Central Bank-Issued Digital Currency

I just published a new report titled Central Bank-Issued Digital Currency: Assessing Central Bank Perspectives of DLT and Implications for Fiat Currency and Policy Stimulus.

The future of DLT appears inextricably linked with the future of banking & capital markets and given the significant impact that central banks are having upon finance, the perspectives of this critical constituency warrants careful examination with respect to such a game-changing technology.

On 28 September 2016, the Financial Services Committee met with Federal Reserve Chair Janet Yellen at the Semi-Annual Testimony on the Federal Reserve’s Supervision and Regulation of the Financial System. Yellen informed the committee members that blockchain could have very significant implications for the payments system, and innovation using these technologies could be extremely helpful and bring benefits to society.

This is further evidence of the significant and growing interest of central banks in DLT, but what is much less understood is how such technology could transform the role of central banks and commercial banks. Central bank-issued digital currencies present an opportunity to re-architect the financial system to achieve key central bank objectives. The perceived benefits include a new payments system, granular data on key macroeconomic variables, expansion of the policy stimulus toolkit, and improved prudential regulation.

Central banks themselves seem at an important juncture as they appear to be reaching the limits of their current policies — whether or not they are will only be determined with hindsight. In the meantime, in this report we delve into the mindset of central banks through analysing their extensive back catalogue of research to gain critical insights into the policy framework they may adopt going forward and how advances in technology may increasingly play a part.

This is the second in my current series of three reports on distributed ledger technology:

  • The first report considered DLT with gold (Micro Gold);
  • This report considers integrating DLT with Central Bank-Issued Digital Currency (CBDC);
  • The final report will compare fiat currency, Micro Gold, and cryptocurrencies as competition for payments systems, storing value, and money itself continues to rapidly unfold.

Micro Gold –This is going to be very big

I published a report today looking at the powerful combination of DLT with physical gold to create an asset class we call Micro Gold.

The report explores the key drivers for this use case including the prevailing environment of negative nominal interest rates, full interoperability with legacy systems, and a blue sky opportunity due to the lack of incumbency.

The combination of a regulated central bank asset with the functionality of DLT presents an enormously compelling platform for payments, wealth management, and a host of other use cases.

For those who have read our report, Beyond the Buzz, you have seen our framework for assessing the maturity of DLT use cases based upon the level of cooperation required with competitors, new FinTech entrants, other market participants, regulators, and so on.

Ultimately though, the key question is how does one achieve broad adoption of a new technology in the financial market place? Well, Micro Gold has demonstrated rates of adoption which outstrip technologies such as Uber, Facebook, and PayPal when they were at similar stages of maturity.

The breadth of relevance of this technology is simply staggering including individual payments, individual savings, global business payments, private wealth management-even the underbanked. Emerging markets and developed markets alike will see the utility of Micro Gold while a seamless UX, regulatory clarity, and micropayment functionality will continue to support adoption rates and, critically, network effects.

It also has a range of ways of mitigating ‘hacking risk’ which continues to be an issue for cryptocurrencies, financial institutions, and (let’s face it) everyone.

The potential for new use cases to emerge via developer APIs adds additional sizzle factor. Hence, I have enormous confidence in Micro Gold. It will be interesting to observe how this story unfolds as vendors and FIs step up their intensity as the pressure grows to implement and commercialize DLT use cases.

This report is the first of a series of three reports which I will be publishing which will explore the implications of DLT for fiat currency; the next report will look at the hot topic of Central Banks and provides a framework for how they may be thinking about its potential.

DLT – Beyond the Buzz

We published our new report on distributed ledger technology (DLT) called Beyond the Buzz today where we take a look at a range of use cases for DLT within banking and capital markets in addition to profiling the state of play across this ever-growing ecosystem of financial institutions, Fintechs, Bigtechs, regulators, and industry consortia.

We bring together a framework for assessing the use cases identified in the report, specifically, their status: Announcement; Proof of Concept, Pilot, Implementation, or Broad Adoption versus whether a consortium is driving the technology or a more unilateral/ bilateral initiative is implementing it. The breadth of use cases and complexity of the underlying markets all point to a very mixed picture such that 2016 and 2017 will continue to be active on the news flow front as the number of use cases proliferates and learning curves are climbed.

Interoperability with legacy systems, regulatory clarity, and modularity of technology architecture will all be critical elements to generating the scale and network effects which are so critical to the financial markets. Parallel running of existing systems and markets versus new DLT-enabled systems and markets will present unique challenges. Consequently, we are excited by the opportunities for private market securities which will be a relatively easier breeding ground for testing and implementation of DLT than large, listed, markets. The risks around the inertia of incumbency as we call it will also be much lower.

Regulators have a very important role to play given the distributed nature of the underlying technology and the global nature of its possibilities which will demand regulatory clarity and consensus on a multi-jurisdictional basis. RegTech was a theme that we identified here at Celent earlier than anyone else and the RegTech benefits of DLT are likely to become clearer to regulators and financial institutions as testing and proofs of concept mature. This could become a very important and supportive dynamic.

While we have focused on markets and use cases which have a significant amount of incumbency, we are hugely excited about the potential of DLT to streamline business processes between organizations and the potential for new investable asset classes to emerge. We are also alive to the reality that so much innovation is taking place outside of traditional financial institutions that a broad lens of observation across the entire DLT ecosystem will be essential to keeping track of where viral adoption rates will occur first.

Our next research will focus on precisely that as we will highlight a DLT use case which seems to be significantly ahead of the pack already with full spectrum relevance to: retail and institutional investors; merchants and enterprises; developed markets and emerging markets; with a variety of use cases across finance…stay tuned.

A New Architecture for a New Age: Digital Transformation of IT Infrastructure in Investment Banking

Digital Transformation of IT Infrastructure

I recently wrote an article for CIOReview. A full copy of the article can be found here. In the article, I state that investment banks are transitioning their IT infrastructure to a new architecture based on a new vision: digital. The goal of digital transformation is clearly to simplify IT and operations, reduce cost, and thus improve ROE. Digital is driving demand for cloud-based infrastructure, BPO, and IT outsourcing with banks moving many applications to cloud.

But to create  A New Architecture for a New Age, the new architecture is about more than movement from analogue to digital. Emerging technologies like machine intelligence can not only drive efficiency, but also offer advanced analytics and insights leading to investing and trade ideas, superior compliance practices, improved customer engagement, additional revenue opportunities, and more.

Moving from Known to Unknown: Blockchange

To create this aggressive form of digital transformation, a new financial technology stack is coalescing around Internet of Things (IoT) and blockchain, powered by cloud. The blockchain design pattern allows for cryptographically secured environments upon which to conduct wholesale and investment banking functions.

We believe financial institutions will deploy blockchain networks with distributed ledgers in increasing numbers. Smart contracts, which are agreements whose execution is both automatable and enforceable (according to Barclay’s CTO Lee Braine) will be powered by the networks and backed by digital assets, legal templates, and standards. IT and open source organizations will provide the fabric for blockchain networks, including cloud, while a number of technology firms will deploy and manage these networks to support applications atop this fabric.

Smart contracts will be enabled by confidentiality, security, and digital identity. The underlying technology will incorporate cryptography, programmable digital assets, distributed ledger technology (DLT), and interledger protocols. Yes, getting to smart contracts requires a lot of organizational change. Fortunately, blockchain creates some first mover advantages. So it’s not just cost reduction, but actual revenue opportunities that will encourage change.

Moving Ahead

Slow to move incumbents will be uncomfortably exposed to an unforgiving environment. Some will seek partnerships with fintech firms, a kind of hedging against the future (not a bad strategy, but an incomplete one), only to become hamstrung by the next quarter's results.

A better strategy is to decide what the future industry architecture will look like and then work toward becoming a leader by offering a new model for the future. Getting to the new architecture will take a minimum of three years, but most likely closer to 4 or 5. ‘Run the bank’ still overshadows ‘change the bank’ massively. To get from a known architecture to an unknown one requires courage.

French effort to use Blockchain for SMEs could have relevance for emerging markets

The recent news that a French consortium is beginning work on building post-trade infrastructure for trading of SME stocks in Europe will be of great interest to market participants across the world. The consortium comprises of BNP Paribas Securities Services, Euronext, Société Générale, Caisse des Dépôts, Euroclear, S2iEM and Paris Europlace.

There have been several notable developments with regard to experiments and adoption of Blockchain and distributed ledger technology in the leading capital markets globally. However, the signficance of this particular announcement lies in the fact that it tries to address the needs of the a sector that usually struggles to obtain easy access to the capital markets. If successful, such a project could drastically reduce the time taken for post-trade operations, slash costs and generally make it easier for SMEs to raise funds.

In a recent Celent report, we had found that most of the leading global post-trade providers believed that it was still a little early to expect major changes due to Blockchain technology. While this may be true, the current development would be of a lot of interest to the emerging markets around the world. In several such countries, the cost of accessing capital markets is comparatively high and the technology is also often found lagging, as in the case of European SMEs. If the French effort becomes successful, it could pave the way for application of Blockchain technology to specific tasks in emerging markets, not just to enable SMEs to raise capital better, but to help the overall market to leapfrog in terms of modernizing the market infrastructure.

Regulators and market participants in emerging markets should now see Blockchain and distributed ledger technology as a relevant means for streamlining their trading infrastructure. To that end, it is also important that they encourage firms within their jurisdiction to experiment and adopt such technology for specific local applications and requirements, and not just wait to see how it evolves in mature markets in the next few years. 

Canada experiments with putting fiat currency on Blockchain

In keeping with the recent focus on Canada in the wealth management blogs, I would like to make note of a significant piece of news with regard to Blockchain and distributed ledger technology. For some time, the use of fiat currency on the blockchain has been touted as a necessary step for the development of distributed ledger technology. While central banks in the UK and the US have taken the lead in discussions on this matter in the past, the Canadian central bank, Bank of Canada, has recently revealed that it is planning to experiment with the use of fiat currency on blockchain. It will use blockchain technology developed by the well-known R3 consortium for interbank payments, involving some of the leading commercial banks in Canada. While this is more of an evolutionary step than a revolutionary one, it shows the growing willingness of central banks to take Blockchain seriously. If the experiment does prove successful, the possibility of interbank payments using Blockchain in a real-life scenario is quite likely. Even though the use of such technology by retail customers in this context is still someway off, Blockchain proponents would realise the significance of this announcement. It should also encourage further innovation within the sector. 

Cyber Security: Is Blockchain the Answer?

Cyber security has long been a serious matter for financial institutions and corporates alike, but fintech and the digital era make cyber security more of an issue. Delivery of products and services through digital channels means that more systems are available to scrutiny by malefactors. The continuing adoption of fintech APIs (by which institutions provide their clients with third party services) and cloud computing may introduce further vulnerabilities. Meanwhile, the growth of the digital economy is also creating a large population of highly trained technologists — potentially creating greater numbers of cyber attackers and cyber thieves.

Cyber threats affect all industries, but financial institutions are particularly at risk, because of the direct financial gain possible from a cyber intrusion. An important question is whether the existing cyber security guidelines issued by various industry organizations will continue to be adequate in the age of fintech and digital financial services.

Fortunately, the evolution of fintech also entails the development of new technologies aimed at creating the next generation of cyber security. A number of startups are beginning to develop applications using semantic analysis and machine learning to tackle KYC, AML and fraud issues. Significantly, IBM Watson and eight universities recently unveiled an initiative aimed at applying artificial intelligence to thwart cyber attacks.

The traditional cyber security paradigm is one of “defense,” and unfortunately defenses can always be breached. Artificial intelligence, as advanced as it is, still represents the traditional cyber security paradigm of “defense,” putting up physical and virtual walls and fortifications to protect against or react to attacks, breaches, and fraud or other financial crime.

What if there were a technology that broke through this “defense” paradigm and instead made cyber security an integral aspect of financial technology?

This is precisely the approach taken to cyber security by blockchain technology.

Bank consortia and startups alike are engaged in efforts to develop distributed ledgers for transfer of value (payments) and for capital markets trading (where the execution of complex financial transactions is done through blockchain-based smart contracts). Accordingly, distributed ledgers and smart contracts are likely to one day have a place in treasury operations, for both payments and trading.

Blockchain is gaining attention primarily because its consensus-based, distributed structure may create new business models within financial services. In addition, though, blockchain technology has at its core encryption technologies that not only keep it secure, but are actually the mechanism by which transactions are completed and recorded. In the case of Bitcoin, blockchain has demonstrated that its encryption technologies are quite secure. The further development of blockchain will necessarily entail significant enhancements in next-generation encryption technologies such as multi-party computation and homomorphic encryption, which are already under development. In other words, blockchain is likely to not only play a role in altering the way payments and capital markets transactions are undertaken, but also in the way next-generation financial systems are secured.

Run, hide, partner, or buy: Fintech, automation, and disruption in wealth management and capital markets

Readers of a certain age may remember Frankfurt's aspirations of surpassing London as the world’s leading banking center. While that vision has not come to pass, Frankfurt remains a powerful hub for global finance. Home to Deutsche Bank, the European Central Bank and the Deutsche Börse exchange among others, Frankfurt’s importance is reinforced by its location at the very heart of Europe.

With this in mind, Research Director Brad Bailey and I are excited to bring the next Celent Wealth and Capital Markets roundtable to Frankfurt on Tuesday, May 10th. Of particular interest will be the role played by fintech firms in disrupting an ecosystem long dominated by large financial institutions. Brad and I will share ideas and examples from recent research, while senior executives with banks and asset managers and other large institutions from Germany, Switzerland, the UK and Italy will offer their perspectives on the disruption and the technology strategies they have adopted in response.

To maximize the participatory nature of this event, Celent is capping attendance at 20 individuals. At present, we have a few seats still open and would love to hear from other clients interested in joining us.

Building smart blockchains

In trying to discern the signal from the noise in the blockchain space, the noise level is high, but the signal is strong. My recent report, Blockchain in the Capital Markets: A Smart Distributed Future describes the implications of the blockchain and smart contracts in the capital markets across the value chain. The report explores the Fintech disruptors and the incumbents who are battling for position. Key themes that continue to arise in capital market blockchain use cases are the review of legacy systems (many of which grew up in a time of high margins), low cost of balance sheet, and freely extended credit. These systems need to be optimized for the realities of the regulatory, capital, and profitability metrics that exist today. I have also been reflecting on my participation in The Blockchain Conference last week in San Francisco. This was a great event that brought together some of the leading players in this space. The conference clearly indicated the impact distributed ledgers will have across industry verticals, as well as showing the implications for both evolutionary change and revolutionary change. There was extraordinary commitment to developing enterprise grade, secure, private solutions that will most impact the capital markets. The presentations and panels offered a look into this rapidly moving space, where everyone (from the smallest startups to the largest tech vendors) is approaching a new database model that will have far-reaching implications. The signal is there, and it is strong!

Digital Asset Holdings, R3 emerging as Blockchain leaders in capital markets

The news from this morning about R3 testing a trading system with eleven firms (Barclays, BMO Financial Group, Credit Suisse, Commonwealth Bank of Australia, HSBC, Natixis, Royal Bank of Scotland, TD Bank, UBS, UniCredit and Wells Fargo) on  Ethereum blockchain fabric hosted by Microsoft Azure was enough to discuss. Now Digital Asset Holding (DAH) has announced that it has raised US$50 million from thirteen capital market players, which can only be eclipsed by the announcement that ASX will engage DAH to build a distributed ledger solution for the Australian equity market. That was just today! Add in the announcement from Nasdaq with Chain around primary issuance of private equity securities at the start of the year and 2016 is turning into an exciting year for distributed ledger and blockchain applications in the capital markets.   The ASX news is fascinating and speaks to the rapid exploration of the distributed ledger space- according to the announcement:
  “In February 2015, ASX announced that it would replace or upgrade all of its main trading and post-trade platforms. Phase 1 of the program runs to the end of 2016 and will replace ASX’s existing trading and risk management systems. Phase 2 focuses on ASX’s post-trade services, including clearing and settlement of the cash equities market. The system that currently provides the clearing and settlement services to the Australian equity market is known as CHESS (Clearing House Electronic Sub-register System).”
  ASX hopes to achieve the call of leveraging a distributed ledger fabric to: reduce costs, latency, errors and minimize capital requirements.   ASX was one of the thirteen firms mentioned in the DAH capital raise. The other firms are: ABN AMRO, Accenture, BNP Paribas, Broadridge Financial Solutions, Inc., Citi, CME Ventures, Deutsche Börse Group, ICAP, J.P. Morgan, Santander InnoVentures, The Depository Trust & Clearing Corporation (DTCC) and The PNC Financial Services Group, Inc.   The current distributed ledger and blockchain environment is yielding interesting cross-pollination of competitors and vendors, with many firms active in multiple initiatives.   Celent will be among the firms that speaking at The Blockchain Conference on February 10 in San Francisco—there will be a lot to talk about!!!