Central Banks apathy for blockchain is waning

Early 2017 I wrote a blog on Central Banks and blockchain (see: Blockchain and Central banks: a Tour de Table Part I and II, 3 and 9 January 2017). My conclusion at that time was:

“It has become clear that central banks are set to take a much more active role in the development of blockchain technology.  But how active that will be is not yet clear”.

The blockchain based technology with fintechs offering new real-world solutions, such as remittances and international payments are rapidly (disrupting and) challenging market players as well as central banks. This technology promises benefits in terms of reducing risk, preventing fraud and executing monetary policy more effectively.

So it is not a surprise that the apathy of central banks towards blockchain technology is waning. They are also beginning to change a bit their tune towards cryptocurrencies. These cryptocurrencies do not present a real threat to the long-term existence of fiat currency, according to many central bankers.

In this blog I touch (not in detail) studies and reports launched this year that are exploring the role of blockchain and digital currencies for central banks. But I will also go into the main actual initiatives, experiments and projects in the various central banks worldwide.

Studies and Reports

During this year a number of interesting studies and reports have been launched, exploring the role of blockchain technology and digital currencies for central banks.

ECB and Bank of Japan Report: Blockchain Will Overhaul Securities Settlements
The European Central Bank and the Bank of Japan have released a joint report that shows the potential of blockchain to transform securities settlements. In this report they claim that distributed ledger technology can generate new securities settlement mechanisms, such as “cross-chain atomic swaps” among unconnected ledgers.

It is the second research report released by the partnership called Project Stella. It was aimed at finding how Distributed Ledger Technology (DTL) can be used in a multitude of forms of securities transactions. The new report titled, “Securities settlement systems: delivery-versus-payment in a distributed ledger environment”, addresses what is known as the deliver versus payment (DvP) method of securities settlement. The cross ledger DvP systems can bring operational challenges to settlements, the report noted. The system can also impact the speed of the transaction, requiring liquidity to be temporarily blocked. The lack of synchronization in the system can leave participants exposed to principal risk in the case where one counterparty in the transaction fails to complete all the steps in the process.

The project researchers created prototypes based on the Corda, Elements and Hyperledger Fabric platforms. They discovered that DvP can execute in a DLT system with cash and securities between separate ledgers and on a single ledger.

“DvP could be conceptually and technically designed in a DLT environment with cash and securities on the same ledger (single-ledger DvP) or on separate ones (cross-ledger DvP).” BoE  report

ECON Study: Central Bank Digital Currencies Will limit use of digital tokens
The European Parliament Committee on Economic and Monetary Affairs (Econ) has recently published a report named Monetary Dialogue for July 2018, where it states that central banks could halt the progress of decentralized digital tokens like Bitcoin and Ethereum.

Another report titled Competition issues in the Area of Financial Technology (FinTech) authored by the Police Department for Economic, Scientific, and Quality of Life Policies, also states that if central banks were to issue their own digital currencies, it could strangulate the demand for decentralized tokens. The report notes:

“The arrival of permissioned cryptocurrencies promoted by banks, even by central banks, will reshape the current competition level in the cryptocurrency market, broadening the number of competitors. A potential inadequacy of traditional competition policy to address competition issues in the cryptocurrency markets can be found, suggesting direct public participation through a central-bank digital currency as a remedy.” ECON study

BIS Report: Central Bank Digital Currencies
Central banks from all over the world have been pondering whether they should issue digital versions of their own money, too. In March this year the Bank for International Settlements (BIS) launched an extensive report titled: Central bank digital currencies. The report merely studies the issue “should central banks replace some “real” money with digital money”.

The report explores ways in which debt, funding and monetary systems would operate should digital currencies become more broadly based, even issues by a central bank.  The reports assumes that a central authority, a central bank, would simply manage the overall monetary pool – comprised of mixed assets spanning traditional forms of today with a digital asset in the future. The report thereby weighs up CBDCs’ possible effects on payment systems, monetary policy and financial stability. CBDCs could be either widely available or tightly restricted. A CBDC open to all would in effect allow anyone to have an account at the central bank.

A steep decline in the use of cash could strengthen the case for a widely available CBDC Experiments with a CBDC just for interbank payments, however have “not shown significant benefits”, according to the report. In Sweden where the use of cash has diminished hugely  the Riksbank is contemplating an “e-krona” for small payments. But in most countries, despite the growing use of cards, accelerated by the advent of contactless payments, cash remains popular. The authors are therefore not sure that the putative gains yet warrant creating CBDCs.

On financial stability, the report is more cautious still. Since central banks cannot control the supply of digital currencies they do not govern, instability on the monetary system will increase since crypto-currencies could subvert central bank policy actions.

When asked if cryptocurrencies could potentially replace fiat currencies, there is a broad consensus amongst central bankers.

“I don’t see that happening as long a central banks continue to do a good job of maintaining monetary policy. But could a cryptocurrency really spell the end of fiat currency? I think so. In a situation of hyperinflation where a central bank has abdicated responsibility for stability then you could see a case for cryptocurrency”. James Chapman, Bank of Canada.

“In general no, but I think it depend on the fiat currency of the central bank. Of course, if a currency is nor performing well, you have hyperinflation and a country where people lose trust of rule of law of its central bank. It depends on the central bank, as long as they do a good job there is no reason for that fiat currency to disappear”. Thomas Moser, Swiss National Bank

Cambridge Centre for Alternative Finance: Global Blockchain Benchmark Study
As part of the 2017 Global Blockchain Benchmarking Study by the Cambridge Centre for Alternative Finance, a group of 25 central banks were surveyed about their blockchain policies. The statistics are quite impressive considering the very conservative nature of central banks. According to the Study, central banks are “upbeat” about blockchain technology.

Survey results show that a growing number of central banks is actively testing blockchain technology for a variety of different use cases, from new central bank digital currencies (82%), new payment systems (55%), regulatory compliance (36%) to records management (32%).

The permissioned ledger protocols are high on the list of protocols that the central banks are interested in exploring, however other decentralized protocols such as Ethereum and Bitcoin also ranked fairly high in their consideration. Findings show that 67% of central banks surveyed are directly experimenting with DLT protocols, with 57% of central banks experimenting with versions of the Ethereum codebase.

Of every five central banks surveyed, one affirmed that they will deploy some form of blockchain technology for their operation in the next 24 months and about 40 percent admit that the technology will be in widespread use within the next 10 years. While 42% of central banks cannot yet predict when trials might begin.

Central Bank projects: RTGS/Securities Settlement

In the past one and a half year central banks around the world are increasingly recognizing the potential of blockchain technology to disrupt the traditional financial services business model. They  are currently allocating growing resources to blockchain technology, exploring the potential of this technology and digital currencies via initiatives, experiments and projects. 

UK Central Bank: Proof of Concept RTGS
The Bank of England is executing a complete overhaul of its interbank payment system. The transformation will initially focus on modernizing its Real-Time Gross Settlement System (RTGS) by the year 2020. Officials have now confirmed that the updated payments system will be compatible with blockchain-based financial technology forms.

“It won’t be based on DLT-system, but we expect and hope that it will be capable of interoperate with DLT system in development by the private sector”. Martin Etheridge, Head of Division ate the Bank of England

The British central bank recently published a report evaluating its Proof-of-Concept (PoC), which was conducted in March with several firms operating in the distributed ledger technology (DLT) space (from DLT startups Baton Systems, Clearmatics Technologies, R3 and Token). A test  intended to examine the feasibility of connecting blockchain firms to an updated version of the bank’s Real-Time Gross Settlement (RTGS) service, and how its functionality could be expanded through the use of new technologies. According to the newly-published report, all participants expressed confidence that they could connect to the RTGS to settle transactions denominated in central bank currency.

“All participants confirmed that the functionality offered by the renewed RTGS service would enable their systems to connect and to achieve settlement in central bank money.” “A number of recommendations were received to ensure optimal access to central bank money.” BOE report

Dutch Central Bank: Project Dukaton
The Dutch Central Bank recently announced that “at the moment, blockchain technology is not beneficial to the payment system in the Netherlands”. Although it could reduce costs and make payments more efficient,  while it may increase the current financial infrastructure’s resilience against cyber-attacks, “this resilience comes at the expense of efficiency, capacity, and scalability”.

This conclusion was based on the results of its Project Dukaton, that set out to conduct research in a bid to understand how much value blockchain technology can bring to the country's existing payment system. It conducted a series of experiments that has tested four DLT prototypes over the past three years.

Given the above, the Dutch Central Bank will still continue to invest in the development of blockchain and “does not completely shut out the idea of a blockchain arrangement that could meet the needs of the Netherlands’ financial system”. The central bank will thereby consider especially improvements in algorithms that would allow faster payments processing speeds. 

South Africa’s Central Bank: Project Khokha
In a report recently launched the South African Reserve Bank (SARB) has outlined its progress with Project Khokha, a Proof of Concept simulation of distributed ledger technology for wholesale payments and inter-bank settlements. Project Khokha is a collaboration of eight South African banks to test bank-to-bank payment transfers.

The project that is operating on JPMorgan’s Quoram, an Ethereum based blockchain platform. aims to replicate South Africa’s current bank-to-bank payment platform, the South African Multiple Gross Operation Settlement System (SAMOS), using blockchain technology. The Reserve Bank however is not looking to replace its legacy systems at this stage, but is interested to examine how the Khokha system will work as a back up to its existing settlement systems. 

“One objective of Project Khokha is to provide a better understanding of how South African Multiple Option Settlement (SAMOS) system would integrate with a DLT system. The intention is not to consider changing the approach with the SAMOS replacement but to provide input to that project”. SARB Report

The project has been deemed a success. The central bank found that it could process the typical daily volume of the South African payments system in under two hours with full confidentiality maintained. SARB concluded that a further study is required. Key considerations in this study will be how support frameworks integrate, and the legal, regulatory and compliance factors.

“This project has laid the foundations for future collaborative work – essential in the blockchain context – and has fulfilled its objective of providing useful insights to all participants.”. “There are many issues to consider before the decision to take a DLT-based system into production can be taken. Some of these issues relate to the practicalities of implementation, but also to legal and regulatory factors and to the broader economic impact”. SARB statement

Other Central Bank Projects

Boston Fed: Upcoming whitepaper on POC
Although there is not (yet) a “communis opinio” about how to treat blockchain within the US Federal Reserve, the Boston branch of the Federal Reserve System stated that blockchain technology can disrupt central banking as any other industry. They have been exploring blockchain since 2016 starting with Ethereum and its smart contracts, but then moved to the permissioned Hyperledger protocol.

Boston Fed plans to publish a whitepaper on the project they are working on later this year. They are “building a proof of concept around Hyperledger Fabric.” Another aspect they are exploring is how blockchain technology might be used by commercial banks and what role the Fed might play in a “spiderweb of banks” transacting effectively peer to peer without necessarily requiring a central clearing house as they do currently. Boston Fed is further exploring together with Harvard and MIT what blockchain technology might look like in ten years in areas like simple payments as well as more complex financial transactions.

Lithuanian Central Bank: LBChain Initiative
The Bank of Lithuania, the country’s central bank, announced that it is soliciting proposals from software developers to kick off its LBChain initiative – a “service-based blockchain platform” aimed to serve as a regulatory sandbox for startups working with blockchain technology. Introduced in January, LBChain is intended to assist both Lithuanian and international companies in acquiring knowledge of the blockchain and in conducting blockchain-focused research.

Although the central bank said in January that it expected the platform to launch in 2019, it now indicates that the implementation stage of the project is expected to be underway this year.

Thailand Central Bank: document authentication, cross border payments, supply chain finance
The Bank of Thailand is now considering using blockchain technology to improve and streamline several administrative and payment services. The bank, working on several initiatives, is thereby  considering the use of blockchain for purposes like document authentication, cross-border payments and supply chain financing.

“The sandbox serves as a platform for financial institutions and fintech firms to test new technologies and operating standards in a safe environment before the products and services are launched to the general public. Technologies under (sic) reviewed include … blockchain applications for cross-border payments, supply chain financing, and document authentication.” “Blockchain would improve regional financial connectivity and facilitate smoother cross-border financial services.” Dr. Santiprabhob , Bank of Thailand Governor

Central Bank of Brazil: help regulators exchange info
The Central Bank of Brazil (BCB) has announced that it will exchange information with other regulators of the Brazilian Financial System (SFN) using blockchain technology. The Information Integration Platform for Regulators (PIER) unveiled by the central bank, will enable data exchange between the BCB and other regulators, such as the Superintendence of Private Insurance (Susep), the Securities and Exchange Commission of Brazil (CVM), and the National Pension Funds Authority (Previc). PIER will be operational at the end of 2018.

Initially, the new tool will be used to share data related to the financial institutions' authorization procedures. The BCB expects that institutions will allow access to information relative to administrative sanctioning processes, but “any participant would be able to grant access to any information considered to be of mutual interest at any moment”.

Central bank of Saudi Arabia and UAE: cross border cryptocurrency exchange
The Saudi Arabian central bank and Ripple have signed a deal for helping “indigenous banks in settling payment transactions” by making use of Ripple’s blockchain technology. Saudi Arabia will thereby utilise xCurrent, Ripple’s enterprise software solution facilitating such payments with end-to-end tracking. This pilot programme should allow local banks to instantly settle payments both within and outside domestic borders. This will help the Saudi Arabia’s banks in bringing upon cheaper, faster and more transparent cross-border remittances.

The central bank of the United Arab Emirates is undertaking a joint project with the Saudi Arabian Monetary Authority (Sama) to use blockchain technology for fostering the issuance of a digital currency which can facilitate cross-border transactions between both the nations. The digital currency would not be for consumers to use, but instead between the two countries’ financial institutions.

Eastern Caribbean Central Bank: digital payments eco system
The Eastern Caribbean Central Bank (ECCB) and a Barbados-based fintech company, Bitt, announced plans to conduct a pilot to create a digital payments ecosystem using blockchain technologies in the ECCB eight member countries. The ECCB and Bitt have now signed a memorandum of understanding MoU), and the pilot is expected to begin later this year.

The pilot will focus on developing a secure, resilient digital payment and settlement platform with embedded regional and global compliance; and the issuance of a digital Eastern Caribbean currency which will operate alongside physical currency. The ECCB and Bitt will develop, deploy and test technology for data management, compliance and transaction monitoring for know your customer (KYC), anti-money laundering (AML) and combatting the financing of terrorism (CFT).

“The aim of the pilot is to ascertain the suitability of blockchain technology to help boost economic growth and competitiveness in the region consistent with the ECCB’s monetary and financial stability objectives. This is intended to improve the risk profile of the Eastern Caribbean Currency Union (ECCU) and mitigate against the trend of de-risking by the region’s correspondent banking partners.” Timothy N. J. Antoine, Governor of the ECCB

CBCS: Explore digital currency
The Centrale Bank van Curaçao en Sint Maarten (CBCS), which is in charge of monetary policy for the two former Netherlands Antilles island territories, is exploring the creation of a digital currency to replace the present Netherlands guilder. For that reason they teamed up with Overstock-owned blockchain firm Bitt, under an MoU to help it determine the viability and functionality of such a system.

"The central bank is determined to address its challenges proactively by exploring the latest technology available, for example, to reduce the level of cash usage within the monetary union, and to facilitate more secure, more AML and KYC compliant, and more efficient financial transactions within and between Curaçao and Sint Maarten." Leila Matroos-Lasten, acting president, CBCS

"A central bank issued digital currency is of particular relevance in a monetary union where member states are separated by long distances - or the ocean - as with the ECCU, and the situation of Curaçao and Sint Maarten”. "A central bank issued digital currency, which can be used on mobile wallets, facilitates secure and frictionless financial transactions and payments, using a mobile phone/tablet, within each jurisdiction and across jurisdictions in the monetary union." Rawdon Adams, CEO, Bitt

Bank of Korea: Cash Free Society Project
The Central Bank of Korea (BOK) recently officially announced its Cash-Free Society project. The Central Bank of Korea will consider cryptocurrencies and blockchain-based applications for its “Cashless Society” project. Project goals are said to be increasing user convenience by eliminating physical money and also saving the cost of producing and distributing it. The BOK had already announced in January that it would initiate research on the impact of cryptocurrencies on the financial system through implementing digital money and the possibility of issuing a central bank password.

The Bank of Korea has also been working with overseas banking institutes to explore the possibility of applying blockchain technology and password security to payment systems.

Monetary Authority of Singapore: Corda for Central Banks
R3 has been in charge with various central bank projects including the Bank of Canada, the Hong Kong Monetary and the Monetary Authority of Singapore (MAS). One of the most recent one is Project Ubin Phase II, a key project that the R3 team has been working on for the past seven months with the Monetary Authority of Singapore (MAS), ten banks, and partner Accenture.

The Project Ubin uses the scenario of a central bank issuing currency receipts to a group of banks who then pass the receipts amongst each other, and redeem them some time later. Main element of the project includes first of all of a front and back end code that reflects cash issuance and transactions among a group of participants. The code is open sourced, allowing participants the freedom to use the software for any purpose, to distribute it, to modify it, and to distribute modified versions of the software, under the terms of the license.

In fact this code is useful any time you have issuance, transfers, and redemption of anything that can be recorded on a ledger.  The code and concepts can be reused for other purposes too. Such as a bank issuing promissory notes or certificates of deposit to its clients; a government issuing bonds; a corporate issuing short or long term debt; a corporate issuing non-cash obligations; and, many other use cases.

Another key element are algorithms that can run a so-called Liquidity Savings Mechanism (LSM) while maintaining transactional privacy over a decentralized ledger. The LSMs can unlock “gridlock” situations where participants want to transact with each other but may not presently have enough of the asset. There are also possibilities where banks or corporates have multilateral obligations to each other.

Need for World Blockchain Platform for Central Banks

Central banks’ interest in deploying blockchain and digital money in the way as described in this blog is largely in step with moves by commercial banks and other financial institutions to use the technology to ease cross-border settlement transactions and overhaul back-office infrastructure. Accenture research estimates that blockchain-based database systems can reduce 70% of central finance reporting costs, lower compliance costs by 30-50% and provide potential savings of 50% on business operations.

However, there is a looming challenge around security and regulatory issues that needs to be solved first. This will require cross-border cooperation between central banks and the IMF. They must come together and create a formal worldwide platform for discussions around regulation of blockchain and digital money that will be used globally.

The emergence of blockchain could trigger a revolution in banking. However, it is in the hands of central banks that the technology could reach its true potential. These numbers will only prove compelling as the world’s central banks prioritise their blockchain agenda over the coming years.