View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

For release on delivery
4:00 p.m. EDT
October 7, 2016

Distributed Ledger Technology: Implications for Payments, Clearing, and Settlement

Remarks by
Lael Brainard
Board of Governors of the Federal Reserve System
Institute of International Finance Annual Meeting Panel on Blockchain
Washington, D.C.

October 7, 2016

We recognize the potential of distributed ledger technology, or blockchain, to
transform the way financial market participants transfer, store, and maintain ownership
records of digitized assets. The genuinely innovative aspect of distributed ledger
technology combines a number of core elements that can be used to support the transfer
process and distributed recordkeeping for digital assets and digital representations of
assets. These elements include peer-to-peer networking and distributed data records,
which provide broadly shared access to a single ledger across participants in the system,
so that all participants maintain a shared, accurate history of all transactions in the
system. In addition, cryptography provides a secure way to initiate a valid transaction as
well as to securely transmit and store data. And consensus algorithms provide a process
for transactions to be confirmed and added to the single ledger, which is an important
feature when more than one participant has permission to propose updates to the ledger.
We are paying close attention to distributed ledger technology, or blockchain,
recognizing this may represent the most significant development in many years in
payments, clearing, and settlement. 1
The Federal Reserve Board has established a working group that is engaged in a
360-degree analysis of financial innovation across the broad range of our responsibilities,
drawing on engagement with industry stakeholders and on expertise from across the
Federal Reserve System, including in supervision, consumer protection, financial stability
and information technology. One important area of oversight is the payments system,
where technology changes are viewed through the prism of our responsibilities for


See Also, see the
forthcoming Feds working paper, “Staff Study on Distributed Ledger Technology in Payments, Clearing,
and Settlement,” 2016.

-2promoting the safety and efficiency of the payments and settlements systems; supervising
financial institutions engaged in payments, clearing and settlement; and safeguarding
financial stability. We want to maintain public confidence in the payments system, while
supporting innovation that provides broadly shared benefits to the public over time,
including through the reduction of unnecessary frictions, costs, and delays.
Illustrative Use Cases
Let me briefly mention a few of the use cases that we have explored in our
discussions with industry stakeholders in order to illustrate the potential of distributed
ledger technologies to improve payments, clearing, and settlement, as well as the
considerations that are important to us in our assessment of benefits and risks.
In cross-border payments and trade finance, significantly faster processing and
reduced costs relative to the long and opaque intermediation chains associated with
current methods of correspondent banking are promising potential benefits of the
technology. Reducing intermediation steps in cross-border payments may help decrease
time, costs, and counterparty risks and may materially diminish opacity, for instance by
enabling small businesses or households remitting payments across borders to see the
associated transfer costs and processing times up front. In trade finance, where
document-intensive processes are not fully automated, distributed ledger technology may
be able to reduce significant costs and speed up processing associated with issuing and
tracking letters of credit and associated documents. To see the full potential of this
technology realized for cross-border payments, it will be important to identify and track
identities associated with the transactions, which in itself may be facilitated by the use of
distributed ledgers, depending on their design.

-3In securities markets, the industry is exploring activities ranging from the issuance
of securities on a distributed ledger, to the clearing and settlement of trades, to tracking
and administering corporate actions. For securities clearing and settlement in particular,
the potential shift to one master record shared “simultaneously” among users of a
distributed ledger-based system could be compelling. Sharing one immutable record may
have the potential to reduce or even eliminate the need for the reconciliation of multiple
records linked to a single trade among and between dealers and other organizations. In
concept, such technology could lead to greater transparency, reduced costs, and faster
settlement. Likewise, distributed ledgers may improve collateral management by
improving the tracking of ownership and transactions. Nonetheless, as is frequently true
in the complex arena of payments, clearing, and settlement, we can also expect that
practical details covering a host of technical, business, and market issues will have an
important role in determining how new technologies ultimately perform.
For commodities and derivatives, there are projects to streamline some of the
more antiquated corners of the markets. In markets that are heavily paper-based and lack
any central means for coordination, distributed ledger technology could potentially be
leveraged to provide coordination that facilitates exchange, clearing, and settlement of
A related development is the potential coupling of distributed ledger protocols
with self-execution and possibly self-enforcement of contractual clauses, using so-called
“smart contracts.” To take a familiar example, for a corporate bond with a specified par
value, tenor, and coupon payment stream, a smart contract would automatically execute
payments on the specified schedule to the assigned owner over the life of the bond.

-4Although the idea of automating certain aspects of contracts is not new, and banks do
some of this today, the potential introduction of smart contracts does raise several issues
for consideration. For example, what is the legal status of a smart contract, which is
written in code? Would consumers and businesses rely on smart contracts to perform
certain services traditionally done by their banks or other intermediaries? Could the
widespread automated interaction of multiple counterparties lead to any unwanted
dynamics for financial markets? These and other considerations will be important factors
in determining the extent of the application of smart contracts.
Regardless of the application, much of the industry is at a “proof of concept”
stage of development. These proofs of concept are often simple, experimental uses of the
technology on a small scale that help stakeholders understand the potential and
limitations of the technology for a specific purpose, which in turn typically lead to
refinements and more developed proofs of concept. As such, many potential applications
are in their infancy, and the industry may still be several years away from an application
that is ready to be fully implemented. Even so, the industry seems to be making
announcements daily on new proofs of concept and progress that may lead to pilots, so
that timeline could accelerate. In some cases, there have been announcements the
technology will be used within the next year or two in actual production environments.
The initial relatively simple proofs of concept must be followed by much more complex
demonstrations in real-world situations before these technologies can be safely deployed
in today’s highly interconnected, synchronized, and far-reaching financial markets.
Although many private and inward-facing projects are being explored, the
industry has also recognized the need to collaborate at early stages of development. An

-5important positive development is that industry participants are actively engaging with
each other to look for common approaches. Some groups are creating standards that
facilitate common platforms to enable greater interoperability of often proprietary
applications that are built on them and interoperate through application program
interfaces, or APIs.
In coming months and years, innovators, investors, and financial practitioners will
no doubt make important strides in addressing key challenges such as adopting common
standards, achieving interoperability between and among legacy systems and evolving
distributed ledgers, improving scalability and computational throughput, and improving
cryptographic security. These are positive developments that we will monitor closely.
Managing Risks
All of this activity demonstrates that we are in a very innovative period. The
industry is eager to get on with adopting the various possibilities that distributed ledger
technology may bring. However, established players and, increasingly, new entrants
understand that there are important guardrails that have been carefully developed over
many years in the arena of payments, clearing, and settlement. The safety and soundness
of financial institutions, safety and efficiency of the payment system, and broader
financial stability are critical to a healthy financial environment that fosters innovation
with broad public benefits over the long run. We expect the private sector to bear
important responsibility for developing and deploying new financial technologies in a
safe and sound manner, even as we all seek an innovative and efficient payment system
over the long run. The deployment of any new financial technology must be undertaken
with a thorough understanding and management of risks.

-6Like many new financial technologies, distributed ledgers could ameliorate or
exacerbate traditional financial risks. What matters to us as policymakers and regulators
is not only whether the migration to a new technological platform increases or reduces
risks, but also whether risks are rendered more or less opaque, and how they are
distributed among and between financial intermediaries and end users. In the payments,
clearing, and settlement arena, some important risk areas for consideration include
settlement, operations, and cybersecurity, as well as money laundering and terrorist
financing. In managing risks, important considerations include system resiliency and
governance as well as the role of licensing in ensuring proper oversight.
In securities settlements, for example, a difference in timing between the delivery
of securities and the delivery of funds introduces settlement risk between counterparties
and other institutions involved in this process. To the extent that distributed ledger
technologies are designed to supplant the traditional reliance on trusted intermediaries to
ensure settlement, they will need to reliably demonstrate their ability to mitigate or even
eliminate settlement risk, especially in cases where the delivery of the securities and the
associated payment take place on different platforms.
Traditional payment, clearing, and settlement are subject to operational risk, and it
is critically important that new technologies operate reliably, securely, and with integrity.
The daily operation of markets and their clearing and settlement functions are built on
trust and confidence. Market participants trust that clearing and settlement functions and
institutions will work properly every day. Confidence has built over time that when
market participants trade, accurate and timely clearing and settlement will follow.

-7Thus, robust security is an important element of any system. The distributed
nature of this new technology, combined with the fact that many connected participants
can update the shared ledger, means that end-point security is another critical component
of any successful implementation of the technology. Adverse actors that can take over a
participant’s access to the ledger remains a key security concern, as thefts of
cryptographic keys in Bitcoin continue to demonstrate. Thus, advances in cryptography
will remain a key priority to enable widespread adoption of distributed ledger
technologies, along with systems for securing private keys, the management of access to
private keys, and differentiated permissions for participants in the system to read and
write to the ledger. Recent episodes have illustrated the importance of having protocols
agreed at the outset to determine whether and under what circumstances to reverse
transactions once they have been recorded in a distributed master ledger.
Finally, it will be important that users and administrators of distributed ledger
technologies can meet their responsibilities to combat money laundering, terrorist
financing, and other key law enforcement concerns. Some of the new technologies
would potentially allow authorized access to certain data records in a much more efficient
manner than has previously been possible. For example, distributed ledgers could be
developed to collect personally identifiable information and country identifiers that
enable banks to identify and report on suspicious activity. It will be important that these
new technological developments and their implementation perform in a safe and sound
manner that is transparent and satisfies regulatory requirements.

-8While prevention will remain the preferred approach, realistically, resiliency and
recovery will also need to be high-priorities. Indeed, many firms have suggested that the
distributed data storage concept has the potential to increase the level of resiliency and
data integrity. The basic idea is it should be harder to corrupt multiple copies of the same
data simultaneously such that digital ledgers could reduce the vulnerability associated
with a single point of failure. We must press firms and experts to identify the strengths
and vulnerabilities of this concept, even as we all look for ways to make databases more
secure and resilient. In an interesting development, some financial institutions have also
begun to consider using distributed ledgers to back up critical databases and enable quick
recovery from potentially virulent cyberattacks. We will be interested in whether such
techniques can make new contributions to cybersecurity.
Overall, the public needs to have confidence that any system employing
distributed ledgers will operate properly, particularly in stressed conditions, and know
that when adverse scenarios do occur, there will be robust management and governance
to respond effectively. Recent events, such as thefts from accounts on distributed ledger
platforms, highlight the challenge that distributed ledgers may have when adverse
scenarios occur and there is uncertainty around what an appropriate response would be.
Such uncertainty around management and governance can raise doubts about the integrity
of a system employing distributed ledgers.
Traditionally, financial regulators in the United States have been given licensing
authority as a key way of ensuring that responsibility for managing risks is transparently
assigned with appropriate oversight. The development of new business models
associated with evolving financial technologies has raised questions about the

-9applicability of existing licenses and their adequacy to new business models. For
instance, the Monetary Authority of Singapore recently issued a consultation paper that
proposes an activity-based payments framework as a way to address the introduction of
non-traditional payment providers. 2 The United States has seen several noteworthy
recent developments, including the New York State Department of Financial Services’
BitLicense, a distributed ledger company, securing Federal Reserve Bank of New York
approval for participation in the National Settlement Service, and, most recently,
discussion by the OCC of a limited-purpose charter.
Ongoing Engagement
Because of the notable potential of distributed ledger technology, financial
authorities, both domestic and international, will follow these developments with keen
interest. At the Federal Reserve, we expect to publish a research paper later this year that
summarizes some of the key findings from our industry engagement so far. Going
forward, we will continue to deepen our engagement with a range of financial
institutions, technologists, multi-stakeholder consortia, and academic experts to refine our
understanding of the new technologies, along with their possibilities and limitations, with
a particular focus on our responsibilities for the payments system, as well as our
oversight of financial market intermediaries. We will also continue to discuss these
issues with other central banks and authorities around the world. We will work together
to foster socially beneficial innovation, while insisting that risks are thoroughly
understood, managed, and controlled.