The Federal Reserve Board released a staff research paper on Monday, December 5, 2016, addressing the potential use of distributed ledger technology (DLT) in payments, clearing, and settlement (PCS) processes.  A distributed ledger is a type of database in which identical copies of information are distributed and maintained among multiple parties or multiple nodes in a computer network.  Uses of DLT include the transfer of cryptocurrencies, like Bitcoin.

The paper (i) describes the current state of DLT; (ii) identifies opportunities to use digital ledgers in PCS processes; (iii) delineates the practical challenges to implementing DLT; and (iv) outlines potential legal and risk management concerns related to DLT.

The Federal Reserve staff paper concludes that DLT is in the very early ”proof of concept” stage of development, in which industry is engaged in simple, small-scale experiments of the technology in a controlled environment. In this respect, the paper echoes recent remarks by Federal Reserve Board Governor Lael Brainard.

Notwithstanding this early stage of development, the paper identifies a number of promising opportunities that DLT presents for PCS processes, including:

• Improving the speed and efficiency of transferring securities, derivatives, and commodities by, among other things, decreasing the need for firms to maintain different ledgers, and eliminating costly and duplicative recordkeeping and record reconciliation processes;

• Reducing the cost and complexity of conducting cross-border payment transactions by reducing the number of intermediaries involved and developing standards to streamline transaction flows;

• Promoting financial inclusion for underbanked consumers; and

• Increasing information sharing across institutions and with auditors and supervisors to enhance network resiliency and stability in case of an attack, increase transparency, and streamline regulatory compliance with respect to the shared information.

Some DLT models are being designed to alter or eliminate certain PCS functions currently performed by financial intermediaries, such as correspondent banks, broker-dealers, and clearing houses. The paper expresses skepticism that DLT will render trusted financial intermediaries obsolete, explaining that intermediaries provide vital coordinating and risk management roles.  At the same time, the Federal Reserve staff acknowledges that financial intermediaries may need to evolve and adapt to DLT-based processes.

The paper identifies potential challenges to real-world implementation of DLT in PCS processes. The challenges identified underscore the critical importance of making appropriate design choices when developing a DLT system.  One challenge is obtaining a critical mass of industry participants adopting DLT to justify the upfront costs that particularly early adopters of DLT will incur.  In addition, DLT must be scalable so it can provide fast and reliable service for the large volume of transactions that the ledgers used for PCS processes would need to handle.  Other hurdles include:

• Ensuring interoperability among ledgers and other record-keeping mechanisms;

• Establishing standards to facilitate interoperability as well as to govern information management issues, such as how to handle fraudulent transactions and how much information to share with competitors;

• Managing security issues, such as the security of cryptographic network keys and access credentials; and

• Deciding how to administer DLT and what role financial intermediaries will play.

The paper includes an overview of potential legal and risk management concerns. For example, the paper explains that smart contracts, which we discussed in a previous post, raise issues relating to:  (i) the application of classic contract principles, such as voiding unconscionable contracts or amending contracts in response to changed circumstances, to automatically executed smart contracts; and (ii) the legal status of and liability for legal violations by organizations administered automatically through smart contracts.

The paper further notes that additional legal guidance regarding DLT and its uses may be necessary in certain areas. For example, the paper notes that additional guidance may be necessary to clarify how the Bank Secrecy Act and Anti-Money Laundering reporting requirements will apply to DLT or to new intermediaries that use DLT.  In addition, the paper notes that the legal and ownership status of completely digital assets, as well as digital tokens used in certain DLT systems as digital representations of a separate physical asset, such as securities, may not be clear under current legal frameworks.  Other legal and risk-management issues identified by the Federal Reserve staff include effective governance arrangements, the finality of transactions when multiple parties have permission to update a shared ledger and must agree on new ledger entries, operational risk related to system resiliency and security (e.g., errors or delays in processing, system outages, capacity limitations, fraud, and data loss), and the nature of licensing requirements for new DLT intermediaries.