Disributed ledger, blockchain and digital currency in the finance industry

What are DLT, blockchain and digital currencies?

In recent years, digital currencies have begun to transform our monetary system and are on their way to forever change it. Current events like the Covid-19 pandemic have just fueled respective initiatives as well as the public, economic and regulator opinion on their broader use. Since the first cryptocurrency, the blockchain based Bitcoin, was introduced in 2009, many new developments of digital currencies have challenged the use of traditional payment instruments and financial contracts. Among current examples are Facebook-led LIBRA, an initiative to challenge national and international payment arrangements, the recent wave of cryptocurrency initial coin offerings (ICOs) that has rattled traditional financial regulation, the rising interest in central bank digital currencies (CBDCs, e.g. the digital Euro/Dollar/Yuan) as a way to modernize payment systems and as an answer to widely unregulated and often criminally misused cryptocurrencies, whose prices are mostly volatile because they lack any intrinsic value and a reliable institution backing them, and stablecoin initiatives.

They all (or will most likely) rely on the so-called distributed ledger technology (DLT), which has different concepts and needs to be distinguished from unregulated centralized virtual currencies in form of coupons (virtual or game currency that can be bought, but not exchanged back into real money). A distributed ledger (also called a shared ledger) is a consensus of decentrally replicated, shared, and synchronized digital data geographically spread across multiple sites, countries, or institutions. Since there is no central administrator, a peer-to-peer network is required as well as consensus algorithms to ensure replication across nodes is undertaken.

The most famous form of a distributed ledger design is the blockchain system, which can be either public or private. In practice, blockchain technology offers a new way to trade, invest, and share information – including cash, tax data, social benefits, property assets, votes, or intellectual property – in a secure, transparent, and efficient way. Since their open approach is transparent and democratic, DLT create trust between parties where necessary – and are therefore predestined for use in administration, finance, politics, the legal sector (smart contracts) and many other businesses and application areas outside of the financial industry.

Moreover, since the distributed ledger database is spread across several nodes (devices) on a peer-to-peer network, each of them replicates and saves an identical copy of the ledger and updates itself independently without the need of a central authority. The primary advantage of such a process, besides an increased transaction speed through faster processing, real-time settlement and lower transaction costs, is the security via automatic update each node constructs with a new transaction, and that the nodes then vote by consensus algorithm on which copy is correct. Once a consensus has been determined, all the other nodes update themselves with the new, correct copy of the ledger. Security is accomplished through cryptographic keys and signatures.

Distributed ledgers may be permissioned or permissionless. This determines if anyone or only approved participants can run a node to validate transactions. They also vary between the consensus algorithm – proof of work, proof of stake, or voting systems, and they may be mineable or not.

Even though a DLT does not have to exist in form of a chain structure (e.g. IOTA or Hashgraph), a blockchain is a growing list of records, called blocks, that are linked to a chain using cryptography, and where each block contains a cryptographic hash of the previous block, a timestamp, and transaction data (generally represented as a Merkle tree).

Using such a design, a blockchain is resistant to modification or manipulation of its data and provides the most secure infrastructure against cyber attacks, since once recorded, the data in any given block cannot be altered retroactively without alteration of all subsequent blocks. Although blockchain records are itself not unalterable, blockchains may be considered secure by design and exemplify a distributed computing system with high Byzantine fault tolerance. For this reason, the blockchain can be described as an open, distributed ledger that can record transactions between two parties efficiently and in a verifiable and permanent way.

When it comes to practical use, blockchain based crypto assets all seem to have a very high and unpredictable volatility, which makes them the perfect investment object for traders or criminals, but insufficient as being used as fiat money that stores and guarantees value. For this reason, some governments like Russia and India are even thinking about a ban of cryptocurrencies.

Stablecoins are said to offer a solution to this problem because they are cryptocurrencies that are less prone to price fluctuations. They are designed to minimize the volatility of their price, relative to some more stable asset or basket of assets by being pegged to and backed by a cryptocurrency, fiat money, or to exchange-traded commodities (such as precious metals or industrial metals), or by being tied to an algorithm and not backed by real assets (seigniorage-style), but have some disadvantages.

DLT has become a prominent field of experimentation in recent years, to which financial service providers, financial market infrastructures, regulators and central banks, among others, are dedicated.

Especially the emergence of digital crypto assets and the underlying DLT have led central banks around the world to think intensively about the digitization of the monetary system and the introduction of CBDCs. A pioneer in this field is the Bank of England who started to analyze the introduction of its own CBDC already in 2014.

Driven by the planned release of digital currencies like LIBRA, which will be backed by several fiat currencies and government bonds and could fast become an unregulated parallel currency, and of widely unregulated cryptocurrencies, central banks globally are now initiating projects and test phases to create and release an electronic form of central bank money accessible to all citizens and firms, which may or may not be DLT-based.

Examples of these CBDSs are, among others, not only the Digital Currency Electronic Payment (DCEP) system in China which is already being tested for a digital Yuan, the e-krona in Sweden, the digital Uruguayan pesos, as well as (planned) pilot CBDC projects by the Russian Central Bank, the Monetary Authority of Singapore, the Bank of Japan or by the Eastern Caribbean Central Bank, but also very recent announcements of CBDC research initiatives by both the US Federal Reserve System (FED) and the European Central Bank (ECB) to create a digital Dollar or Euro, respectively.

A study published by the Bank for International Settlements (BIS) in January 2020 shows that 70% of all global central banks are currently analysing the issuance of their own digital central bank currency and that 30% of the participating central banks are likely to introduce such digital currency either in the short-run (up to three years) or in the medium-term (up to six years).[1]

Even though there are many strong arguments in favour of using DLTs, they are not necessarily obligatory as the technological basis for the digitization of the monetary system and the introduction of a CBDC. Nonetheless, it drives the discussion and brings back old economic ideas about the design of the monetary system to the centre of the scientific debate, as DLT enables us to rethink all the different types of money in today’s monetary system and to materialize the advantages of DLTs in different ways.

It is becoming clear that the future of currencies lies in a digital form and that DLT will form an essential pillar of the digitization of the monetary system in particular and the financial system in general.

What are the challenges for the finance industry?

The financial sector has thus recognized the many possible use cases for DLT and digital currencies and the potential for efficiency gains, which is why there are currently a large number of initiatives to identify and specify the areas of application of this technology. However, despite technical obstacles like interoperability, usability and scalability there are still many other hurdles, especially from a regulation perspective, like payments-related issues, including consumer protection, cybersecurity, privacy and data rights, but most importantly possible misuses around money laundering and terrorism financing.

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[1] https://www.bis.org/publ/othp33.pdf