FINTECH NOTES NOTE/20/01 DISTRIBUTED LEDGER TECHNOLOGY EXPERIMENTS IN PAYMENTS AND SETTLEMENTS Ghiath Shabsigh, Tanai Khiaonarong, Harry Leinonen PUBLICATIONSFINTECH NOTE INTERNATIONAL MONETARY FUND Distributed Ledger Technology Experiments in Payments and Settlements Prepared by Ghiath Shabsigh, Tanai Khiaonarong, and Harry Leinonen (IMF Consultant) June 20202020 International Monetary Fund Cover Design: IMF Multimedia Services Composition: The Grauel Group Names: Shabsigh, Ghiath. | Tanai Khiaonarong. | Leinonen, Harry. | International Monetary Fund, publisher. Title: Distributed ledger technology experiments in payments and settlements / Prepared by Ghiath Shabsigh, Tanai Khiaonarong, and Harry Leinonen (IMF Consultant). Other titles: FinTech notes (International Monetary Fund). Description: Washington, DC : International Monetary Fund, 2020. | FinTech notes. | June 2020. | Includes bibliographical references. Identifiers: ISBN 9781513536330 (paper) | 9781513536354 (web pdf) Subjects: LCSH: Blockchains (Databases). | Financial services industryTechnological inno- vations. | Electronic funds transfers. Classification: LCC QA76.9.B56 S53 2020 Publication orders may be placed online, by fax, or through the mail: International Monetary Fund, Publication Services PO Box 92780, Washington, DC 20090, U.S.A. Tel.: (202) 623-7430 Fax: (202) 623-7201 Email: publicationsimf imf bookstore DISCLAIMER: Fintech Notes offer practical advice from IMF staff members to pol- icymakers on important issues. The views expressed in Fintech Notes are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF managementiii International Monetary Fund | June 2020 Abbreviations v Executive Summary vii Introduction 1 Distributed Ledger T echnology 1 Experiments and Research 2 Risk Management Issues 5 Financial Market Infrastructure Standards 7 Potential Impact on the International Monetary System 8 Conclusion 8 Annex I. List of DLT Experiments and Research in Payments and Settlements 10 Annex II. Distributed Ledger Technology Protocols 11 References 12 CONTENTSv International Monetary Fund | June 2020 BOC Bank of Canada CBDC central bank digital currency CCP central counterparty CLS CLS Bank International CPMI Committee on Payments and Market Infrastructures CPSS Committee on Payment and Settlement Systems CSD central securities depository DLT distributed ledger technology DVP delivery versus payment FMI financial market infrastructure GPI Global Payments Innovation IOSCO International Organization of Securities Commissions LSM liquidity saving mechanism LVPS large-value payment system MAS Monetary Authority of Singapore PFMI Principles for Financial Market Infrastructures PKI public key infrastructure RTGS real-time gross settlement SWIFT Society for Worldwide Interbank Financial Telecommunication USC Utility Settlement Coin ABBREVIATIONSvii International Monetary Fund | June 2020 The last decade was a wake-up call for the financial sector with many explorations made into the use of distrib - uted ledger technology (DLT) for payments and settlements. 1 DLT has triggered a wave of innovations, exper- iments, research, and analysis of policy issues. Many lessons can be drawn from these projects to help inform policymakers and the industry on DLTs potential benefits and risks, which could have implications on interna- tional standards for financial infrastructures to ensure safety and efficiency in the publics interest. So far, experiments with DLT point to the potential for financial infrastructures to move toward real-time set- tlement, flatter structures, continuous operations, and global reach. Testing in large-value payments and securities settlement systems has partly demonstrated the technical feasibility of DLT for this new environment. The projects analyzed issues associated with operational capacity, resiliency, liquidity savings, settlement finality, and privacy. DLT-based solutions can also facilitate delivery versus payment of securities, payment versus payment of foreign exchange transactions, and efficient cross-border payments. The analysis points to key issues that could require further attention. Most experiments have been completed under controlled and technology-focused environments. All reviewed projects concluded that DLT is, at least to some extent, feasible as the basis for a large-value payment system (LVPS) infrastructure, but there were some views warning against this technologys immaturity and lack of interoperability. Very few projects have explicitly and rigorously assessed risks against international standards for large-value payments and securities settlement systems. Almost none of the projects involved a cost-benefit analysis, and no conclusions could be reached on whether DLT-based or improved legacy systems could be the more efficient alternative in the future. Liquidity, credit, trans- action delay, settlement finality, counterparty, and operational risks could also change in varying degrees in a new environment. Key issues include major changes to the current payments, clearing, and settlements arrangements, which could have a strong impact on users, participants, and markets. The evolution toward new infrastructures would require stakeholder consultations, a review of system rules, market conventions, transaction reconciliation practices for synchronized distributed ledgers, and an analysis of the impact on continuous operations (based on 24/7/365). Second, further work would benefit from a more explicit and rigorous analysis of potential risks against the inter- national standards for financial market infrastructures and against the analytical framework for DLT introduction in payment, clearing, and settlement. Further, international standards may warrant new interpretations with respect to the evolving new types of risks. Third, investment and operational costs would need to be determined and included in a transparent cost-recovery pricing policy as part of any cost-benefit analysis before actual implementa- tion. And fourth, interoperability issues would need to be addressed to avoid fragmentation risk. 1 This note draws on IMF (2019a), which was prepared in the context of the Bali Fintech Agenda. EXECUTIVE SUMMARY1 International Monetary Fund | June 2020 Introduction Major transformations in payments and settlements have occurred in generations. The first generation was paper-based. Delivery times for payment instruments took several days domestically and weeks internation- ally. The second generation involved computerization with batch processing. Links between payment systems were made through manual or file-based interfaces. The changeover period between technologies was long. Some paper-based instruments like checks and cash remain in use. The third generation, which has been emerging, involves electronic and mobile payment programs that enable integrated, immediate, and end-to-end payment and settlement transfers. For example, real-time gross settlement (RTGS) systems have been available in almost all countries. Distrib- uted ledger technology (DLT) has been viewed as a potential platform for the next generation of payment systems, enhancing the integration and the reconcilia- tion of settlement accounts and their ledgers. This is in addition to other technological developments (Box1). Research in using DLT for payments and settle- ments has provided insights on their potential benefits, risks, limitations, and implementation challenges. Large-value interbank payment projects have been completed in Brazil, Canada, the Euro Area/Japan, Singapore, South Africa, and Thailand. Securities settlement projects have been investigated in Australia, Canada, the Euro Area/Japan, Germany, Singapore, and the United States. Central banks and the pri- vate sector have also analyzed the improvement of cross-border payments through DLT. This note takes stock of DLT experiments and research in payments and settlement systems. 1 DLT and its protocols are described, and the experiments and research projects are summarized. Emerging risk management issues, implications for international stan- dards, and potential implications for the international monetary system are discussed. The note aims to pro- 1 AnnexI includes a list of the experiments and research projects. The stock-taking exercise is based on the availability of public information. Retail payment applications are not in the scope of this note. vide a balanced view with considerations for practical implementation and probable long-term applications and benefits for payment system developments. Distributed Ledger Technology DLT enables entities to carry out transactions in payment and settlement systems without necessarily relying on a central authority to maintain a single ledger. 2 DLT networks could be open or closed (per- missioned) depending on their participation policies. Various DLT protocols have been used so far in exper- iments in payments and securities settlement arrange- ments. 3 A validation protocol defines how transactions are validated and included in the overall transaction history. The main objectives of the transaction history are to prevent double spending and reconcile the distributed parts of the ledger. Decentralized infor- mation could easily be copied and reused without a double-spending-prevention mechanism. The main differences between DLT protocols are in the construction of the consensus mechanism. 4 That is, how validation is done and by what kind of validators (for example, institutions, private or public entity, indi- viduals, and so on). When there is more than one val- idating participant, these need to reach consensus on the transaction history. Another key difference is in the transparency of the transaction history, which affects the possibility for auditing the transaction history. Early DLT setups were token-based and specialized for maintaining accounts of funds, but later gen- erations enabled smart contract solutions and new applications. 5 The latter can be used for maintaining different kinds of distributed registers in addition to 2 See CPMI (2017). DLT refers to the processes and related technologies that enable nodes in a network (or arrangement) to securely propose, validate, and record state changes (or updates) to a synchronized ledger that is distributed across the networks nodes. 3 Annex II includes a list of DLT protocols. 4 See CPMI (2017) for a description of cryptographic tools and consensus mechanisms that determine how a ledger distributed across multiple nodes could have varying roles and permissions. 5 Smart contract is a computer protocol that allows the program- ming of logic or conditionality into an asset or transaction, usually associated with DLT applications. DISTRIBUTED LEDGER TECHNOLOGY EXPERIMENTS IN PAYMENTS AND SETTLEMENTS2 MONETARY AND CAPITAL MARKETS DEPARTMENT FINTECH NOTES International Monetary Fund | June 2020 accounts. For example, securities can be viewed as asset accounts of tokens or a register of smart contracts transferring ownership titles to individual shares and bonds. All proof-of-concept tests from central bank-led initiatives indicate that only permissioned DLT net- works are suitable for financial market infrastructures (FMIs), considering compliance and other regulatory requirements (access, know your customer, and so on). These protocols have different features. Additionally, ongoing projects are seeking continuous improvement protocols while additional research remains to establish a stable and sustainable protocol. Experiments and Research Many central banks have oversight and operational responsibilities in payment and settlement systems and have taken a keen interest in DLT experiments, which provide an opportunity to test prototypes while analyzing their potential safety and efficiency implica- tions with public interest in mind. Likewise, industry groups and participants have also used experimen- tations to explore market opportunities and address shortcomings in the current payments and settlement systems landscape. Large-value Payment Systems Prototypes confirmed the feasibility of using DLT as a transaction booking method. The proof-of-work design and the completely transparent transaction database used in Bitcoin-type protocol were deemed unsuitable for large-value payments because of process- ing capacity needs and lack of privacy. All prototypes were based on DLT consensus protocols using less processing resources and providing more privacy. This required more trust in the validator nodes, which is not a problem in a system maintained by the central bank or other trusted authorities. Prototypes, however, have insufficiently focused on the necessary criteria for operational production, including throughput, 6 reliability, and resiliency. Therefore, they could not be viewed as sufficient proof for production feasibility. Almost all prototypes were stand-alone type built as an add-on payment process- ing layer upon or in parallel with the existing LVPS. Real-time interfaces with central banks or financial institutions internal payment systems were not tested except for one prototype (in Singapore), which had a direct operation link with the current RTGS system. 6 Throughput refers to intraday deadlines by which banks need to send a proportion of the value of their days payments to a payment system. The key factors driving the evolution of the pay- ments system landscape have included: Rapidly rising information technology processing power and storage capacity at low investment cost (for example, through cloud computing) and capac- ity to process big data sets, and real-time access to all systems and applications on a 24/7/365 basis, with immediate transaction-based processing. Sig- nificant advances in artificial intelligence underpin these developments. Greatly increased communication capacity and con- nectivity at very low costs directly point-to-point within networks. Low-cost user-interface hardware and software platforms (for example, mobile phones, personal computers, tablets, and so on) for secure interfaces and for connecting to automated devices. Advances in application programming interfaces between different system components across service providers resulting in modular structures of large systems. Enhanced common processing platforms, operative systems, open source, freeware and shareware, free libraries of apps, and widely used complex financial software applications or external software services that will facilitate the rapid development of new payment features within all kind of systems. Widespread use of encryption, digital identity, and e-signature services for safeguarding data and funds, recognizing business partners remotely and verifying transactions transferred over common and open telecommunication connections. Box 1. The Evolving Payments System Landscape3 DISTRIbuTED L