Public blockchains pose risks for operations, security, governance, legal, compliance, and settlement even as digital assets become more prevalent, according to two reports.
Distributed ledger technology (DLT) and digital assets are becoming the preferred way to meet cash and liquidity requirements for digital securities settlements, according to a report from Citi Securities Services.
However, the Bank for International Settlements (BIS) is cautioning that banks using permissionless a.k.a public blockchains face “risks related to operations and security, governance, legal, compliance — including money laundering/financing of terrorism (ML/FT) — and settlement finality.”
The Citi Securities Services report, “Securities Services Evolution 2024: Disruption and transformation in financial market infrastructures,” argues that firms are using digital money “beyond central bank digital currencies (CBDCs),” a major change compared to last year.
More than two-thirds of respondents for the Citi report — 65 percent — “plan to use non-CBDC options like stablecoins, tokenized deposits, money market funds, and digital payment systems to support cash and liquidity requirements for digital securities settlements by 2026, versus 15 percent who plan to use CBDCs. This is a stark contrast to the previous year where CBDCs were the preferred form of digital money at 52 percent,” according to the report.
“After years of experimentation, growing volumes of sovereign issuance are providing the bedrock of a digital ecosystem,” according to the Citi report. “With FMIs [financial market infrastructures] helping to ‘bridge’ the digital and traditional markets, market participants are increasingly looking to FMIs as their partner of choice in mobilizing their digital securities in an environment that is secure, trusted, and scalable.”
Tokenization is becoming “the preferred path for over 55 percent of banks, trillions of dollars in tokenized collateral are now being exchanged every day and millions of dollars are accumulating in tokenized money market funds. With 12 percent of all our survey respondents in commercialization mode today with digital assets, the volumes of live DLT-based transactions continue to grow, driving a marked industry shift towards practical execution in blockchain choices and in digital cash,” according to the report.
“Nowhere is the regional narrative more evident than in DLT, though, and, while Europe embraces collateral liquidity, North America is looking to the private markets, and Asia is looking to an eventual convergence of crypto and traditional markets,” according to the report. “Much lies ahead but there is a clear sense that 2024 marks the beginning of a new stage in the evolution of the global securities services industry.”
As traditional and digital assets and operating models converge, “the need is greater for modern platforms, reliable data, and real-time information. We expect to see continued investments into automation, cloud infrastructure, and APIs as well as solutions that integrate with DLT networks,” says Amit Agarwal, head of custody, securities services, at Citi. The whitepaper polled 500 market participants at buy- and sell-side institutions and includes insights from 14 FMIs.
The white paper from the Basel Committee on Banking Supervision “Novel risks, mitigants and uncertainties with permissionless distributed ledger technologies,” points out that permissionless blockchains are decentralized “across unknown parties.”
By contrast, permissioned blockchains “are closed networks in which a previously designated party or parties (sometimes members of a consortium) interact and participate in consensus and data validation,” according to the report.
“Decentralized governance poses a challenge for regulated entities that must establish clear lines of responsibility and accountability and conduct due diligence on third parties they rely on,” according to the report. “In many permissionless blockchains, nodes must agree on changes and upgrades to the blockchain. This distributed governance may pose challenges in addressing bugs or security vulnerabilities and increase the risk of loss associated with assets that exist on these blockchains.”
With decentralized blockchain, “banks could struggle to conduct effective due diligence and oversight of third parties. Further, when participants cannot agree on updates to network rules, they may split the blockchain itself, often referred to as a hard fork,” according to the report. “If a blockchain splits into two networks, assets that exist on the blockchain may be subject to significant price volatility or loss, potentially causing problems for activities such as price determination, exposure calculation, and fulfilling capital requirements.”
Also, when a blockchain splits, it can create two separate networks.
“When traditional financial assets are tokenized, a hard fork will lead to a situation in which there are two or more tokens running on different DLTs but only one underlying asset. Soft forks may also present governance challenges, since every version of an asset may not be technically identical. Soft forks are changes to the code that are backwards compatible,” according to the report.
The BIS report also focuses on problems with DLT-based settlement.
“In many permissionless DLTs, settlement remains probabilistic, meaning the probability that a transaction could be revoked converges to, but never reaches, zero with the passage of time,” according to the report. “This creates settlement risk in permissionless blockchains.”
“For a variety of reasons, the system may reverse a block containing what participants may have thought was a settled transaction. These may be referred to as ‘orphaned blocks,’ which while a small fraction of total blocks, may occur at a daily frequency,” according to the report.
“Well-designed and well-operated payment and settlement systems ensure clear and certain settlement of transactions, giving confidence to their users about when transactions become final and that once final, transactions cannot be revoked or unwound,” according to the report.
“Even if the relevant legal framework and the blockchain’s rules, procedures, and contracts have defined the point at which final settlement occurs, the use of probabilistic settlement may still cause misalignment between legal finality and technical settlement which can result in uncertainty about the settlement status of transactions for the parties involved,” the report states.
The report from Citi can be found here: https://shorturl.at/cselv
The BIS report can be found here: https://shorturl.at/EYZ2y
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