concrete questions of what problems DLT could actually solve. The ongoing work on applications of DLT for specific products, and the testing of all prototypes in the post-trade sphere, will determine the direction and whether it can be seen as an evolution or a revolution.
A DLT solution in 5—10 years?
To ensure that its services continuously evolve and keep pace with technology and user needs, the ECB has issued strategic reflections on the future development of the Eurosystem’s market infrastructure. Its strategy aims to improve the efficiency of European market infrastructure. There are three pillars, based on liquidity management of central bank money, securities and collateral, thus covering payment transfers, securities settlement and collateral management.
The first pillar is the technical and functional consolidation of Target2, the ECB’s euro real-time gross settlement system, and Target2-Securities (T2S), the ECB’s securities settlement system, which went live last year. Consolidation could, for example, allow users to benefit from a single point of access.
The second pillar looks at the possible support of pan-European instant payment services, that is, electronic retail payment solutions available 24/7/365.
In the third pillar, the ECB is targeting harmonisation in the area of collateral management and studying the business case for building a common Eurosystem collateral management system.
The key to the ECB’s strategy is technology that fulfils the requirements of safety and efficiency. A number of factors reduce the likelihood of DLT being that solution in the immediate future, says Bullmann. “Today, numerous DLT approaches and models are under consideration, accessed in various ways. There are also different validation methods governing how changes to the ledger are implemented and which data is shared.”
Work is ongoing to shape DLT according to the specific needs of the financial industry, including scalability and processing speed in the area of market infrastructures. However, there are also legal considerations, such as governance and ensuring finality of settlement. “What is the right governance model and who is responsible in a DLT environment are questions that I don’t think anyone has the answer to yet,” says Bullmann. “Given these questions, DLT is not ready for prime time, reducing the likelihood that it can be used in the context of the ECB’s strategic review of its market infrastructure.
“We need to base our services on proven and tested technologies and we have to acknowledge that it is unlikely that we will have a true DLT environment in place in the next few years.”
Three scenarios for DLT
The ECB has identified three scenarios for the use of DLT in the post-trade space. These scenarios are described in a staff paper published in April 2016. In the first scenario, different groups of market players adopt different DLT solutions to improve their internal efficiency.
In the second scenario, referred to as ‘evolution’, core players adopt market-wide distributed ledgers.“T2S adopting DLT would be a concrete example of such a theoretical scenario,” says Bullmann. “Smart contracts could also be employed to automate asset servicing, which could lead to the disintermediation of some market players”.
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.
In the medium term, says Bullmann, we are likely to see a scenario somewhere between the status quo and evolution. “But it is hard to imagine that specific functions are rendered superfluous in the future,” he adds. “In the settlement layer, the notary function needs to be exercised to ensure there are no discrepancies between the amount of issued securities and the amount of traded securities. In another example, the clearing function continues to be required for trades related to derivatives. So the peer-to-peer world that DLT could bring is not very likely to materialise. But again, time will tell.”
What is clear is that the market infrastructure of the future will continue to operate within the paradigm of efficiency, safety and technological advancements. A shift in expectation towards instant payment services has to be addressed and cyber resilience has become more of a concern in the securities industry.
Irrespective of the technology used, the underlying market infrastructure, or plumbing, will remain, believes Bullmann. However, the service layer offered by banks, custodians and other market players may change.
“But this is more about how market players position themselves in this new environment,” says Bullmann, drawing an analogy to T2S — already a game changer in the post-trade world. With T2S harmonising settlement in Europe, some market infrastructure providers are positioning themselves as connectors to the centralised platform, while custodians are differentiating through asset servicing.
Harmony with DLT?
The ECB sees itself as a catalyst, co-operating with the financial sector and with financial authorities to improve overall market efficiency and contribute to the wider goal of financial market integration in Europe. “What we see today is that individual consortia and market players are working on DLT-based solutions, which involves the risk of fragmentation,” says Bullmann.
“If we see that a development like DLT could jeopardise financial market integration by increasing fragmentation, we have to address that.” Under the umbrella of T2S governance, the ECB has already established a task force composed of market participants to study the impact of DLT on T2S and the post-trade ecosystem. “It is vital to ensure interoperability of services, in particular through standardisation at the technical level, and through harmonisation efforts in the business and legal domains.”
Bullmann compares this to the work the ECB has done in a T2S context, where it has identified 24 harmonisation initiatives of a technical, business and legal nature. In co-operation with the market participants, it works on these initiatives to enable an optimal use of T2S. DLT could potentially lead to fragmentation and require a harmonisation effort, says Bullmann, which could involve some of the 24 initiatives already identified. “For example, with DLT the question is whether settlement should be T+2 or whether it should move to T+0 or T instant settlement. We can look at those aspects in the context of the governance structure and with the analytical framework we have in place for T2S harmonisation. We have started this work with Steven Lomas, Head of GTB Market Policy, Deutsche Bank, as a chair and we can drive this forward.”
Adviser in the Directorate General Market Infrastructure and Payments
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