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For release on delivery
1:15 p.m. EDT
April 14, 2016

The Use of Distributed Ledger Technologies in Payment, Clearing, and Settlement

Remarks by
Lael Brainard
Member
Board of Governors of the Federal Reserve System
at
Institute of International Finance Blockchain Roundtable
Washington, D.C.

April 14, 2016

Innovation in digital finance, loosely referred to as fintech, is capturing
imaginations from Silicon Valley to Chicago to Wall Street. We’re seeing a steady
stream of announcements of new startups and partnerships, and consumers are
downloading fintech apps at an even faster pace.
Financial products, services, and transactions lend themselves to successive
waves of technological disruption because they can readily be represented as streams of
numerical information ripe for digitization. However, as technological tools used by the
industry change over time, it is important to keep sight of their impact on the public,
whether it be on families seeking to own their own home, seniors seeking financial
security, young adults seeking to invest in education and training, or small businesses
attempting to smooth through volatile revenues and expenses.
Current developments in the digitization of finance are important and deserving of
serious and sustained engagement on the part of policymakers and regulators. The
Federal Reserve Board has established a multi-disciplinary working group that is engaged
in a 360-degree analysis of fintech innovation. We are bringing together the best
thinking across the Federal Reserve System, spanning key areas of responsibility, from
supervision to community development, from financial stability to payments. As
policymakers, we want to facilitate innovation where it has the potential to yield public
benefit, while ensuring that risks are thoroughly understood and managed. That
orientation may have different implications in the arena of consumer and small business
finance, for instance, as compared with payment, clearing, and settlement in the
wholesale financial markets.

-2Technological and Organizational Changes in Payment, Clearing, and Settlement
Today, I will focus on newly emerging distributed ledger technologies and related
protocols, which were inspired originally by Bitcoin, and their potentially important
applications to payment, clearing, and settlement in the wholesale markets.
Successive waves of technological advance have swept through payment,
clearing, and settlement over the past two centuries. In the 19th century, railroads and the
telegraph helped improve speed and logistics. In the second half of the 20th century,
computers were introduced to deal with the clearing of overwhelming volumes of paper
checks and stock certificates stimulated by post-war growth. Starting at about the same
time and continuing through today, new electronic networks have been established to
allow high-speed computerized financial communication. As automation has evolved,
payment, clearing, and settlement systems have been developed for conducting and
processing transactions within and between firms. However, many of these systems have
historically operated in silos, which can be hard to streamline or replace. In some areas,
business processes may still rely heavily on manual or semi-automated procedures.
Over time, banks and other firms have organized various types of clearinghouses
to coordinate clearing and settlement activities in order to reduce costs and risks. The
adoption of multilateral clearing in the United States was a key organizational innovation
that began with the founding of the New York Clearing House in the 1850s. This led to
notable efficiencies and risk reduction in the clearing of checks. Multilateral clearing
was also used early on to improve clearing in the securities and derivatives markets. By
the 1970s, the United States turned to technologies based on the centralized custody and
clearing of book-entry securities in order to respond to the paperwork crisis in the

-3equities markets. Following the recent financial crisis, the United States--along with
many other countries--expanded the scope of central clearing to help address problems in
the bilateral clearing of derivatives contracts.
Today, the possible development and application of distributed ledger technology
has raised questions about potentially far reaching changes to multilateral clearinghouses
and the roles of financial institutions as intermediaries in trading, clearing, and settlement
for their clients. In the extreme, distributed ledger technologies are seen as enabling a
much larger universe of financial actors to transact directly with other financial actors
and to exchange assets versus funds (that is, to “clear” and settle the underlying
transactions) virtually instantaneously without the help of intermediaries both within and
across borders. This dramatic reduction in frictions would be facilitated by distributed
ledgers shared across various networks of financial actors that would keep a complete
and accurate record of all transactions, and meet appropriate goals for transparency,
privacy, and security.
At this stage, such a sea-change may sound like a remote possibility, particularly
for the high volume and highly regulated clearing and settlement functions of the
wholesale financial markets. But profound disruptions are not unprecedented in this
arena. In the early 1960s, the use of computerized book-entry securities systems to
streamline custody, clearing, and settlement in the securities markets may have seemed
like a technologist’s pipe dream. But these technologies became an important part of
industry-wide changes in the 1970s. Today we rely on these types of systems for the
daily operation of the markets.

-4Given this backdrop, it is important to give promising technologies the serious
consideration they merit, seek to understand their opportunities and risks, and actively
engage in dialogue about their potential uses and evolution. At the Federal Reserve, we
approach these issues from the perspective of policymakers safeguarding the public
interest in safe and sound core banking institutions, financial stability, particularly as it
pertains to the wholesale financial markets, and the security and efficiency of the
payment system.
Distributed ledger technology was introduced for the transfer and record-keeping
of Bitcoin and other digital currencies. The essential advantage of the technology is that
it provides a credible way to transfer an asset without the need for trust in intermediaries
or counterparties, much like a physical cash transaction. To do that, a transfer process
must be able to credibly confirm that a sender of an asset is the owner and has enough of
the asset to make the transfer to the receiver. This requires a secure system or protocol to
transfer assets (the rails), protection against assets being transferred twice (the so-called
double spend problem), and an immutable record of asset ownership that can be
automatically and securely updated (the ledger). The tokenization of digital assets can
facilitate the transfer process.
The genuinely innovative aspect of the technology combines a number of
different core elements that support the transfer process and recordkeeping:
o Peer-to-peer networking and distributed data storage provide multiple copies
of a single ledger across participants in the system so that all participants have
a shared history of all transactions in the system.

-5o Cryptography, in the form of hashes and digital signatures, provides a secure
way to initiate a transaction that helps verify ownership and the availability of
the asset for transfer.
o Consensus algorithms provide a process for transactions to be confirmed and
added to the single ledger.
While Bitcoin was originally associated with the concept of a universally available,
publicly shared digital ledger technology without any central authority, many of the use
cases that are currently under development and discussion rely on “permissioned” ledgers
in which only permitted, known participants can validate transactions. These in turn can
be either public or private in terms of access to the ledger.
The resulting Internet of Value holds out the promise of addressing important
frictions and reducing intermediation steps in the clearing and settlement process. For
example, in cross-border payments, faster processing and reduced costs relative to current
correspondent banking are cited as specific potential benefits. Reducing intermediation
steps in cross-border payments may help reduce costs and counterparty risks and may
additionally improve financial transparency.
In securities clearing and settlement, the potential shift to one master record
shared among participants has some appeal. Having one immutable record may have the
potential to reduce or even eliminate the need for reconciliation by avoiding duplicative
records that have different details related to a transaction that is being cleared and settled.
This also can lead to greater transparency, reduced costs, and faster securities settlement.
Likewise, digital ledgers may improve collateral management by improving the tracking
of ownership and transactions.

-6For derivatives, there is interest in the potential for digital ledger protocols to
enable self-execution and possibly self-enforcement of contractual clauses, in the context
of “smart contracts.”
As we engage with industry and stakeholders to assess the potential applications
of digital ledger and related technologies in the payment, clearing, and settlement arena,
we will be guided by the principles of efficiency, safety and integrity, and financial
stability.
Efficiency
Many are excited about the potential for these new technologies to reduce costs
and frictions, such as those associated with collateral management and custodial services,
reduce settlement risk, enhance security, increase transparency, and offer new services.
But there are also concerns about the costs and risks from the early adoption of rapidly
evolving and uncertain technologies and technological hurdles in integrating new
technologies into legacy systems and achieving interoperability across different ledgers
and networks. There are questions about the need for substantial new investments to
obtain capabilities like real-time processing where these capabilities already exist at some
of the industry’s core infrastructures. There are also cautions that realizing the full
potential of distributed ledger technologies could take many years.
Much of the case for adopting distributed ledger technologies revolves around
achieving greater efficiency and reducing time and risks to post-trade clearing and
settlement. But first, important technological challenges will need to be addressed to
permit widespread adoption and migration away from legacy systems and networks.
These include the need for standardization, the development of protocols that will permit

-7interoperability between other ledgers and networks, and the reduction of computational
intensity and costs.
Moreover, distributed ledgers will have to compete with other options and
priorities of financial firms and clearinghouses in a highly regulated financial ecosystem.
Thus, a major threshold question for the adoption of distributed ledger technology within
and between groups of firms engaging in particular types of transactions is whether the
advantages outweigh the costs of replacing legacy systems.
In some cases, where distributed ledger technology can be employed internally
within a firm to automate and speed up business processes, traditional business case
analysis would presumably lead to efficient technology choices. By contrast, where
coordinated industry-level decisions would be needed to develop distributed ledgers
shared by multiple firms, the case must be compelling for entire networks of market
participants that will need to make the investments, as well as for the broader public
interest.
This set of competing considerations suggests there are likely to be a spectrum of
cases. At one end are the high-volume, heavily regulated markets that have made large
investments in central clearing to provide safe and efficient clearing and settlement for
the industry and the public. These markets must always actively consider technological
and other enhancements to strengthen efficiency and safety. But as a practical matter, the
large-scale adoption of wholly new clearing technologies to replace existing legacy
technologies for major markets may face a significant hurdle initially, such that
incremental change or delayed adoption until the technology has achieved greater
maturity and standardization may be more likely.

-8At the other end of the spectrum, there appear to be some markets or segments
where clearing practices are relatively cumbersome and outmoded, and the network
hurdles to the adoption of new technologies are lower. Improvements in smaller markets
would also provide an opportunity for market participants to gain operational and
business experience with distributed ledger technologies that could help inform and
strengthen the case for broader applications over time.
A middle case would involve the application of distributed ledger technologies to
bilateral clearing even where improvements have already been made since the financial
crisis. A threshold issue will be the design and safety of new technologies and whether
firms will want to share a distributed ledger to manage transactions with their different
counterparties and customers. No doubt much will depend not only on cost but also on a
host of business, technical, security, and other issues. Even so, change might hold
promise for improving bilateral clearing, and might also help us think about the long-run
trade-offs between bilateral and central clearing.
An assessment of the longer-term potential for deployment of distributed ledger
technology naturally raises questions about whether it might ultimately impact the
organizational structure for clearing and settlement. As multilateral clearing
organizations have strengthened and spread across many of the major asset classes traded
in the markets, they have enabled coordinated action on governance, rules, technology,
and risk management. It is possible that new technologies could substantially change the
way these functions are pursued, but it would be surprising if they would obviate the need
for multilateral clearing in the major markets. Governance, in particular, is a core
function that is inescapably necessary if multilateral activity, even activity dealing with

-9distributed ledgers, is to operate effectively. Indeed, if new technologies could lower the
costs of multilateral clearing relative to bilateral clearing in new market segments,
multilateral clearing could even grow.
Today’s clearing houses will likely continue to play a central role in highly
regulated markets and be well positioned to evaluate and implement new clearing
technologies, while continuing to provide core governance functions in the market.
Nonetheless, it is also possible that if distributed ledgers ultimately cross asset classes
and even industries, traditional clearinghouses serving specific market segments might
have to evolve or new organizations might develop to provide an optimal approach to
implementation. Moreover, in principle, the use of distributed ledgers in new market
segments may call for new clearing arrangements more in tune with new technologies.
Similarly, organizations that can provide governance or other coordinating functions in
bilaterally cleared markets may also require organizational structures somewhat different
from traditional clearinghouses. We will be following these issues with interest.
Safety, Integrity, and Financial Stability
Safety and integrity in clearing and settlement is a critical, long-standing public
policy objective of the Federal Reserve, and is critical for broader financial stability.
Regardless of the technologies employed, if risks to clearing and settlement are not
identified and addressed, then banks, dealers, and other firms will not be able to manage
their obligations and market functioning may be impaired. This is a key reason why
major clearing and settlement systems are highly regulated. Hence, the fundamental
threshold test for new technologies will be whether they can be deployed and operated
safely, with the requisite high degree of operational and financial integrity, security, and

- 10 resilience across a wide range of adverse scenarios. Regulators and the public need to
know that if adverse scenarios do occur, there will be robust management and governance
to respond effectively.
Digital ledger technologies will need to be able to address the range of issues
revolving around the confidentiality and security of firm and client records and data on
the one hand, as well as law enforcement requirements and issues on the other. New
technologies must be robust in practice, not just in theory, to attacks on security, and
must be able to maintain appropriate confidentiality for records and data.
In addition, it will be important that digital ledger technologies can meet the
requirements of law enforcement and other regulators to address money laundering,
terrorist financing, and other key law enforcement concerns. Indeed, there is some
potential that the new technologies could enable improved authorized access to certain
data records in a much more efficient and comprehensive manner than has previously
been possible, thereby potentially reducing costs associated with complying with the
Bank Secrecy Act.
Overall we should be optimistic that a range of new technologies hold the promise
of providing more robust security, resilience, and information. We cannot afford to
assume that change necessarily equals greater risk. Of course, much will depend on the
technology itself, its scalability, its level of maturity, the controls and environment
surrounding it, the standardization and accessibility of transactions data, the quality of
management and governance, and the policy environment in which it is deployed.

- 11 Key Challenges Going Forward
Today, many industry participants are experimenting with distributed ledger
technology in controlled, permissioned environments. If some of these experiments bear
fruit, it will be important to address the challenge of how they would scale and achieve
diffusion. In addition, determining exactly how the different distributed ledger
technologies interoperate with each other, and legacy systems, will be critical. New and
highly fragmented “shared systems” may create unintended consequences even as they
aim to address problems created by today’s siloed operations. Since distributed ledgers
often involve shared databases, it will also be important to effectively manage access
rights as information flows back and forth through shared systems. There may well be a
tradeoff between the privacy of trading partners and competitors on the one hand, and the
ability to leverage shared transactions records for faster and cheaper settlement on the
other hand. And of course, development of sound risk-management, resiliency, and
recovery procedures will be necessary to address operational risks. The Federal Reserve
will continue to engage actively with the industry, stakeholders, and our regulatory
colleagues as the industry works through these challenges and the technology evolves.
I want to close by remembering a simple point that central bankers and markets
have learned through hard lessons over many years. 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. Any disruption to this
confidence comes at great cost to market integrity and financial stability. This is a matter

- 12 of fundamental public interest. In safeguarding the public interest, the first line of inquiry
and protection will always rest with those closest to the technology innovations and to the
organizations that consider adopting the technology. But regulators also should seek to
analyze the implications of technology developments through constructive and timely
engagement. We should be attentive to the potential benefits of these new technologies,
and prepared to make the necessary regulatory adjustments if their safety and integrity is
proven and their potential benefits found to be in the public interest.