Amidst a growing body of global thought leadership on blockchain and distributed ledger technology (DLT), the International Monetary Fund (IMF) released its "Fintech and Financial Services: Initial Considerations" staff discussion note on 19 June 2017 (IMF Paper)1.
The IMF Paper provides an excellent and accessible summary of the opportunities presented by fintech (and in particular, DLT) for the financial services sector. Given the IMF's mandate to promote the stability of the international monetary system, it focusses on rapidly changing cross-border payments. It highlights three areas:
- Technology and regulation
- Central bank digital currencies
- Re-shaping cross-border payments.
We discuss each below.
- Technology and regulation
The IMF Paper identifies a number of current risks (or uncertainties) with emerging technologies:
- Financial instability (due to):
- accelerated speed/volumes of financial transactions;
- higher asset price correlations as a result of automated transactions;
- cyberattack vulnerabilities; and
- concentration risk on key nodes.
- Oversight: The need to regulate the algorithms underlying fintech innovations and verify the robustness of the underlying technology;
- Privacy: Balancing privacy with the need for transparency to reduce transaction costs and conduct supervision. For example, existing laws cover data controllers – however, with DLT, there is no data controller;
- Property and contract law: Current property and contract laws may not reconcile with transfers in ownership of digital tokens. For instance would a registration outside the ledger (eg in a corporate share registry) still be required?
- Settlement finality: Some jurisdictions prohibit the reversal of payments, to ensure certainty of transaction settlements. However, this may not work in a distributed network based on technologies that provide only probabilistic (rather than settlement) finality at a definitive point in time.
The regulatory environment needs to respond, and adapt, to the emerging technologies. For example:
- Some jurisdictions (including the United Kingdom, Australia and Canada) have already established 'regulatory sandboxes'. These allow new technologies and business models to be tested in a controlled environment and enable regulators to address the potential risks of new technologies. The IMF stresses that these are not a substitute, however, for permanent regulatory frameworks.
- Ensuring AML/CFT requirements are met is another example of the regulatory challenges presented by DLT and digital currencies/wallets. The Financial Action Task Force (FATF) has issued guidance for countries to impose customer due diligence (CDD) obligations and other AML/CFT preventive measures (by clarifying the financial institution status) on some virtual currency service providers (primarily virtual currency exchanges). The European Commission is also considering imposing CDD obligations, but for wallet service providers as well.
The IMF Paper acknowledges that the current lack of consistency in regulatory approaches across jurisdictions has the potential to both undermine regulation at the national level and create incentives for regulatory arbitrage. It also acknowledges efforts to strengthen cross-border co-operation and harmonisation, including:
- Bilaterally: through co-operative arrangements for innovation and information sharing; and
- Multilaterally: a number of international standard setters have been monitoring and studying the implications of technology change. For example, the International Organisation of Securities Commissions' February 2017 Research Report on Financial Technologies, and the Committee on Payments and Market Infrastructures' February 2017 report Distributed Ledger Technology in Payment, Clearing and Settlement: An Analytical Framework. The Financial Stability Board is also working on the topic.
- Re-shaping cross-border payments
The IMF Paper discusses how DLT could reshape the cross-border payments landscape:
- Back-end processes: DLT could be used to improve the speed, transparency and end-to-end tracking of cross-border payments, including reconciliation with invoices. Liquidity and risk management could also be optimised using DLT;
- Compliance: DLT could be used for know-your-customer utilities, digital identification, and meeting AML/CFT regulation. This, however, is currently limited by privacy and security issues;
- Means of payment: DLT-based virtual currency could be used to underpin an entirely new means of payment. It identifies two possible ways to achieve this:
- 'A hub and spoke' payment network: where fiat money is exchanged with virtual currency, transferred, and then exchanged back into foreign fiat money. Although this will shorten the payments chain (cutting out correspondent banks), risks such as fluctuations in the value of virtual currency, trust issues, and lack of interoperability among networks could remain. If networks are not interoperable, network externalities could be strong and providers can take advantage of market power to charge higher fees. Existing regulators for retail payment systems, such as UK's Payment Systems Regulator, could minimise this risk.
- Central banks could offer their own digital currencies (discussed below).
- Central bank digital currencies
The IMF Paper also suggests that central banks could offer their own digital currencies as a widely available DLT-based representation of fiat money. This would reduce the risk of lack of interoperability and trust associated with private virtual currency networks.
A DLT-based central bank digital currency may also:
- Allow the central bank to perform its role in ensuring an effective payments infrastructure (issuing currency and fulfilling its lender of last resort function) more efficiently;
- Reduce coin and note costs for the state;
- Reduce transaction costs for individuals and small enterprises that have little or costly access to banking services;
- Allow the central bank to retain control of monetary policy effectiveness, if private virtual currencies gain significant traction;
- Be more secure and resilient than current settlement systems, which are exposed to a single point of failure risk;
- By facilitating small value payments, boost the adoption and efficiency of the new, decentralised, service economy; and
- Increase trust in the technology (as the digital currency will be backed by the central bank).
Next steps, and the future of DLT
The IMF Paper is designed:
"... to showcase policy-related analysis and research being developed by IMF staff members and is published to elicit comments and to encourage debate. The views expressed ... are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management".
It concludes that fintech is an international issue, that international co-operation will be essential, and that the IMF is well placed to play a significant role.
The IMF Paper will be the subject of much deliberation and debate by central banks, regulators, and the financial services sector globally, as they continue to grapple with the rapidly changing face of technology. It highlights the transformative role of DLT (in conjunction with other technologies), the continuing role of digital currencies and wallets, and the need for an engaged, co-ordinated, and global, sector and regulatory response.
1 Rochon, He, Tourpe et al. "Fintech and Financial Services: Initial Considerations" (IMF Staff Discussion Note, 19 June 2017)
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