The use of blockchain distributive ledger technology (blockchain, or DLT) is unlikely to challenge the franchise values of the U.S. trust and processing banks or their integral roles in trade settlement or asset custody, Fitch Ratings says.
Evidence for the purported efficiencies of DLT in trade settlement appears slim, without addressing the attendant network security, regulatory and implementation challenges the technology has introduced. However, aspects of the blockchain technology may have uses in smaller scale applications, most likely involving trusted counterparties as part of a centralized ledger.
The multi-agent processing required under DLT is unlikely to prove revolutionary for trade settlement, mainly due to scalability issues. Trials indicate it is inherently more costly and less efficient than existing centralized processes used for clearing and settling large trade volumes, as seen at trust banks such as Bank of New York Mellon, Northern Trust, State Street and credit card processors. The most advanced block chains can process at most five to eight transactions per second, while credit card networks like Visa can handle over 65,000 transactions per second.
A utility Setttlement Coin by 14 Banks
A 14-bank consortium, including Bank of New York Mellon and State Street, have formed Fnality, a company that is developing a utility settlement coin (USC), a tokenized fiat currency using DLT, targeted for 2020 release. Settlement coins are designed to make trade settlement between financial institutions near-instantaneous, with tokens functioning as a payment device and messenger service carrying all the necessary settlement information, backed by collateral held at central banks to reduce counterparty risk. Separately, JPMorgan announced in February that it would create JPM Coin, each valued at one U.S. dollar, to facilitate trade settlement using technology similar to DLT.
While DLTs such as USC are not expected effect ratings in the near term, the development of blockchain-related initiatives by banks is viewed positively. Banks’ commitment to innovation is supportive of franchise values and competitive positioning, helping defend the trust and processing banks’ central role in the financial system for transaction settlement and safekeeping of assets.
Settlement on Blockchain was Slower !
Joint trials testing the use of DLT in securities settlement by the German central bank (Bundesbank) and the Deutsche Boerse found that settlements were not only slower, but also carried higher computational costs relative to the current systems. The president of the Bundesbank concluded that, despite numerous tests of blockchain-based prototypes, the technology did not result in innovative breakthroughs that could replace current platforms. The Committee on Payments and Market Infrastructures also noted that as DLT relies on a consensus algorithm to effect final settlement, the finality may not be as clear as with traditional systems, where settlement is at a well-defined point in time, backed by strong legal precedent.
Narrower, more specific and customized applications could benefit most from DLT, such as transactions involving centralized ledgers and trusted counterparties, rather than high-volume transactions where efficiency and the reduction of multilateral counterparty risk are prioritized. Private blockchain technology for banks involving trusted counterparties, as seen with trade invoices, letters of credit and syndication platforms, has greater potential upside, whereas downside risks are more likely within high-volume, fast-paced liquid markets like FX, equities, government bonds, where DLTs cannot compete with the scale or efficiency of current bank and clearinghouse platforms.
Potential applications include private equity (PE) asset servicing, as demonstrated with the agreement between Northern Trust and Broadridge Financial Solutions, as PE transactions are generally lower volume and bilaterally cleared. Blockchain also has the potential to improve transparency and execution time of traditional securitizations and covered bonds but is largely untested and currently narrowly employed.
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