Various features of the blockchain and the underlying distributed ledger technology (DLT) make it ideally suited for use in any kind of transfer system whether it be payments, trading or lending. As discussed in the previous article, DLT creates superior security and transparency than existing systems, however in terms of functionality it goes far beyond that.
The movement towards online banking has catalysed consumer demands for ever-quicker banking services available to them 24 hours a day, including over the weekend. The burst of FinTechs beginning to offer payments services is evidence of this demand, however, consumers and especially firms are still extremely reliant on traditional payment systems.
Businesses are especially exposed to changing fees from payment processing companies with Amazon threatening to suspend the use of Visa in the UK after its processing fees increased five-fold1. This is especially concerning given the market power concentration in card networks; Visa and Mastercard have a combined global market share of 54 percent2.
A decentralised, P2P payments system based around DLT would allow for payments to occur free from high and unpredictable processing fees and at a far faster rate. In a typical transaction, Visa stands between the issuing and acquiring bank, processing the transaction between consumer and merchant; a blockchain payments system would allow for transactions directly between two parties, eliminating cost and delay. DLT also ensures instantaneous settlement and clearing of payments, preventing this lengthy delay and crucially avoiding the high processing fee.
Beyond drastically cutting back on costs and settlement times, a DLT payments system would constitute significant progress on fraud prevention. The security advantages discussed in the previous article are especially relevant for payments, due to the growing prevalence of fraud since the pandemic. The decentralised ledger also allows for auditing of transactions on demand, allowing for an identification of fraud in real time.
Blockchain technology could facilitate a trading network amongst banks and regular counterparties with trades occurring peer-to-peer (P2P) and crucially without intermediation. The lack of a third-party standing in between the trade allows for cost savings along with cutting down on trading times. Intermediation can be removed without drastically increasing counterparty risk as admittance to the network can be controlled based on strict criteria on creditworthiness.
As discussed in depth in the previous article, blockchain technology ensures that there is a highly secure and immutable ledger, recording all transactions within the network; this is accessible by any member on demand and reflects the latest information, as it updates almost instantly. This system greatly reduces operational risk by allowing for direct oversight over the network and due to its resiliency to cyberattack.
These benefits have already begun to be realised by financial institutions through the use of DLT in managing their liquidity requirements. Financial institutions actively manage their day-to-day liquidity primarily through repurchase agreements (repos) – short-term borrowing/lending secured by high quality assets. By tokenising Treasury Bills3, the whole transaction can be performed P2P over a blockchain network.
The use of smart contracts4 on blockchain networks designed for conducting repos can eliminate failed trades – where one of the counterparties either fails to deliver the collateral or fails to pay before settlement – ensuring more predictable funding and saving banks from substantial penalties.
Beyond cutting down on costs and risk, DLT creates new opportunities due to the features of the underlying technology. The P2P nature of the blockchain allows for instantaneous settlement of trades, a drastic improvement over the current T+2 system. This means that banks can conduct repos that last a matter of hours allowing them to continuously optimise their borrowing and lending, bringing about substantial cost savings. This system has been implemented on a platform by JP Morgan, processing more than $300 billion of repos using tokenised Treasury Bills for intraday lending – this leaves the banks’ capital buffers unaffected as they are calculated at the end of day5.
Smart contracts embedded in the network can also automate this process so that a bank automatically engages in a repo if its cash requirement unexpectedly rises or a reverse repo if it has excess liquidity, which it can lend out for profit.
[1] Financial Times (20-Nov 2021), “Visa hits back at Amazon over claims its fees are too high”
[2] Seeking Alpha (25-Jan 2021), “Visa vs. Mastercard: Battle of the Payment Giants”
[3] A method of introducing real assets into the blockchain network. In this case, the Treasury Bills never move off balance sheet, with only their corresponding tokens being transacted.
[4] Effectively lines of code embedded on the blockchain that execute actions when certain criteria are met. In this context, the smart contract can ensure that both counterparties have the cash/collateral to execute the repo before it occurs.
[5] Financial Times (23-May 2022), “Banks turn to blockchain in search for high-quality trading assets”
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