Giulia Secco is the Strategic Partnership & Ecosystem Manager at Fnality International.
In the aftermath of the 2008 financial crisis, a person or group of people operating under the pseudonym Satoshi Nakamoto created the first cryptocurrency, Bitcoin. Unlike government-issued currencies, the creators wanted Bitcoin to be operated peer-to-peer by its users in a decentralised fashion, meaning that no central authority, middleman or group would be needed to authenticate and validate the transactions.
To make this possible, Satoshi Nakamoto created a digital ledger which could distribute the currency: the so-called blockchain, which enabled the creation of an immutable recording of ‘blocks’ of transactions, validated in a distributed way by its own network participants (nodes). In the years since, many believe that this it is this technology that could truly revolutionise the financial sector.
Crypto enthusiasts believe that the decentralised blockchain architecture will help to address many current financial inefficiencies, for example by eliminating intermediaries (i.e., banks, custodians, clearinghouses, etc) which play an essential third-party guarantor role in the current centralised system, where ledgers of records are maintained by a central authority that validates transactions. By removing intermediaries, and so, single points of failure, the system gains in resiliency, whilst associated costs can be massively reduced.
Blockchain, also known as Digital Ledger Technology (DLT) – even if the 2 terms do not mean perfectly the same thing – can indeed revolutionise the way different economic agents cooperate enabling a faster, cheaper, reliable, and more transparent capital market infrastructure, which facilitates the building of a secure and reliable P2P global financial market. This can be achieved essentially thanks to the peer-to-peer nature of DLTs, by moving from the current status where settlements require several days to complete (T+), and where one party of the trade is highly exposed to the risk of the other party not fulfilling its liability, to the near-immediate final settlement of financial transactions (T0).
Today Bitcoin is no longer the only cryptocurrency in circulation. Aside from Ethereum, which is the second-largest cryptocurrency in terms of market capitalisation, there is a specific category known as “stablecoins”. As suggested by the name itself, stablecoins have been created with the intent to mitigate the typical volatility of cryptocurrencies, by linking their value to real assets or fiat currencies. The largest stablecoins’ price is usually designed to be pegged as closely as possible to 1-to-1 to the US dollar.
The speed of market acceptance of stablecoins has been remarkably quick, not only for the promise to reduce volatility and offer a more reliable cash-asset but also for providing a quick, cheap, and programmable payment leg able to support the trade of “tokens”, digital representation of values, good and services, based on blockchain.
Differently from what crypto enthusiasts believe, in our view, the future of Finance will not witness complete disintermediation in accessing capital markets and so, certain intermediaries, such as banks and custodians, won’t be disappearing altogether, but rather their role has to change considerably (if they don’t want to perish or even worst, be replaced by innovators).
Why is this? Why can the finance system not just adopt a stablecoin to pay and transfer money globally and instantly?It is because of customer protection. Many regulators and central banks around the globe have developed a deep understanding of this new technology and the growing demand for tokenised cash and assets, and they now recognise the benefits brought about by innovative technology adoption.
Just as an example, the Bank of England announced in April 2021 the introduction of a new omnibus account model that created an opportunity for innovative financial market infrastructures to access the Bank’s RTGS system in a new way. But they are also concerned about potential threats. The main one is around financial stability: if a very large stablecoin suffers from a loss of confidence leading to a stablecoin run that can have knock-on effects on the entire financial and economic system. Another major concern comes from the anonymity that stablecoins can guarantee, making them the ideal medium to facilitate illicit and criminal activities against anti-money laundering, tax compliance, and sanctions.
While stablecoin arrangements are under regulatory scrutiny and in order to be able to bring new payment solutions at scale they will need to be regulated, their role is now also better defined: based on the latest USA President’s Working Group on Financial Markets’ report, stablecoin issuers will need to be treated as depository institutions (aka, banks).
Most payments in the wholesale financial market between banks and other larger institutions are today conducted via central banks’ RTGS systems (real-time gross settlement) due to their zero-credit risk characteristic. Stablecoins however bear credit risk as funds/assets are usually held by commercial banks or other non-central bank entities. In order to replicate such a zero-credit risk payment facility on DLT, the idea of CBDC (Central Bank Digital Currency) has been brought up where central banks themselves issue tokens backed by central bank money.
Despite several POCs, and unlike in the retail space, no wholesale CBDC has yet gone live. We expect that some CBDCs – which are essentially a digital form of a country’s fiat currency, issued and regulated by the national central bank – will serve the retail domestic financial market bringing all the benefits that we have previously discussed (efficiency, resiliency, auditability, transparency). The reason for narrowing CBDCs to domestic markets only, in our view, is due to the significant collaboration required between jurisdictions for cross-border payments, from a technical, legal, and risk perspective.
We believe that the absence of any wholesale CBDC solution yet live indicates that public sector institutions will take advantage of private-sector innovations, like the ones that Fnality Global Payments aim to offer.
We believe that the current traditional financial system could be significantly improved through the introduction of a regulated distributed financial market infrastructure (dFMI), and the introduction of a cash-on-ledger solution with the credit risk characteristics of central bank money (in each national Fnality payment system funds are “backed” 1 – 1 with real fiat currency, kept in a bankruptcy-remote central bank account).
Fnality Global Payments will offer that harmonisation between jurisdictions needed to unlock the potential of tokenised financial markets: through the introduction of such a network of interoperable payments systems, a broad range of applications and platforms will be allowed to use balances held on each system, introducing near-instant settlements, effective intraday liquidity management, and a reduction of costly and inefficient intermediaries.
In association with technology analytics company FNA, we have estimated that for banks, this approach has the potential to reduce their intraday liquidity requirements by up to 70% (a recent Oliver Wyman report has suggested a potential annual saving of up to $75m per bank with an intraday liquidity reduction of just 25%. If the top 105 Tier 1 banks reduced their intraday liquidity requirements by this 25%, they could realise potential industry savings of $8 billion).
Such an approach will empower financial market participants to manage the entirety of their cash and collateral portfolio from a “single pool of liquidity”, solving today’s problems around the fragmentation of liquidity.
With tokenised assets and new exchanges being introduced at an increasing rate, the safe, effective, and regulated cash-on-ledger solution represents the third essential ingredient for this infrastructure. It cannot succeed without it.
The introduction of this on-chain payments leg will mean the full benefits of a tokenised marketplace can be realised. Without it, the cost of dealing with an inefficient legacy payment infrastructure simply doesn’t outweigh the benefits of a new approach.
But with it, traditional finance actors and the broader global economy can truly unlock the full potential of tokenised markets.