CAI0045

Written evidence submitted by TheCityUK

 

About TheCityUK

 

  1. TheCityUK is the industry-led body representing UK-based financial and related professional services. We champion and support the success of the ecosystem, and thereby our members, promoting policies in the UK, across Europe and internationally that drive competitiveness, support job creation and ensure long-term economic growth. The industry contributes 12% of the UK’s total economic output and employs over 2.2 million people, with two thirds of these jobs outside London. It is one of the largest exporters and generates a trade surplus exceeding that of all other net exporting industries combined. It is also the largest taxpayer and makes a real difference to people in their daily lives, helping them save for the future, buy a home, invest in a business, and protect and manage risk.

 

Introduction

 

  1. This response is focussed on a single aspect of the inquiry, the potential impact of distributed ledger technology on financial institutions, including the central bank, and financial infrastructure. We explore where there are existing proof of concepts and where there are some compelling use cases.

 

  1. TheCityUK and its members welcome the inquiry into this new asset class and in particular the use of the underlying Distributed Ledger Technology (DLT). DLT is a database, distributed amongst multiple computers, all of which share the same versions of that database. This database is maintained by a network of computers which can transfer information between one another without an intermediary. It has two features that differentiate it from other databases:
    1. Consensus – As the database is distributed, there needs to be agreement between all participating computers on what the correct version of reality is. This is done through rules governing the system which decide the legitimacy of contributions made by computers to the database.
    2. Immutability – Once data is stored to the database, it cannot be deleted and is part of a permanent shared record. There are cryptographic mechanisms by which this is done securely, and the same cryptography also allows for authentication and authorisation of transactions of data between participating computers.

 

  1. These features lend themselves to instances where information needs to be seen by multiple intermediaries, to instances where manual input can be automated, where the intermediaries need the information to be the same and immutable.

 

  1. A broader benefit beyond how one firm might find it beneficial is that it could act as a single platform that brings together all the different stakeholders that work together today. Currently, these use different environments, standards, and data formats, this creates inefficiencies when needing to work together and is something that DLT can solve.
     

Impacts to financial institutions

 

  1. The impacts of DLT to individual financial institutions are varied. It is important to note that financial services are heavily driven by information (to manage risk, fraud, and money laundering, to research markets and companies), and the increasing responsibilities and expectations placed on the industry only increase the need for secure information which is close to infallible.

 

  1. Proof of concepts have been undertaken to test:

a)      Using DLT for the distribution of insurance policies, both nationally and internationally.

b)      The settlement of foreign exchange trades bilaterally between two participants. This use case saw significant reductions in the time taken.

c)      The issuance of a tokenised debt transaction through a DLT platform.

 

  1. It is already used in other regions for:

a)      The issuance of construction insurance certificates - Traditionally a paper certificate would need to be presented at construction sites as it is illegal to build without insurance. Now a private digitised network accessible by project managers reduces the risks associated with paper like degradation.

b)      Intra-bank payments for global bank balance sheets - This has given a single source for all intra-company trades, reduces the cost and time these trades take, and has provided a global view of the firm’s balance sheet allowing for better optimisation and efficiency. Some of the largest global banks conduct millions of these trades annually.

 

  1. Considering the existing proof of concepts and use cases, DLT can also be applied to a range of use cases:

a)      Trade financing – The existing slow processing of credit for delivery and its payment as well as reduced liquidity and high bureaucratic costs make this an attractive use case for DLT. Shipping and trade undergoing digital transformation, with Maersk rolling out a DLT solution.[1]

b)      Anti-Money Laundering - The technology could strengthen the identification and verification of customers while maintaining an accurate recording of all transactions. However, the Financial Action Taskforce (FATF) has raised concerns that blockchain analysis tools are not always effective or consistent. FATF found big variations in what these tools view as Peer-2-Peer payments, the size of the P2P sector, and as a result the amount of money laundering or fraud occurring on these DLT platforms.[2]

c)      Audit – DLT is a good solution to ensure that auditors get necessary payment information from trusted or verifiable sources, given that there is no possibility of errors, data integrity and traceability are ensured.[3]

d)      Compliance – DLT could revolutionise regulatory reporting, where smart contracts (contractual algorithms which can automate specific conditions within a contract) held by firms will send timely, granular, high quality, data to responsible regulators.

 

Impacts to central banks

 

  1. The European Central Bank and Bank of Japan have done a lot of analysis on the use of DLT on a number of central bank systems. The key findings are:

a)      DLT-based payment solutions[4]

These solutions could meet the performance needs of a Real-Time Gross Settlement system (RTGS). They found that a DLT based solution would begin to have a trade-off between the volume of payments and its performance once approaching 250 requests per second. The UK’s RTGS (CHAPS) saw an average of 179,078 daily payments (2 requests per second).[5]

These solutions did appear to strengthen the resilience and reliability of the payments system. They found that the system was less prone to issues from outages from individual participants and that the systems could identify incorrect data formats provided to the network without impacting its performance.

 

b)     DLT-based securities settlement[6]

Post-trade securities settlement could conceivably run on DLT platforms while meeting international standards. It was suggested that it could even be built in an environment with cash and securities on the same ledger, reducing complexity. The findings do point out a number of dependencies impacting the findings:

-          The characteristics of the DLT platform (e.g. what information would be available to all participants)

-          The use case for the platform.

-          What functionalities might be permitted, like cross-chain swaps allowing for interoperability between two (same or different) DLT platforms.

-          What process steps are selected to remain as part of the trading of securities.

 

c)      DLT-based cross border payments

The relative safety of cross-border payments could be improved with DLT. We refer you to the proof of concept conducted by Ripple.

 

Impacts to financial infrastructure

 

  1. We are supportive of the proposal for a Financial Markets Infrastructure (FMI) Sandbox as proposed in the Financial Services and Markets Bill (FSMB). We are also supportive of its initial investigation into the use of DLT and openness to other innovative technologies.

 

  1. We would like to flag some aspects of the UK market architecture which make it attractive, and which might be positively impacted using this technology:

a)      Open architecture – At present, the UK’s market architecture is open. A risk in using DLT is that, if done piecemeal, systems become siloed. Each new platform designed and used for segments or sections of the market. The practicality of connecting these different platforms also gives a risk to international connectivity and any efficiencies that might be gained.

b)      International connectivity – Another risk is that of further international fragmentation, DLT by its nature would require some standardisation of systems (e.g. transaction ID, date, time, transaction volume, payee and recipient, etc.) the way that each sovereign geography chooses which information to hold and standardise might make it arduous for the ability for global firms to connect to multiple systems.

 

  1. FMIs are already experimenting with the technology, with Euroclear partnering with Fnality with the intention to provide an innovative solution for the settlement of digital securities against digital cash on DLT. This follows a pilot they conducted with the Banque de France to experiment with issuing, settling, and managing the lifecycle French government bonds on DLT, which was successful.[7]

 

  1. DLT could contribute to markets’ endeavours to reduce the time of the trading settlement cycle from the current 2 days (T+2), to one day or even an instant settlement. Indeed, such settlement cycle reductions are also achievable using current delivery-versus-payment (DvP) technology, though the T+2 market convention persists due to prevailing operational and market financing arrangements. 

 

Privacy considerations

 

  1. Transactions on DLT networks arguably raise questions on privacy since participating entities own nodes and share transaction information amongst themselves. A truly distributed ledger allows all participants to see identifiers for other participants. There were multiple instances of this occurring during the height of the crypto-asset market, particularly when individuals used non-fungible tokens (a unique crypto-asset) as their social media profile pictures. Using just the image from social media and the open blockchain to find the owner of that image, people could easily identify one another.

 

  1. If all payments were done on a truly distributed ledger, the ability for someone to identify an individual on a public register which includes all of your payments is easy. For example, individual A buys a coffee at a 10:00 AM, individual B wonders who they are, they look at the shared ledger to find the payment for a coffee, next to the payment is the account number/public key, individual B can see every purchase individual A has ever made with that account. If the account is their main account, individual B could identify individual A’s employer (from pay to that account), their landlord, their approximate address (from the accounts of businesses near the home), etc.

 

Conclusion

 

  1. The potential for DLT in Financial Services is centred around the key advantages we would associate with digitisation, standardisation, automation, and transparency. It is important when considering the technology whether it is the best suited for the use described. We recommend that when the Committee is considering responses to this inquiry, they apply a critical eye on whether the uses of DLT are problems in need of DLT, or if the solution is a reflection of improvements that could be made through some combination of digitisation, standardisation, automation and transparency.

 

  1. In many instances DLT could be used to make aspects of financial services markets, more efficient and transparent where there are multiple participants or intermediaries in those markets. In some cases, it could even be argued that this technology has the potential to fundamentally change a market.

 

 

September 2022

[1] TradeLens

[2] Updated guidance for a risk-based approach for virtual assets and virtual asset service providers, FATF

[3] Balancing confidentiality and auditability in a distributed ledger environment, ECB and Bank of Japan

[4] Payment systems: Liquidity saving mechanisms in a DLT environment, ECB and Bank of Japan

[5] A brief introduction to RTGS and CHAPS, Bank of England, Page 3

[6] Securities settlement systems: delivery vs payment in DLT environment, ECB and Bank of Japan

[7] Euroclear further advances its DLT strategy with investment in Fnality, Euroclear