Evidence submitted by Baton Systems (DGC0050)

Link: https://www.parliament.uk/business/committees/committees-a-z/commons-select/treasury-committee/inquiries1/parliament-2017/digital-currencies-17-19/

1.0 Introduction

Baton Systems is a software company that builds payment and other post trade solutions. Our products are used by large banks to enable clearing and settlement of various assets such as currencies (GBP and FX) as well as securities. The settlements can be synchronized, even across jurisdictions. The team at Baton Systems has expertise in digital payments and problems in the space for both capital markets and retail markets. Baton Systems is a direct settlement agent with the US Federal Reserve. Baton Systems is also working the Bank of England on a POC for the new RTGS System.

We would like to present our views of the challenges in payments to set the context for our answers to the questions below. Baton Systems bases its recommendations on information gleaned from our discussions with large banks and other institutions in capital market payments and retail market payments where we identified inefficiencies. In addition, we also refer to several other publicly available publications and documents related to digital currencies and payments. There are a few important published papers, which we think are relevant and have useful statistics.

1. World Payments Report 2017 (CapGemini and BNP Paribas) (https://www.worldpaymentsreport.com/download)
2. Central Bank on Digital Currencies (https://www.bis.org/cpmi/publ/d174.htm)
3. Key Regulatory and Industry Initiatives (https://www.worldpaymentsreport.com/kriis)

1.1 Payment Statistics

We want to provide the following statistics from the World Payments report that we think are relevant for the questions being addressed in this response.

1. Global non-cash use grew 12.2% from 2011 to 2015. Emerging Asia grew at 43.4% and CEMEA grew at 16.4%. The majority of this growth was driven from greater adoption of mobile payments, payment wallets and credit card use.
1. Non-Cash use in Mature markets grew at 6.8%
2. Contactless payments is becoming the new norm in Europe with wide adoption
3. Payment by cards grew at the fastest pace and in this segment, debit cards (over 70% of total) use grew significantly faster
2. Despite this large growth, there has been a significant digital divide. The rural population has been slow to realize the benefits of non-cash use. This area is still significantly untapped.
1. Practical Mobile payment initiatives in emerging markets - Kenya, Brazil, Thailand, and Vietnam have demonstrated that the unbanked population can also be brought into the banking world.
2. Government backed payment initiatives in China and India are also likely to yield tangible benefits
3. These initiatives have focused on improvement of accessibility and security of the banking infrastructure, rather than creation of new payment type.
3. Despite the increases in non-cash payments, the use of cash in various countries has not been significantly reduced as seen in the following graph (source: Central Bank of Digital Currencies).

4. Corporations are increasingly using non-cash transactions with SMBs increasingly using digital invoicing, virtual cards, and cloud-based accounting solutions. Automation of AP and AR is increasing. Despite this, corporations still need better tools for liquidity management and better predictability for the accounts receivables and collections.
5. Innovations from FinTech companies have started gaining adoption and this could start cutting into commercial banks operating revenues. Retail customers and corporations can now look for unbundled solutions from FinTech companies rather than bundled services from banks.
6. Banks are facing increasing pressures in terms of high operating costs, increasing regulations, customer retention, etc.

1.2  Problem Areas in Payments

1. Lack of standardization or data synchronization across the banking landscape, makes it difficult for all parties in the ecosystem to build extensible solutions. SEPA (Single Euro Payments Area) and PSD (Payments Service Directive) are helping with this standardization and synchronization
1. Similar initiatives are underway in various jurisdictions and throughout the industry in general. But a lack of uniform standards is still impacting the extensibility.
2. Increased regulation and sometimes conflicting recommendations around AML, OFAC, and international payments is adding to inefficiencies.
3. CyberSecurity is now a serious threat (phishing, digital identity spoofing, etc.) for all payment participants. The sophistication of the attacks is increasing. This could undermine several consumer protections the governments have implemented as the least technically sophisticated people are likely to be impacted the most.

1.3 Central Bank Digital Currency (CBDC)

Reference to the ‘Money Flower’

The following Venn diagram (source: Central Bank on Digital Currencies) is a good framework with which to examine the applicability of digital currencies.

The General Purpose digital currencies impact retail payments. This is also the area that has received the most attention as a plausible solution for problems in retail payments. Wholesale banking has fewer participants, has large value payments and the primary members are large financial institutions who have the technical and operational resources.

Based on this, we will address the questions below.

2.0 Baton’s Responses

2.1 Question 1

The role of digital currencies in the UK, including the opportunities and risks digital currencies may bring to consumers, businesses, and the Government (and associated bodies)

The problems in retail (peer-to-peer, business-to-consumer, business-to-business) and wholesale (large value payments, mostly bank-to-bank) are different. We will attempt to break down the problems in consumer, business/corporates, banks and governments in this section and address how digital currencies can play a role.

Consumer Payments: We would broadly classify the problems as follows:

1. Immediate access to funds, credits, payment methods
2. Opening an account, especially for the rural or unbanked
3. Lower Costs
4. Security and Reliability

From the data in section 1, we are already seeing a significant shift to non-cash payments. This has been triggered primarily with increased access to mobile payments (peer-to-peer, e-banking), payment wallets, and debit / credit cards. These have the ability to provide liquidity and lower costs. Overseas remittances is another area where we have seen an increase in options for consumers with PSP providers like PayPal, Xoom, etc. competing with the traditional higher cost services such as Western Union or Moneygram. These new services can be significantly faster than comparable services offered by commercial banks. The rural and unbanked population have been behind on the non-cash use, and we think there is an opportunity for these technologies to provide much needed solutions.

In the Mayflower money Venn diagram (1.3), this would be the general-purpose tokens. We believe the rationale for digital currencies is less compelling in this arena. Since non-cash based payments are increasing significantly, we think it would be more beneficial to see a greater adoption of these technologies. We also believe providing incentives to encourage mobile banking and the opening of accounts for rural customers would bring more benefits than simply focusing on a digital currency. We do see incremental value in a digital currency that is based on a bank account, however, we would like to caution that digital currencies which are not backed by an account have no recourse for fraud.

Business Payments: A large portion of SMBs use non-cash transactions (section 1.1 bullet item 4) and increasingly use cloud-based accounting solutions for digital invoicing management of accounts payable, etc. We broadly classify the problems into the following:

1. Lack of predictability in accounts receivable and collections
2. Large businesses face inefficiencies when it comes to dividend payments, issuance of bonds, corporate treasury management
3. Trade finance, export-import is still very complex
4. Overseas payments are slow and expensive

Here, we see benefits from Distributed Ledger technologies starting to benefit corporations. There may be some smaller benefits from use of digital currencies for corporations around overseas remittances. However, several of the larger problems can already be solved today quickly and more efficiently by using existing infrastructure combined with better interoperability and standards. 

Banks Payments: Interbank payments in retail and wholesale markets are complex. The problems here are related to cost pressures, a wide array of regulatory requirements, customer retention, legacy technology stacks, etc.

Here, we do see benefits of a limited use of digital currencies to manage high value settlements. Most of the arguments for the use of digital currencies comes from the inability to access central bank money 24 hours a day. The global trading day is 6.5 days a week. In addition to the central banks, it is also important to have access to securities that are custodied at the central securities depositories. We believe these inefficiencies are better solved with interoperability and accessibility (longer windows of operation). In this case, digital currencies serve as a payment mechanism versus a store of value. While digital currencies can be useful, they could also increase risks due to volatility of the asset value, supply and demand of the currency, cyber security, etc.

2.2 Question 2

The potential impact of distributed ledger technology on financial institutions, including the central bank, and financial infrastructure.

Distributed Ledger technologies have been a major technology innovation which has the potential to create a new class of products and solutions that can bring both capital and operational efficiencies to banks. Clearing and settlement in institutional, retail, and wholesale payments have the following problems:

1. Slow and complex: The end-to-end payments flows across financial institutions both within and across countries is slow and complex
2. Operationally intensive: The operational costs for banks is very large. The operational staff is typically very effective but is limited by the tools and technology they use. This is starting to be a bottleneck for financial institutions.
3. Payments are opaque: Payments in capital markets are complex involving PvP (Payment versus Payment), DvP (Delivery versus Payment), Repo trades, Fx, Swaps, etc. These are complex, require pre-funding and are slow due to market infrastructure and technology issues. Often you don’t know when you are receiving a payment until it actually shows up in your account
4. There are 140 global currencies that are traded and settled. This process is expensive and inefficient.

Baton Systems has been working with several leading financial institutions to bring efficiencies to capital market payments. We see distributed ledger technology bringing significant efficiencies in the following manner:

●        Contract Automation: We see several parts of contract automation that would benefit from a shared ledger. Today, contracts are mostly in paper and are not structured. Therefore, it is difficult to verify that the terms of the contract have been adhered to in the daily operations. These contracts can range from documents of credit for trade finance to ISDA agreements for OTC trading, issuance of corporate bonds, repo and reverse repo agreements, etc. We see enhancements, such as the common domain model (from ISDA) and other initiatives to standardize contract syntax and moving some of the process to distributed ledger technologies, bringing efficiencies to the entire ecosystem

●        Payments: DLT technologies from companies like Baton Systems can bring significant efficiencies. Baton Systems has been able to achieve faster and less expensive clearing and settlement of all asset classes. Specifically, we were able to reduce the need for pre-funding, settle assets on demand, deliver real-time predictive analytics on overall liquidity positions for financial institutions.

●        Operational efficiencies: Areas in post trade around payments, regulatory reporting, reconciliation etc. are slow and expensive. We see distributed ledger technologies delivering significant efficiencies to market participants.

●        Record Keeping for digital assets: The CSDs and Central banks can gain efficiencies by having an immutable and tamper resistant data store that records all changes in ownership of assets

●        Regulators and central banks can get real time views of the market risks. They will be able to see risks building up in the markets and be able to take action in near real time. Today, the regulatory reports are received and acted on after events have passed.

2.3 Question 3

The regulatory response to digital currencies from the Government, the FCA and the Bank of England in relation to Anti-Money Laundering legislation and how regulation could be balanced to provide adequate protection for consumers and businesses without stifling innovation.

The identity of users on a blockchain and the underlying digital currencies can range from being completely anonymous to being completely open. The immutability and tamper resistance of the ledger ensures that every update of a record is recorded with an audit trail. The most compelling reasons for a digital currency and the blockchain is the lack of a central authority in managing the ledger.

Anonymous users: This is the case of a bitcoin where the users are accessed by an identifier and it is relatively hard to resolve the real identity of a person from the unique identifier. This means that users can have multiple identifiers and can transact with other pseudo anonymous users.

Non-Anonymous users: On the other hand, when we deal with a private blockchain and tokens to facilitate payments, there is a need to be able to resolve the unique identifier to a real identity of a user, business or financial institution. This brings up the issues of who manages the identity, who handles dispute resolution etc. This brings it back to the need for some kind of a central party or authority

Banks need to comply with AML, KYC, BSA, OFAC and other regulatory needs. This means that the identity of the user is important for account opening and monitoring financial transactions for AML. This is where solutions at the completely anonymous end of the digital currency spectrum will need significant enhancements. In addition to identity, we think there are other inherent problems of using digital currency as a store of value rather than as an exchange for payments. We do not see a world where cash is completely eliminated as use of cash as a percentage of GDP has remained steady despite the very fast adoption of non-cash. In the best-case scenario, we see digital currency coexisting with cash. Using digital currency as store of value like cash will imply that the asset will need to be interest bearing just like cash. This leads to more complex issues at a commercial bank level as well as the central bank level, to manage monetary policy through central bank policies and tools like the corridor system and the floor systems. This is explained in detail in the central bank on digital currency publication.

Regulation: There is an area around the issuance of ICOs and securities that we think needs to be regulated and we are seeing several regulatory bodies set clear policies and begin enforcement. We think this is a good first step as the public has been impacted by ICO scams and it is difficult to judge the intrinsic value of an issued token through an ICO. Outside of this, we recommend the governments and central banks play an advisory role at this point and set guidelines rather than set hard regulations or rules which participants need to adhere to. We think it is the early days of this technology innovation. We consider several whitepapers and initial proof of concepts as experiments. We believe it will take 3-5 years for some of the first benefits of the digital currencies and blockchain innovations to bear fruit.

2.4 Other questions

Some of the key questions the Committee will consider in this inquiry include:

Are digital currencies ultimately capable of replacing traditional means of payment?

We do not think this is practical. At best we see digital currencies coexisting with the other forms of payments like m-payments, mobile wallets, credit and debit cards. The marginal benefits that digital currencies can bring as a generic form of money is not very compelling.

However, we do think there are areas (as explained in this document) where digital currencies and blockchains could make an impact and bring efficiencies to market participants.

To what extent could digital currencies disrupt the economy and the workings of the public sector?

We only see limited arguments favoring digital currencies in public sector. While there are inefficiencies in terms of speed of payments and overall costs to the entire ecosystem, we think it is more practical to address them within the current payments infrastructure by using better standards around messaging, APIs and interoperability.

We do see a significant opportunity for the public sector to fully embrace non-cash payments like e-invoicing, electronic, mobile, credit, debit and contactless payments. There is already a steady increase in non-cash based payment methods for SMBs. We see this trend continuing. We also think that use of cash as a percentage of GDP is going to continue to remain steady or decline at a very slow pace. This implies corporations will have multiple ways to make and accept payments for the foreseeable future. While cash based payments have the possibility for counterfeits, digital currencies also have the possibility of identity spoofing and fraud even if there is a digital record. This is where, we think the arguments for digital currency are not as compelling.

What risks and benefits could digital currencies generate for consumers, businesses and governments?

The same arguments that make digital currencies not so compelling in the retail payments arena also apply in this sector. We see the use of digital currencies more as a medium for payments rather than a store of value. We bring this up as we do not see a world in the next twenty years where cash will be completely eliminated from society. This leads to the problem of using digital currency as a store of value will need to deal with the complexities of the supply and demand for the digital currency. The problems with this and the complexities for central banks to manage the monetary policy has been well researched.

●        Issuance of Sovereign Debt, Corporate bonds and coupon payments: This process today is complex and expensive and involves several investment banks and direct investors. The process is manual and relatively show. We think this is an area where digital tokens (not necessarily backed by central bank currency) can be valuable

●        Cross Border Payments: Here, we think digital currencies as a medium for payments can help speed settlement of retail (low value payments) overseas remittances.

●        Improvements in supply chain: Digital currencies could bring efficiencies in this space as the end to end process is quite complex.

We think it is more practical to make incremental enhancements to the current systems in order to solve some of the problems rather than overhauling it to use digital currencies. However, we do think blockchains have the ability to positively disrupt and impact the public and government sector in very big way. The following are some of the areas in government sector that blockchains can help:

●        Record Keeping and as an identity store: The blockchain can be used as a digital record keeping ranging from home ownership records, personal property taxes, vehicle records etc. We also think using the Blockchain as the underlying store with the proper permissions for digital identity can bring significant benefits. Further work needs to be done to ensure that the right security and access control is provided. But we can envision a more efficient interface that can open up the sector to significant innovation from private sector.

●        Collaboration medium for research: Here again we see great potential for researchers to use the Blockchain to collaborate, publish research findings, and share information across interested parties

●        Issuance of new bonds, corporate dividend payments: This is an area where digital currency and blockchain can have a wide impact.

●        Digital Rights Management and other authorization stores: There are multiple data stores which can be used to check for authorization before an action is performed

How is distributed ledger technology being applied in the financial services sector, and how might it be applied in future?

We have addressed this in section 2.2 of the document

What work has the Government (and its associated bodies) done to understand, prepare for and, where relevant, encourage changes that may be brought about by increased adoption of digital currencies?

How might the Government’s processes adapt should digital currencies be adopted more widely (e.g. tax implications, anti-money laundering measures)?

Is the government striking the right balance between regulating digital currencies to provide adequate protection for consumers and businesses whilst not stifling innovation?

Could regulation benefit digital currency start-ups by improving consumer trust?

We have addressed this in section 2.3 of the document

How are governments and regulators in other countries approaching digital currencies and what lessons can the UK learn from overseas?

April 2018

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