Correspondentbanking reinvented with Blockchain technology
The advantages of blockchain technology for global payments have been discussed in the first two parts (Part 1 and Part 2) of this series. The current global payments landscape is not fit for increasing numbers of global payments and growing demand for peer-to-peer payments across the globe. Blockchain technology, market and regulatory requirements will be brought together in this part proposing a global payments platform. The platform will orchestrate our prerequisites: finality, trust, transparency and settlement in local liquidity with universal settlement assets.
Blockchain, ready for banking
Blockchain technology, as introduced in “Bitcoin: A Peer-to-Peer Electronic Cash System” by Satoshi Nakamoto, aims to revolutionize the global banking system with, basically, anarchy. There have been several revolutions beyond Bitcoin within the Blockchain community, in effect spawning numerous different Blockchain networks – or in short: Blockchains. Blockchains may occur with or without a native crypto currency. “Crypto”-Blockchains use a cryptographically secured crypto currency as seen in Bitcoin, Ethereum or Stellar. Other Blockchains, e.g. Hyperledger Fabric, do not have a native currency but may use other kinds of digital assets in their specific configurations as described in part two of this series.
Crypto currency is the standard digital asset of a Blockchain. For instance, for the Bitcoin network, it’s bitcoin (BTC), for Ethereum, it’s Ether (ETH) and for Stellar, it’s Lumen (XLM). Crypto currencies are used to pay and cover fees for network operations. Real-world assets, e.g. fiat money, estate, identity or licenses, can be put on a blockchain as a digital asset regardless of the usage of a crypto currency. The ultimate goal is to represent all kinds of assets with the benefits of Blockchain: immutability, transparency, efficiency and security.
One key purpose of crypto currencies, however, was the exchange of value between participants of the network without using fiat. In a mainly fiat-driven economy participants usually exchange their crypto currency into the fiat currency of their choosing, i.e. essentially selling their position of any crypto currency they may have obtained. This scenario will remain as long as salaries, taxes, etc. are being paid in fiat.
Satoshi Nakamoto described BTC as a cryptographic currency with the goal to replace fiat currency and ultimately a blockchain economy. The revolution was, in fact, that users have come to a consensus of the valuation of BTC being the information stored within. Due to the volatility of BTC and other issues, it does not cover liquidity prerequisites for global payments. Furthermore, Bitcoin only provides probabilistic asymptotic finality, i.e. finality is only approximated. In practice this is achieved by waiting for a number of blocks after the transaction has been committed to the chain.
The design of Bitcoin substitutes finality for liveness. But for the purpose of global payments all participants of the Blockchain need trust in the finality of transactions: Finality over liveness, i.e. as a worst-case downtimes are accepted in order to assure deterministic finality. This means that the state of the network stays untouched until consensus of the next block is reached. Every participant can trust that transactions are immediately final once successfully committed to the chain.
Current crypto currencies are not a good fit as settlement asset for global payments due to volatility and wildly different legal status around the world. A better solution are global settlement assets, i.e. digital assets that can be used by all participants while observing their business needs as well as local and global regulations.
Participants have to follow their local regulations, meaning that global settlement assets will underly regulation as well. In order to mitigate fragmentation, these assets need to be interoperable, i.e. can be exchanged between regulatory borders. Further, the Blockchain needs to facilitate either exchange within the network itself or allow participants to operate exchange services off-chain using secured interfaces.
All strings come together for transparency: Every participant involved in a transaction, but not everybody on the network, can trace who else is involved and which flow of digital assets is used in order to execute the transaction end-to-end – straight through. This can be achieved in a number of ways, by either restricting overall access to the Blockchain – the so-called permissioned Blockchain and/or every participant can define who they are going to conduct business with. For example, every issuer of a digital asset may define who can hold and trade this asset and every participant may define what kind of asset they accept from whom. This evolved form of whitelisting is known as trustline e.g. on the Stellar network. This means that issuers and holders of digital assets know each other and thus can fulfill their respective regulatory requirements.
Another factor, most important for payer and payee of a transaction is ex ante clarity on how much a transaction will cost and what amount will be received by the beneficiary. Payments need to be atomic: Either all operations of a payment are successful, or the payment won’t be executed.
Although this given context of digital assets steps away from the core approach of Bitcoin, this approach brings the application of Blockchain technology closer to the current economy. The world is ready for new technology, not a world without banks.
That said, payments infrastructure needs to be reinvented fundamentally – and Blockchain is the new paradigm to do so. A platform combining these prerequisites, Blockchain and regulatory compliance is the key to affordable, fast and secure global payments.
A global payments platform
A Blockchain on its own will not solve the equation for global payments but can bring the technical foundation to elevate the current system of correspondent banking to a better, more evolved form. This will be achieved by introducing Blockchain based services that facilitate payments. A global payments platform will give market players, incumbent or new, the opportunity to transform their business model to eventually grow their business.
Banks or licensed payment operators, e.g. payment service providers (PSP), will be able to execute global payments at scale, as start and end points. They will provide access to the network while ensuring compliance with local payment services regulations on the one hand and finality, trust, transparency and security for their customers on the other hand. Although every PSP can decide on their specific conditions, it is crucial that best practices like transparent pricing and instantly available liquidity in the target currency are being followed.
The distributed ledger of the Blockchain will support transparency by giving a consistent view of all operations that have been executed in order to facilitate global payments. This data can be encrypted to ensure privacy for all entities involved. Customers should also have insight in that data, especially on fees spend and what channels were used to execute the payment.
In order to conduct business, most banks are obliged to Know-Your-Counterparty (KYC) activities when opening accounts. Payments for different kinds of entities, business or private, may be executed within a rulebook fitting to needed requirements. The Blockchain has to support this, either natively or by supporting services with adequate interfaces. As every entity on the platform may underly specific KYC requirements, the Blockchain needs to determine the required KYC data points and validate if the payment can be executed between the involved parties. KYC data points are defined according to local regulations and business requirements by each participant. This will ultimately lead to trust between all parties in the network, allowing only compliant participants to conduct business. In effect, this is what trustlines running on the Stellar Network, as one example – enforce, ultimately fulfilling compliance.
Payments across the globe will be deducted in local currency at the payer’s side and credited in the target currency to the payee. In between, either a direct stablecoin pairing, e.g. EUR to USD, or bridge assets, as introduced in part two, can be used: e.g. EUR to USD to NGN. This introduces two key players on the platform: Issuers and Market Makers.
Issuers provide liquidity for the platform by accepting collateral in fiat or other trusted commodities. Every unit on the Blockchain is represented by a unit of that asset in custody, ready to be paid out. A baseline of liquidity will be provided by issuers in specified currencies but also on demand when a PSP orders liquidity and deposits collateral. This ensures local liquidity around the clock for global payments settled within seconds in fiat currency.
The overall solution benefits from pathfinding: The process of navigating possible bridge asset chains between the origin currency and target currency. This requires a service, that exchanges digital assets on the Blockchain: Market Makers.
Market Makers hold positions of digital assets ready to be exchanged in order to execute a payment. Pathfinding identifies the cheapest and fastest way to execute a payment, including bridge assets. Once the payer sends a request the cheapest quotes are determined and locked, ready to be executed. This provides complete price transparency to the payer and assurance regarding the amount that will be received by the payee. Once accepted, positions are settled to execute the payment. All in seconds, within given trustlines between PSPs, Market Makers and Issuers, at low cost compared to traditional correspondent banking.
The consensus guarantees finality, the Blockchain technology replaces disjunct legacy correspondent accounts while releasing liquidity held in traditional nostro accounts. At every given point, every participant maintains required book-keeping, simplified by not using crypto currencies but digital representations of fiat. Trustlines, administrated by every participant, will manage compliance with local regulations between PSPs, Issuers and Market Makers. Stellar for example has introduced “Issuer-Enforced Finality”, which basically ensures digital assets are only held and transferred by entities that are known and trusted by the issuer.
Nevertheless, the “last mile” of the payment, i.e. crediting of fiat to the bank account of the payee, will be executed on existing local payment infrastructure. Schemes like SEPA Instant Credit Transfer will support this feature, if the account of the payee is not held by a bank that is part of the global payment platform. Reachability needs to be transparent at all times, making the use of standardized addresses or aliases of bank accounts inevitable. This has been implemented for instance by Stellar as federation addresses provided by federation servers that can run by network participants.
A quantum leap for global payments
The proposed global payments platform will combine benefits of Blockchain technology with business needs of payment services market players and the need for a solution for easy, reliable, cheap and fast transactions on a global level This is achieved through reducing trapped liquidity by removing correspondent banking accounts, leveraging Issuers and Market Makers and streamlining payment processes, while enabling straight-through-processing (STP) on a global level.
Trust between all parties involved ensures compliance, using trustlines that manage who may do business with whom. This represents bilateral, real-world agreements digitally and enforces boundaries on the Blockchain itself. Identity managed by either PSPs or possibly even identity service providers enables KYC to be included in every atomic payment process, reducing exposure to risk by facilitation of fraudulent payments.
Liquidity in local currencies that is credited to the beneficiary within seconds without any doubt about the finality of the payment meets market requirements supporting incumbent and new players in their payment business strategy, possibly opening new business opportunities. Asymptotic Finality has to be avoided at all costs: Participants have to accept downtimes due to network failure or missing consensus but can always be sure that a transaction cannot be revoked or nulled away.
The Stellar Network is a good example of a Blockchain enabling payment applications with all that is needed: Finality, universal settlement assets, transparency and trust. It is not only a question of technology, but also governance and consensus within the industry: The global payments platform will only be broadly established and accepted in the market when there is consensus on the technology used.
The specified global payments platform describes a quantum leap for current payments with manageable effort to implement. Existing infrastructure can be used to support this endeavor, eventually helping incumbent players to adapt easily. As the adoption progresses, the global platform will be able to support new assets, e.g. commodities like gold as collateral or other financial products like loans or insurances.
In addition, the proposed solution honors all well-established requirements, both for compliance as well as economic feasibility. As long as our economy is based on fiat, the platform will support this – as well as a possible shift to a crypto economy. The technology is feasible but needs the correct configuration and reliable governance. In practice, the re-organization of existing contracts to fit into the blockchain and stablecoin paradigm will be a focus challenge.
A concluding question is that of platform operation and governance. As outlined, it needs to be carried by a wide consensus in the market. The elevation to the new world in global payments is just a quantum leap ahead – the implementation is feasible and can be achieved within the next few years, no need for another decade of waiting. From there, a crypto economy is just one more step easily done on the global payments Blockchain platform.
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