This article relates to Shearman & Sterling's upcoming inaugural Digital Finance Summit on November 15-16. Learn more about the Summit.
Banks engage in maturity transformation, meaning they borrow short-term and lend long-term. To manage the attendant risk - that a bank's assets cannot be liquidated quickly enough to meet a sudden demand for repayment by depositors - there is a raft of regulation of banks' capital and liquidity, which is costly for the banks. This distorts incentives and leads to the displacement of what is essentially banking activity to non-banks.
Technology could help to address more accurately some of the risks that arise for the banks, removing some of these distortions and rendering the system safer.
The digital balance sheet
The use of blockchain technology, which allows for simultaneous access, validation, and updating of records across a network spread across multiple entities or locations, could allow for greater transparency, with the result that both the market and the regulators can be more certain of the level of risk which a bank is carrying. This could be effected through the introduction of a "digital balance sheet", assembled using digital ledger technology embedded in the instruments representing a bank's exposures, and allowing for real-time insight into the level of those exposures. This would in turn permit a greater reliance upon market discipline by the regulators, resulting in a reduced need for some of the existing capital and liquidity requirements imposed on banks.
More significant cost reductions could be realised through the use of properly backed digital currencies. The two principal examples are a central bank digital currency (CBDC) and stablecoins backed by fiat deposits or other assets such as Treasuries or Gilts. In both cases, the availability of alternative ways for banks to hold monies on behalf of clients will mean there should be less of a need for extensive capital regulation in its current form.
CBDCs – what benefits?
Controversies surrounding retail uses for CBDC mean that we should focus for now on the benefits to be obtained in the wholesale sector. This is where the largest transaction values arise. The potential benefits of CBDCs include simplifying back-office processes, saving costs and potentially reducing risks within the financial system. Currently, certain payments are implemented on an end-of-day basis, which leads to each party carrying the risk of the other’s default during that day (from the moment of agreement onwards). CBDCs can facilitate cheaper and safer settlements, allowing for instantaneous payment.
However, the issue is this: while cash is fungible, CBDC tokens are not, which means that the owners of the tokens can expect to retain a beneficial interest in their monies and for this to be safeguarded and not on-lent without their consent. When wholesale customers do consent to having their money lent out, they may expect to receive payment for its use – i.e. a share of the fees obtained from the borrower(s). This will change the bank model.
Wholesale CBDCs would allow banks to act as custodians for the CBDC interests, removing or reducing the need for maturity transformation with wholesale monies. Furthermore, banks could, in the future, conduct identity verification and provide assurance as to identity and, potentially, creditworthiness of customers (at least, based on assets held with them). This would lower "know your customer (KYC)" verification costs within the system and also make the system more responsive to the real (rather than feared) implications of a market downturn.
Stablecoins and stability
A similar change to the banking model might be achieved by permitting the use of stablecoins, which are cryptocurrencies whose price is designed to be pegged to a reference asset. For present purposes, they would be backed by deposits in a fiat currency (e.g. USD or GBP), or by appropriately managed portfolios of fixed income assets (which would generally be sovereign bonds, issued by a state in control of its own central bank) denominated in the corresponding fiat currency. For banks holding the fiat currency underpinning the stablecoin, additional profits could be made by ensuring that underlying deposits and other stable investments are in place and appropriately managed.
If banks held the CBDC or stablecoin for customers as ring-fenced assets, this would allow for the recalibration of bank capital and liquidity requirements. The wholesale markets could shift some of their cash balances to CBDC or stablecoin, augmenting the transition away from the existing, expensive, regulatory system.
The technology treasure trove
An abundance of other opportunities, grounded in blockchain technology, could arise if we allow ourselves to reconsider the current approach to regulating risk in the financial markets. Some of these benefits are as follows.
Given the fact that blockchain technology allows for atomic settlement, i.e. the instant exchange of two assets that are linked, such that the transfer of one occurs only upon transfer of the other one, many of the extensive practical, legal and regulatory arrangements to address settlement risk can be reduced or dropped, saving on cost and reducing risk in the system as a whole.
Crypto products lend themselves to reverse solicitation models, whereby customers in certain jurisdictions are allowed to reach out from under the blanket of financial regulation in those jurisdictions, and opt instead to be protected solely by the regulations of the state which hosts the seller of the financial product or service. This would allow regulated entities to operate with less regulatory risk and far more cheaply, under a single set of safely managed laws and regulations.
The use of CBDCs and stablecoin may lead to potential improvements to traceability of customer assets, allowing clients to verify, in real-time, that their assets exist and are designated as their own, reducing fraud-related risks.
Building on portability concepts already in use, clients could become better equipped to retrieve their assets and transfer them easily to another provider, since they will now be simple to identify.
The technology might be leveraged to tackle environmental risk more accurately, by linking assets to specific uses and liabilities.
Overall, blockchain technology allows for the reduction of risk, providing the launchpad for a re-evaluation of the existing, costly regulation of banks. The opportunity should now be seized to explore the benefits it brings to the financial system as a whole.