(Nov 13): Bitcoin has taken the world by storm. Yet, the game changer for global financial services is not the meteoric rise of cryptocurrencies, but the technology that is used to mine them. Two central banks — Bank of Canada and the Monetary Authority of Singapore (MAS) — have moved in this direction by creating their own digital currencies.

In June last year, Bank of Canada introduced the CADcoin. MAS, meanwhile, announced Project Ubin and the creation of a Digital SGD prototype on distributed ledger technology (DLT) in November 2016.

Digital SGD and CADcoin are not alternative currencies but are instead part of tightly controlled experiments in wholesale banking where their issuance will not affect money supply. And their creation could eventually call into question the value of the bitcoin.

“Project Ubin is a collaborative project with the industry where we introduced a digital representation of the SGD to explore the use of DLT in interbank payments and settlement. It’s not for retail payments,” clarifies Jacqueline Loh, MAS deputy managing director, monetary policy & investment/ development & international/fintech & innovation. As for calling into question the value of cryptocurrencies, that could happen should banks issue their own digital currencies that can generate interest, she adds. A central bank- issued cryptocurrency is for financial transactions on a distributed ledger while a cryptocurrency in an initial coin offer is used for speculative demand.

Russia is reported to be planning a Crypto Ruble. Unlike a typical cryptocoin, the CryptoRuble will not be open for miners. Instead, it would be issued, controlled and maintained by a central government authority, just like the legal tender ruble.

Currencies issued by central banks are at an advantage compared with unregulated cryptocurrencies. Currencies have to be of value to their holders and be accepted as payment for purchases. While bitcoin can be used to buy some items, its use is not widespread and it is associated with the dark web.

Fiat currencies, on the other hand, are enormously useful. Governments set taxes and a significant amount of economic activity is paid in taxes. According to UBS, a third of all annual economic activity in developed countries is paid to the government as tax. “As such, people will always demand government-backed currencies because they are useful for paying taxes,” UBS says.

Central banks take lead in blockchain technology “Virtual currency not only executes payment (without intermediation) but also helps in digital settlements and clearing. The proof-of-concept results [for Project Ubin] confirm Digital SGD as a faster, secure and more accurate alternative,” says Mohit Mehrotra, strategy consulting leader, Deloitte Southeast Asia.

In Singapore, MAS has taken the lead in using Digital SGD to pilot payment and settlement solutions in partnership with the local banks and a handful of foreign banks. “We believe that central banks like MAS can play a bigger role beyond just providing research funding. Collaborative projects such as Project Ubin support the creation of open intellectual property and foster collaboration between industry players,” MAS says.

Digital SGD could also bring “off-ledger” transactions of assets and securities into the virtual environment, thus leading to increased efficiency in, and monitoring of, the nation’s financial system, Mehrotra adds.

DLT itself could be harnessed for many aspects of transaction banking. According to Nigel Dobson, banking services domain lead, digital banking, ANZ, commercial banks are looking into using DLT for more than just payments and settlement. “Banks became interested and learnt more about the attributes and benefits of distributed ledger, and it became evident that the information-sharing attributes of DLT were key to their implementation in the financial services environment.”

“If a bank or a series of banks can share information reliably so that I know what you see is what I see and we can do that in as near real-time as possible, that is a big benefit to financial institutions sharing information routinely. That information could be used to improve settlement, payment and securities transactions,” he says.

https://edgemarkets.s3-ap-southeast-1.amazonaws.com/s3fs-public/805-S8-MAS.jpg

Benefits of disintermediation According to MAS’ own studies, DLT allows for the disintermediation of processes that once required centralised third parties, since “nodes” in the chain work directly with one another. Eventually, DLT is expected to make financial transactions such as trade finance, cross-border payments, reinsurance, clearing and settlement quicker and more reliable. For commercial banks, DLT also reduces locked-in capital and the risk of fraud.

“For the central banks, DLT is a tool to transform existing financial infrastructure into an efficient (automated and disintermediated), transparent (digitised and decentralised), and risk-reduced (crytographed and tamper-proof) system,” Mehrotra says.

Disintermediation also minimises the time it takes to clear transactions, and the costs associated with transferring assets. DLT is tamper-proof and enables the use of smart contracts.

In November 2016, Oversea-Chinese Banking Corp announced it had performed a first — a cross-border fund transfer between OCBC in Singapore and OCBC Malaysia using DLT. The transfer took less than five minutes compared with one day normally, the bank said. As DLT removes the need for intermediaries and manual processing, it means lower costs for banks and their clients. It is also more secure as the fund transfer takes place directly between the originating bank and receiving bank, removing the need for manual input and intermediaries.

The trade finance business of commercial banks is seen as a major beneficiary if they are able to establish a DLT framework. “[In trade finance], some documents can be used fraudulently and there are famous cases where banks have been presented with fraudulent documents that have resulted in financial loss and reputational damage,” Dobson points out.

https://edgemarkets.s3-ap-southeast-1.amazonaws.com/s3fs-public/805-S8-MAS-chart.jpg

Digital SGD In creating Digital SGD, the participating banks in Project Ubin — the three local banks, Bank of America Merrill Lynch, Credit Suisse, HSBC, JP Morgan, Mitsubishi UFJ Financial Group and the Singapore Exchange (SGX) — pledge cash into a custody account held at the central bank. MAS then creates an equal value in Digital SGD on the distributed ledger and sends each bank an amount of Digital SGD equal to the amount they pledged.

Once banks receive their Digital SGD transfers from the central bank, they are free to make transfers to each other or back to the central bank. The exchange of Digital SGD on the distributed ledger occurs without credit risk for participants because transfers of Digital SGD are transfers of a binding claim on the central bank’s currency. In addition, a legal structure is in place to ensure there is no credit risk associated with the creation, distribution, use or redemption of Digital SGD.

Phase 2 of Project Ubin successfully produced a three-software model on the distributed ledger to implement decentralised netting of payments in a manner that preserves transactional privacy — a global first.

In future phases, the experiment may involve cross-border payments and settlement using DLT. Eventually, the creation of a Digital SGD “money market” is envisaged. This would allow banks to borrow Digital SGD from other banks without posting cash with MAS. Such an option may help to optimise liquidity requirements in the market. Credit risks associated with increased functions of Digital SGD “would have to be evaluated”, MAS says.

MAS and Bank of Canada have taken the lead in creating their own digital currencies to be used specifically in wholesale banking because DLT is a very new technology. “Historically, industries in infancy stage have been promoted by governments through the establishment of nationalised firms, which became privatised once the industries were established. Currently, governments are playing a similar role to embed disruptive technologies like DLT in the ecosystem, including the national infrastructures… giving the industry a demonstration of the potential of such technologies,” Mehrotra explains.

Of course, central banks have to be careful when issuing digital currency as it will affect monetary policy and financial stability. The Bank of Canada issued and destroyed CADcoin so as not to affect the money supply. MAS itself looked at a few options and opted for something called the continuous depository receipt model, which does not affect the Singapore dollar in circulation.

Other pilots OCBC’s second pilot last year was a local fund transfer between OCBC Singapore and Bank of Singapore. In April this year, ANZ and Westpac partnered with IBM and Scentre Group, which owns and operates Westfield malls in Australia and New Zealand, to prove that a blockchain solution could replace the current paper-based bank guarantee process, reducing the potential for fraud, driving standardisation and increasing efficiency for tenants, landlords and banks.

In Hong Kong, Deloitte has been working with the Hong Kong Monetary Authority and Hong Kongbased banks such as Bank of China, Bank of East Asia, Hang Seng Bank, HSBC and Standard Chartered Bank to develop DLT for trade finance. The project aspires to create a DLT platform for banks, buyers and sellers, and logistics companies. “We see a lot of activity around the trade platform. It’s about digitising, standardising and sharing information between counterparties,” Dobson says.

Trade finance is likely to be a lot more challenging than bank guarantees because of the many more parties involved. “The complexity of that supply chain means implementation will not be quick. You have to move with the pace of the slowest actor. While banks may be raring to go, some of the SMEs and logistics companies involved around the supply chain may not be ready or able to digitise their supply chain at the same pace,” Dobson says.

In October, Bank of Montreal, CaixaBank, Commerzbank and Erste Group announced that they had joined an initiative launched by UBS and IBM in 2016 to build a new global trade platform based on blockchain technology.

Totally disruptive What will all these DLT initiatives mean for banks and their fintech enablers? What would happen to payment intermediaries and jobs?

“The blockchain landscape is changing and most of the organisations that have ventured into blockchain at this moment are figuring out game-changing uses of blockchain, especially in the payment landscape. We believe some of the traditional payment intermediaries and the e-payment companies may be affected or even displaced if and when blockchain takes over mainstream payment methods,” says Praveen Raina, senior vice-president, group operations & technology, OCBC.

Mehrotra says DLT can improve operational efficiency and organisational risk management and enable real-time execution of transactions, including payments and clearance for intermediaries such as SGX and other payment solution companies. He acknowledges, however, that the technology will eventually cause huge disruptions. “Nearly all the intermediaries involved in validation of transactions — payments, settlements and clearing — will potentially see their roles changing in the future. The list of impacted intermediaries becomes very long when applied to businesses like trade finance, asset management, traded financial instruments [securities, and so on], insurance and other areas of banking.”

Inevitably, jobs will be affected. “There may be some reduction in mundane tasks such as checking documents. Automation will broadly reduce some element of manual processing which will be, net-net, a benefit for industry and society,” Dobson says.

Some market watchers reckon that even mainstays in the financial sector such as SWIFT and SGX could be affected. Former investment banker Peter Choo, who is currently vice-chairman of CNMC Goldmine Holdings, says: “Blockchain’s very nature as a public ledger means middlemen’s days are numbered in the long term as transacting parties do not require a central payment system as an intermediary.”

Interestingly, SGX and SWIFT are both collaborating with central banks, commercial banks and service providers. SGX is involved in Project Ubin while SWIFT is experimenting with real-time Nostro reconciliation using a SWIFT-developed DLT in collaboration with 33 global transaction banks.

“Some of these [intermediary] companies are already experimenting and collaborating with financial institutions to harness blockchain technology, and to come up with new business models so that they will not be left behind in this digital evolution,” Mehrotra says.

Whatever the case, the technology that brought us bitcoin is likely to change our lives forever.

MAS digitises SGD for interbank payments to stay ahead in fintech

Related News

Highlights

Qarbotech named winner of inaugural EQT Impact Challenge

Related News

Hong Kong investor and EPF pare stake in Interra Resources, Riverstone respectively

DBS and Sea: Two ends of a barbell?

SGX sticks to multi-asset push as MSCI ditches Singapore to cast its lot with Hong Kong