There has been a buzz about blockchain and there have always been many debates about the potential of the blockchain technology in regards to improving the payments globally – particularly international payments.
To make way for the payments, perform currency conversions, and deploy and manage liquidity in different jurisdictions, all subject to heterogeneous regulatory constraints, need a consensus of various parties in this business.
There are many ways that blockchain can tackle issues. One of the issue that blockchain can settle is the complexity of payments network which is due to the fragmentation of the financial industry itself, which makes no sense to the individual banks to deal directly with all other banks on the planet.
Example: When a bank gets payment instruction from the client, they need to find a correspondent bank that is ready for the funds of the client and conclude the payment locally at the receiving bank. To do this, the correspondent banks need to have a nostro or a Vostro account with the receiving bank, ideally with enough pre-funded liquidity to complete the payment on the client’s behalf.
When something like this happens, the receiving bank has no idea how to verify that the incoming transfer from the (last) correspondent bank, in fact, corresponds to the original client sending the money. This is the reason why a SWIFT message from the sender is needed so that the receiving bank understands the purpose of the incoming funds, do proper due diligence or anti-money laundering checks on the payment, and inform the receiver of the funds.
There are different parties that maintain different ledger. They do not share a particular version of the truth. This results in poor coordination between the different parties and is error-prone, several times depending upon the manual intervention of the back office team. Furthermore, someone needs to perform currency conversion at either end, and different parties need to manage liquidity levels at nostro/Vostro accounts, which involves settling against central bank accounts as well.
Blockchain’s promise is specifically providing a solution of a single version of the truth that is not to be seen in the above case.
One part of blockchain that can be of great help is smart contacts. smart contract-enabled blockchain provides a single ledger and transactional engine. Where the balances can be maintained and transacted upon and where payments can live as single, common digital objects that make messaging and reconciliation unnecessary.
Smart contracts are very useful as various parties can register tokenized funds and payments. They can also set rules applying to all aspects of the end-to-end payments processes, eliminating errors and misunderstandings, increasing transparency and audit ability, and reducing fraud and cyber risk. This results in keeping everything on the same ledger, with the same smart contracts for all, and with the same computational engine, with no possibility of errors or tampering.
These days most of the decentralized solutions focus on improving payments processes either by digitizing the messaging layer described above or, even better, eliminating it by creating single, digital representations of payments that can enforce transactions on proprietary ledgers, connected to one another with some sort of inter-ledger protocol. This is indeed a significant improvement on today’s message-driven payments processes.
The main problem that arises is when one tries to scale such type of systems, specifically when a huge amount of payments issued by corporate clients are at stake: Management of Liquidity.
Basically, fast payments depend upon the pre-funded Nostro accounts, therefore, the correspondent bank has cash in hand to conclude the payment and to avoid any settlement risk. A large amount of money has to be transferred through central bank to re-balance these Nostro accounts within the course of business days. This is a time-consuming process and also prone to errors compared to real-time transactions, with finality within seconds, promised by permission blockchains.
When there is the low velocity of international liquidity, ends up tying up liquidity at nostros at levels that are higher than really necessary. The significant opportunity costs of these funds mount from tens or hundreds of basis points to tens of percentage points in emerging economies, which is a major problem.
A revolutionary and fundamental answer to this to improve this situation is having the possibility to digitize the tokens that act as the medium of storing the value within the same ledger where payments, balances of commercial bank and Nostro balances are stored. To exchange liquidity between liquidity providers and market makers, these tokens can be used globally in real time.
With this, token-based secondary markets for liquidity exchange is possible to be implemented. This will help the liquidity providers to trade with one another with much less friction, improved transparency and reduce the levels of liquidity deployed in Nostro accounts in different places due to much higher capital velocity.
The use of tokens and smart contracts helps the participants to even post unused liquidity in certain geographies as collateral to borrow liquidity in places where it is more urgently needed, in real time.
Making the tokens universal and capable of supporting liquidity needed in the currency market, is the main key. According to the Bank for International Settlements, the currency market amounts to more than $7 trillion per day. The certain part of this market is deliverable and liquidity related.
To play this role, there is a proposal to use cryptocurrencies and unbacked crypto assets. But, unfortunately, there are quite a number of limitations.
Because of vital volatility and the total circulation of liquidity is tiny, the risk of such assets is quite difficult to digest in comparison to what is needed in the market; A market that works quite well with U.S. dollar as a universal and hyper-liquid asset available today.
There are several institutions trying to work towards tokenized, digital central bank money.
Both the ways, these initiatives show a viable approach to improving liquidity management for commercial banks and market makers, it promises to provide much greater liquidity velocity and transparency, with the potential result of enabling a significant reduction in liquidity levels within the whole financial system.
As these initiatives mature and flourish, we believe they will become a key enabler of the decentralized, tokenized economy the world is so intrigued about