Distributed Ledger Technology in Payments Clearing and Settlement

Distributed ledger technology
in payments, clearing, and settlement

David Mills, Kathy Wang, Brendan Malone, Anjana Ravi, Jeff Marquardt,
Clinton Chen, Anton Badev, Timothy Brezinski, Linda Fahy,
Kimberley Liao, Vanessa Kargenian, Max Ellithorpe,
Wendy Ng, and Maria Baird¹
2016-095
Please cite this paper as:

Mills, David, Kathy Wang, Brendan Malone, Anjana Ravi, Jeff Marquardt, Clinton Chen, Anton Badev,
Timothy Brezinski, Linda Fahy, Kimberley Liao, Vanessa Kar- genian, Max Ellithorpe, Wendy Ng, and
Maria Baird (2016). “Distributed ledger technology in payments, clearing, and settlement,” Finance and
Economics Discussion Series 2016-095. Washington: Board of Governors of the Federal Reserve System,
https://doi.org/10.17016/FEDS.2016.095.
NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminary materials
circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the
authors and do not indicate concurrence by other members of the research staff or the Board of Governors.
References in publications to the Finance and Economics Discussion Series (other than acknowledgement) should
be cleared with the author(s) to protect the tentative character of these papers.
Working Papers may be quoted without additional permission.
¹ The authors would like to thank Mari Baca, Daniel Ebanks, Sarah Wright, Thomas Doheny, Robert Carper, Patrick Adler, Peter Lee, Michael
Warner, and Kaushik Ashodiya for their contributions and assistance. The views expressed in this paper are solely the responsibility of the
authors and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System, or anyone else in the
Federal Reserve System.
ISSN: 0971-1023 | NMIMS Management Review Distributed ledger technology in payments,

60 Volume XXXVI | Issue 2 | August 2018 clearing, and settlement
1. Overview roles that financial institutions and infrastructures
Digital innovations in finance, loosely known as currently play.
fintech, have garnered a great deal of attention across
the financial industry. Distributed ledger technology Although there is much optimism regarding the
(DLT) is one such innovation that has been cited as a promise of DLT, the development of such applications
means of transforming payment, clearing, and for PCS activities is in very early stages, with many
settlement (PCS) processes, including how funds are industry participants suggesting that real-world
transferred and how securities, commodities, and applications are years away from full implementation.²
derivatives are cleared and settled. DLT is a term that Even so, given the industry momentum in developing
has been used by the industry in a variety of ways and new proofs of concept (PoCs), this timeline may
so does not have a single definition. Because there is a accelerate. In some cases, there have already been
wide spectrum of possible deployments of DLT, this announcements that the technology will be used
paper will refer to the technology as some within the next year or two in actual production
combination of components including peer-to-peer environments. An important goal of this paper is to
n e t wo r k i n g , d i st r i b u te d d ata sto ra ge , a n d examine how this technology might be used in the area
cryptography that, among other things, can potentially of payments, clearing, and settlement and to identify
change the way in which the storage, recordkeeping, both the opportunities and challenges facing its
and transfer of a digital asset is done. practical implementation and possible long-term
adoption.
The driving force behind efforts to develop and deploy
DLT in payments, clearing, and settlement is an The Federal Reserve's interest in DLT
expectation that the technology could reduce or even In the aggregate, U.S. P C S systems process
eliminate operational and financial inefficiencies, or approximately 600 million transactions per day, valued
other frictions, that exist for current methods of at over $12.6 trillion.³ Given that safe and efficient
storing, recording, and transferring digital assets arrangements for conducting PCS processes are
throughout financial markets. The purported benefits critical to the proper functioning of the financial
of DLT that could address these frictions, including markets, and to financial stability more broadly, the
improved end-to-end settlement speed, data benefits and risks that may arise with any potentially
auditability, resilience, and cost efficiency, have led transformative changes to PCS processes should be
industry participants to investigate the application of thoroughly understood and managed by the relevant
DLT to a wide variety of PCS processes. Proponents of stakeholders. As part of its core objective to foster the
the technology have claimed that DLT could help foster safety and efficiency of the payment system and to
a more efficient and safe payments system, and may promote financial stability, the Federal Reserve has a
even have the potential to fundamentally change the public policy interest in understanding and monitoring
way in which PCS activities are conducted and the the development of innovations that could affect the
² For example, technology research firm Gartner, which monitors emerging technologies, estimates that it will be five to ten years until DLT
achieves "mainstream adoption." See Gartner (2016), "Hype Cycle for Emerging Technologies."
³ Average daily volume and value were calculated using 2014 data on U.S. retail and wholesale PCS systems and were approximated based on
the number of business days in the year. See Committee on Payment and Market Infrastructures (2015), Statistics on Payment, Clearing and
Settlement Systems in the CPMI Countries, http://www.bis.org/cpmi/publ/d142.htm.

Volume XXXVI | Issue 2 | August 2018 clearing, and settlement 61
structural design and functioning of financial markets.⁴ DLT that were identified over the course of the
Further, as a regulator and supervisor of financial research team's industry engagement and summarizes
institutions involved in PCS activities, an operator of the approaches the industry is taking to investigate the
retail and large-value payment and settlement potential of the technology. Sections 5 and 6 introduce
systems, and a catalyst for payments system some of the challenges to the adoption and
improvement, the Federal Reserve is also in a unique implementation of DLT. Section 5 focuses on business,
position to view the different implications of payments technology, and financial design challenges, while
innovations from a wide range of perspectives. section 6 focuses on challenges related to risk
management. Section 7 provides a summary.
As a preliminary step to understanding the
implications of DLT developments in payments, 2. Payments, clearing, and settlement
clearing, and settlement, a team of Federal Reserve Many proponents in the fintech community have
staff (FR research team) held discussions with a broad suggested that the widespread deployment of DLT
range of parties that are interested in, participate in, or may bring fundamental changes to not only the
are otherwise contributing to the evolution of DLT.⁵ technology architecture of financial markets but also
The team conducted interviews and conversations the financial market structure. This view stems from
with approximately 30 key industry stakeholders, the perceived potential for DLT to facilitate certain PCS
including market infrastructures, financial institutions, processes in ways that are not currently achievable
other government agencies, technology start-ups, without the aid of financial intermediaries that are
more-established technology firms, and industry entrusted by market participants, including
consortia. Additionally, the team attended numerous households and businesses, with ensuring that their
industry conferences and symposia and continues to transactions are settled successfully on an on-going
engage with industry participants and follow basis. As the first step in analyzing the potential impact
developments related to the technology. This paper is of DLT on how activities in payments, clearing, and
informed by this outreach. settlement are conducted, this section discusses the
essential elements of PCS processes and how these
Organization of this paper
processes have evolved with previous innovations,
The paper is organized as follows. Section 2 provides a
including how they have shaped the roles that financial
description of the essential elements of payments,
intermediaries, such as financial institutions and
clearing, and settlement, including an overview of the
infrastructures, currently play.
role financial intermediaries play.⁶ Section 3 describes
the key technological components of DLT and how
they relate to the essential elements discussed in
section 2. Section 4 describes several potential uses for
⁴ The Federal Reserve Board adopted its Federal Reserve Policy on Payment System Risk (PSR policy) with the objectives of fostering the safety
and efficiency of payment, clearing, settlement, and recording systems and promoting financial stability, more broadly. The PSR policy
includes the Board's views on standards for the management of risks (including legal, operational, and financial risks) in these types of
systems. See Board of Governors of the Federal Reserve System (2016), "Federal Reserve Policy on Payment System Risk," Board of
Governors, https://www.federalreserve.gov/paymentsystems/files/psr_policy.pdf.
⁵ The research team is a multi-disciplinary group of officers and staff from the Board of Governors of the Federal Reserve System, the Federal
Reserve Bank of New York, and the Federal Reserve Bank of Chicago.
⁶ For purposes of this paper, a financial intermediary is broadly defined to include financial institutions (such as banks, broker/dealers, and
other institutions that interact with the end-users of a financial transaction) and infrastructures (such as payment, clearing, and settlement
systems for funds, securities, and derivatives).

Essential elements of a financial transaction validation, conditionality, and settlement. These
In its simplest form, the clearing and settlement of a processes are generally facilitated by financial
financial transaction, regardless of the asset type, intermediaries, such as payment systems.⁸ After a
requires (1) a network of participants, (2) an asset or sender submits a payment message to a payment
set of assets that are transferred among those system, the message must pass through that system's
participants, and (3) a transfer process that defines the validation procedures. Validation will vary by system
procedures and obligations associated with the and can include security measures, such as verification
transaction. Typically, the set of direct participants are of the sender's identity and the integrity of the
financial institutions such as banks or broker- dealers. message. If a payment is determined by the system to
Indirect participants include end users such as be valid, the system then typically checks whether
households or businesses. An asset can be any necessary conditions for settlement are satisfied, such
financial instrument, such as a monetary instrument, as the availability of sufficient funds or credit for
security, commodity, or derivative. settlement. Payments that pass the conditionality test
are prepared for settlement. Under some payment
Communications among the participants in a network system frameworks, settlement finality (that is, when
involve sending electronic messages, settlement is unconditional and irrevocable) occurs
a c k n ow l e d ge m e nt s , state m e nt s , a n d o t h e r when the receiver's account is credited.
information between computer systems typically
maintained by a network operator and its participants.
Payments and post-trade securities clearing and Securities, commodities, and derivatives
settlement are characterized by somewhat different post-trade processes
transfer processes and may involve different types of For securities, commodities, and derivatives
financial intermediaries, as described in sections 2.1.1 transactions, post-trade processes provide
and 2.1.2., respectively.⁷ Section 2.1.3 describes confirmation of trade terms, clearing, and settlement.
further the role(s) of financial intermediaries that In many cases, these processes are facilitated by
facilitate today's PCS processes. financial intermediaries, such as payment systems,
securities settlement systems (SSSs), central securities
Payments processes depositories (CSDs), and central counterparties
For a funds-only transfer, the process involves a series (CCPs), which specialize in particular PCS functions.⁹,¹⁰
of four conceptual steps that are called submission,
⁷ The discussion in sections 2.1.1 and 2.1.2 are based on Annex D of the following: Committee on Payment and Settlement Systems and
Technical Committee of the International Organization of Securities Commissions (2012), Principles for Financial Market Infrastructures,
http://www.bis.org/cpmi/publ/d101a.pdf. Effective September 2014, the Committee on Payment Settlement Systems changed its name to
the Committee on Payments and Market Infrastructures.
⁸ A "payment system" is defined in the PSR policy as a set of instruments, procedures, and rules for the transfer of funds between or among
participants. Payment systems include, but are not limited to, large-value funds transfer systems, automated clearing house systems, check
clearing houses, and credit and debit card settlement systems. See Board of Governors of the Federal Reserve System (2016), "Federal
Reserve Policy on Payment System Risk," Board of Governors, https://www.federalreserve.gov/paymentsystems/files/psr_policy.pdf.
⁹ A "securities settlement system" is defined in the PSR policy as an entity that enables securities to be transferred and settled by book entry
and allows the transfers of securities free of or against payment. A "central securities depository" is defined in the PSR policy as an entity that
provides securities accounts and central safekeeping services. A "central counterparty" is defined in the PSR policy as an entity that
interposes itself between counterparties to contracts traded in one or more financial markets, becoming the buyer to every seller and the
seller to every buyer. See Board of Governors of the Federal Reserve System (2016), "Federal Reserve Policy on Payment System Risk," Board
of Governors, https://www.federalreserve.gov/paymentsystems/files/psr_policy.pdf.
¹⁰ In some cases, one entity may perform multiple PCS functions, such as securities clearing and settlement, as well as safekeeping and custody.

Confirmation involves counterparties agreeing to the roles generally include the provision of services as well
terms of the trade and settlement date. The next step as financial, operational, and legal risk management,
is clearing, in which an entity calculates the and a governance structure for them, their customers,
counterparties' obligations to make deliveries or and the markets they serve.
payments on the settlement date. This entity may
compute settlement obligations individually (that is, Intermediaries such as banks and broker-dealers are
on a transaction-by-transaction basis) or on a net basis typically trusted by end users, such as households and
(that is, determining the net obligations of buyers and businesses, to store, maintain ownership records of,
sellers for a number of transactions). and transfer assets on their behalf. When these end
users initiate a transaction, their banks or broker-
After clearing comes settlement, during which the dealers interact with other intermediaries, such as
relevant delivery and payment obligations of the financial market infrastructures (FMIs), that can take
counterparties to the securities, commodities, or the form (and function) of a payment system, SSS,
derivatives transaction are discharged. For example, in CSD, or CCP.¹² FMIs centralize and facilitate the
a securities transaction, settlement occurs when clearing, settlement, and recording of financial
securities are delivered to the buyer and funds to the
transactions for the markets they serve, often on a
seller. Depending on the commodity and terms of
multilateral basis. In doing so, FMIs can allow
settlement, commodities transactions may involve
participants to manage their risks more effectively and
settlement of only funds obligations, or it may also
efficiently and may reduce certain risks.¹³
involve the delivery of financial instruments, other
documents, or even a physical commodity (e.g.,
The transfer process is typically organized with the FMI
precious metals, oil, wheat, etc.). The settlement of
as a central hub through which banks or broker-
derivatives contracts other than commodity contracts
dealers interact with one another. Because banks and
also depend on the type of derivative and terms of
broker-dealers may be active in multiple financial
settlement. Finality of each leg of the transaction
markets, they often interact with multiple FMIs. Figure
occurs when the transfer is irrevocable and
1 depicts a very simple hub and spoke system with one
unconditional. When there are multiple legs in a
FMI and its participants. In the figure, the FMI has a
transaction, delivery versus payment (DvP)
master copy of the transactions ledger for trades that
mechanisms are often used to coordinate settlement
go through it. Each participating financial institution
of the different legs, as well as manage the risk that
has its own ledger of transactions which may include
one leg settles with finality when the other does not.¹¹
both transactions that go through FMI A and
transactions that do not. In practice, FMI A may have
Roles of financial intermediaries in
multiple ledgers organized by business line,
payments, clearing, and settlement operational activity, geographic area, or accounting
Certain institutions serve as intermediaries in center. The reconciliation within and among the
payments, clearing, and settlement and may play one various parties to a transaction may occur as part of
or more critical roles in fostering the smooth the clearing process or daily balancing activities. Some
functioning of the broader financial system. These reconciliation steps may take place after individual
¹¹ For a description of the different models, see Annex D of the following: Committee on Payment and Settlement Systems and Technical
Committee of the International Organization of Securities Commissions (2012), Principles for Financial Market Infrastructures,
http://www.bis.org/cpmi/publ/d101a.pdf. See also Committee on Payment and Settlement System (1992), Delivery Versus Payment in
Securities Settlement Systems, http://www.bis.org/cpmi/publ/d06.htm.
¹² A "financial market infrastructure" is defined in the PSR policy as a multilateral system among participating financial institutions, including
the system operator, used for the purposes of clearing, settling, or recording payments, securities,
¹³ However, FMIs may also concentrate risks and create interdependencies between and among FMIs and participating institutions.

transactions have been settled. FMIs may cross jurisdictional boundaries, as shown by
the connections of FI 6 and FI 7 in figure 2, which adds
The broader financial system contains numerous hub another layer of legal and operational complexity.¹⁴
and spoke systems that are intricately linked through,
among other things, the PCS relationships between
entities ranging from end-users to intermediaries.
Figure 2 depicts a stylized example of how the simple
hub-and-spoke structure is essentially more complex
because of the interconnectedness of various
participants. Financial institutions may often
participate in multiple FMIs, as shown by FI 2 in figure
2. Further, participation in derivatives, or other
financial transactions. See Board of Governors of the Figure 2: Example of a more-complex hub and spoke structure
with multiple FMIs, FIs, and jurisdictions
Federal Reserve System (2016), "Federal Reserve
Policy on Payment System Risk," Board of Governors,
Innovations in payments, clearing, and
https://www.federalreserve.gov/paymentsystems/fil
es/psr_policy.pdf. settlement
The methods for executing, clearing, and settling
financial transactions have evolved over centuries.¹⁵
As transaction volumes and the complexity of market
participants increased, certain frictions emerged and
increased the costs as well as the risks of transacting in
financial markets. Frictions, such as operational and
financial inefficiencies, prompted market participants
to seek solutions that would reduce costs.
Solutions to these inefficiencies, in turn, took the form

of technological development, changes in market
s t r u c t u re ( fo r exa m p l e , fo r m a t i o n o f n e w
intermediaries or changes to the roles of existing
intermediaries), or a combination of the two.¹⁶ The
availability and maturity of technology are key factors
Figure 1: Simple example of a hub and spoke structure with in determining the extent to which a technological
one FMI and financial institutions (FIs) as participants solution versus a change to the market structure would
serve to address a particular friction or inefficiency.
¹⁴ For an example depiction of this complex set of linkages in the derivatives market, see figures 1 and 2 in Jerome Powell (2014), "A Financial
System Perspective on Central Clearing of Derivatives," speech delivered at "The New International Financial System: Analyzing the
Cumulative Impact of Regulatory Reform", a conference sponsored by the Federal Reserve Bank of Chicago and the Bank of England, held in
Chicago, Illinois, November 6, 2014, https://www.federalreserve.gov/newsevents/speech/powell20141106a.pdf.
¹⁵ Trade execution takes place before PCS processes, but is referenced here for illustrative purposes.
¹⁶ One example in which a change in market organization and structure provided a solution to an operational inefficiency was the formation of
check clearing houses. The New York Clearing House was formed in the 1850s for the purposes of interbank check collections, before
computer technology was available to address the increasingly cumbersome physical settlement of checks by payment in gold among
multiple banks. As a result, the settlement process itself was redesigned by introducing a new facility that centralized physical check clearing
and settlement on a multilateral basis in one location. Many other local or regional check clearing houses were subsequently created around
the United States. See J.S. Gibbons (1859), the Banks of New- York, Their Dealers, the Clearing House, and the Panic of 1857 (New York: D.
Appleton & Co), pp. 292-295.

Often, the introduction of a new technology authority to update their own electronic transactional
necessitates a change in market structure. One such databases (that is, ledgers) within their purview, the
example was the introduction of advanced different financial intermediaries worked under rules
communications networks and electronic databases to and governance processes that provide the necessary
the physical processes associated with clearing and integrity and reliability for end users to have
settling paper stock certificates. This evolution confidence in the transfer process.
reduced both the liquidity and operational costs
required to complete a geographically diverse, multi- Opportunities for new innovations in
party transaction and was aided not only by the payments, clearing, and settlement
technical ability to produce digital representations of
Innovations have made way for the bulk of today's
physical certificates or assets, but also by the changing
payments, clearing, and settlement in the wholesale
roles of financial intermediaries.
and retail financial markets to be conducted over a set
New FMIs were created to play the roles of CSDs and,
of large and complex electronic networks of
in some cases, CCPs. These market infrastructures
participants and processes. Taken together, these
assumed the responsibility and legal liability of
comprise the financial architecture and are often
ensuring that valid transactions submitted by banks
broadly called the U.S. payment system. There remain,
and broker-dealers for themselves and their
however, opportunities for improvement.
customers were cleared and settled. The CSDs, which
often also operate as SSSs, provided the storage and Traditional payment services, often operating on
recordkeeping of ownership of securities by their decades-old infrastructure, have adjusted slowly to
members and facilitated funds and securities transfers changes in technology, increasing end-user
by providing trust, and in many cases, liquidity, expectations for speed and convenience, and
throughout the transfer process. If CCPs were also increases in security threats.¹⁸ DLT represents an
created for a particular market, they would frequently opportunity to deal with existing frictions in payments,
provide the clearing function and, importantly, would clearing, and settlement (section 4) and, as stated
typically provide a “guarantee” of settlement between above, may cause market structure changes. The
shortly after the trade date until the settlement date of extent of these changes, however, depends on how
the transaction.¹⁷ Broker-dealers and banks fulfilled the financial industry addresses certain challenges to
their roles, in part, by maintaining various implementation and adopts the technology. Before
independent ledgers for recording and posting debits examining these challenges, this paper first considers
and credits to customer funds and securities accounts the technological components of DLT and how they
on those ledgers. As trusted intermediaries with sole may be applied in the PCS context.
¹⁷ An important element of any CCP design is the legal mechanism for the CCP to become the counterparty to its participants' trades (such as
through innovation and substitution of counterparties), which allows the CCP to assume the original parties' contractual obligations to each
other. Other legal mechanisms that allow the CCP to guarantee obligations may also exist, such as explicit and legally binding settlement
guarantees.
¹⁸ Federal Reserve System (2015), "Strategies for Improving the U.S. Payment System," white paper, January 26,
https://fedpaymentsimprovement.org/wp-content/uploads/strategies-improving-us-payment-system.pdf

3. Distributed ledger technology and settlement. For example, in very extreme but
In the strictest sense, a distributed ledger is a type of unlikely scenarios, the use of banks to conduct
database that is shared across nodes in a network.¹⁹ payments could become obsolete. In between these
However, because the financial industry is considering extremes lie a number of potential future states for the
a wide range of applications for the technology, this financial architecture.
paper considers “distributed ledger technology” in a
very broad sense to be some combination of The extent to which DLT will have an impact on the
components, including peer-to-peer networking, financial architecture may become clearer as the
distributed data storage, and cryptography that, technology matures. The level of impact will depend at
among other things, can potentially change the way in least in part on decisions about which components of
which the storage, recordkeeping, and transfer of a DLT are adopted and how DLT arrangements are
digital asset is done. The composition of these ultimately implemented. As the industry considers a
combinations is dictated by the particular friction or wide variety of applications, DLT arrangements are
inefficiency a particular implementation of DLT is likely to take on a range of forms, with different
designed to solve. components of the technology being used for different
purposes. Thus, this section reviews some of the key
In order to differentiate between the broader topic of components of DLT that could be adopted in the
DLT and specific implementations of DLT, this paper context of payments, clearing, and settlement.
refers to a “DLT arrangement” when describing a
Entities can be connected on a peer-to-peer
particular selection, combination, or configuration of
basis via nodes
these technological components. These arrangements
In a DLT arrangement, nodes are the devices running
could take a number of forms, that, when
the DLT software that collectively maintain the
implemented, range from having a minimal to a very
database records. In this design the nodes are
significant impact on how PCS processes are
connected to each other in order to share and validate
co n d u cted . Fo r examp le, ex istin g f in an cial
information.²⁰ At its extreme, this structure enables
intermediaries may adopt a few of the key
any entity, such as end-users, financial institutions, or
components of DLT as an enhancement to their
FMIs, with a node to share database management
existing technical platforms. This type of incremental
responsibilities directly with each other on a peer- to-
adoption may not change any underlying business,
peer basis. This is in contrast to traditional database
operational, or behavioral practices supporting the
architectures that operate with a central hub that acts
PCS process. At the other extreme, a comprehensive
as the single source of valid information and control.
DLT arrangement might be implemented to replace
Outside of the conduct of PCS processes,
entire functions traditionally managed by existing
financial intermediaries (that is, entire PCS processes). DLT also enables a single party to maintain its database
This type of comprehensive approach might result in records across multiple nodes, for purposes including
very significant changes to the architecture of the increased operational resiliency.
financial system for conducting payments, clearing,
¹⁹ One specific type of distributed ledger is a block chain, which adds changes to the database via a series of blocks of transactional data that
are chronologically and cryptographically linked to one another. The terms “distributed ledger technology” and “block chain technology” are
often treated as synonyms in the industry even though block chain is actually a specific type of distributed ledger.
²⁰ Communication channels between nodes may be separate from the channels used by end users to access the nodes or the institutions that
maintain them.

Figure 3 represents two examples of this peer-to-peer figure 3, the ownership and housing of the nodes are
connectivity. In contrast to the hub-and-spoke model different. In the left panel, the nodes are hosted within
of figure 1, in which each entity maintains its own a single entity. In the right panel, however, multiple
independent ledger, each node in figure 3 has a copy of entities are in the arrangement, and each of them
a common ledger. Further, although the connectivity hosts a node. Section 3.9 will discuss the importance of
of the nodes is the same between the two panels of this distinction.
Figure 3: Two simple examples of node connectivity structure
An entity's ability to participate in a DLT arrangement, Participants in a DLT arrangement can be

however, depends not only on that entity's computing
permitted to play different roles or functions
resources (i.e., operational capabilities) for running
Regardless of whether a DLT arrangement is open or
nodes, but also on whether the arrangement is
closed, participants (and therefore the nodes they
designed to be an open or closed system. Open
maintain) may be differentiated by the roles they are
systems are those that accept all interested entities
permitted to play or functions they are permitted to
that have the technical ability to participate. Closed
perform. DLT arrangements in which the participants
systems have additional membership criteria that
are allowed to perform all activities are often called
must be satisfied in order for an entity to be permitted
“permissionless.” Those that restrict participants'
to operate a node. These criteria can include financial
activities are often referred to as “permissioned.” For
requirements such as the entity's creditworthiness or
example, for certain DLT arrangements, some
ability to access liquidity resources, as well as legal
participants may only be permitted to have nodes that
requirements such as the entity's ability to meet any
send and receive asset transfers for existing assets.
contractual obligations to the arrangement or to have
Other participants may have the ability to issue new
proper business licenses to conduct business. Crypto
assets. Still others may have permissions to validate
currency DLTs such as Bitcoin are generally open
transactions (as discussed below), while another set of
systems. Many DLT arrangements being contemplated
participants may be able to update the history of
by the financial industry, however, are envisioned as
transactions to the ledger (also discussed below).
closed.²¹
²¹ In the context of Figure 3, the left panel is a clear example of a closed DLT arrangement, as all the nodes are hosted by a single entity. The right
panel, however, could represent either an open or closed arrangement. The determining factor of which is whether the entities that host the
nodes also needed to meet additional criteria to be permitted to participate in the arrangement.

Some participants may be limited to only reading the To transfer an asset, a participant may create what is
ledger, while others may also be allowed to write to the known as a digital signature with its non-shared
ledger. Crypto currency DLT arrangements such as cryptographic credential called a private key. To
Bitcoin are examples of permissionless systems. The confirm that the asset in question belongs to the
financial industry, however, is focused mainly on participant initiating the transaction, other
developing permissioned systems because these participants of the DLT arrangement with the required
systems offer a way to provide controls over important permissions to act as validators of transactions can
functions performed in the arrangement. verify authenticity of the ledger entry by decrypting it
with a mathematical algorithm and the asset owner's
Ownership of an asset can be stored on a publicly available public key. As a consequence of this
process, ownership of an asset, including the ability to
ledger within the DLT arrangement
transfer it to other parties, often depends on having
Assets can be designed in a variety of ways. For
access to the correct private keys.²³
example, they can be issued and traded entirely within
the ledger or they can be representations of assets that
Additionally, cryptography may be used to encrypt
exist outside the ledger. Regardless, ownership
transactional information on the ledger such that only
information with respect to an asset can be stored on a
certain participants can decrypt the details of each
ledger within the DLT arrangement, which maintains
transaction. Since most DLT arrangements require
the ownership positions of all participants in the
some level of distribution of records on the ledger,
system. The asset owner within the DLT arrangement
cryptography employed for this purpose can be an
could be financial institutions such as banks or broker-
important tool in instances where some degree of
dealers, much like today. In a more extreme scenario
privacy is necessary.
where services are disintermediated, these assets
could be held directly by households and businesses.
Finally, cryptography can also be used to facilitate the
consensus process discussed in 3.6.
DLT arrangements can use cryptography to
facilitate PCS processes Transactions histories and current states of
DLT arrangements use cryptography for several
ownership can be distributed across the
purposes, such as identity verification and data
encryption. For example, during asset transfers, a form nodes of the DLT arrangement
of cryptography known as public key cryptography In a DLT arrangement, information regarding records
usually forms the foundation of the transaction of ownership and transaction histories can be
validation process.²² distributed across the nodes in the network.
Importantly, this distribution is the foundation of the
technology, with the ledger of transaction histories
²² Public key infrastructure (PKI) is the name given to the set of entities and procedures that govern the creation, distribution, and validation of
public keys. With respect to some implementations of DLT, roles and procedures played by specific entities in the traditional PKI framework
may be executed by the DLT protocol and thus may not require centralized authority or control. For additional information on public key
infrastructure, see U.S. Department of Commerce, National Institute of Standards and Technology (2013), Digital Signature Standards (DSS),
http://nvlpubs.nist.gov/nistpubs/FIPS/NIST.FIPS.186-4.pdf, and U.S. Department of Commerce, National Institution of Standards and
Te c h n o l o g y ( 2 0 0 1 ) , I n t r o d u c t i o n t o P u b l i c K e y Te c h n o l o g y a n d t h e F e d e r a l P K I I n f r a s t r u c t u r e ,
http://nvlpubs.nist.gov/nistpubs/Legacy/SP/nistspecialpublication800-32.pdf.
²³ U.S. Department of Commerce, National Institute of Standards and Technology (2013), Digital Signature Standards (DSS),
http://nvlpubs.nist.gov/nistpubs/FIPS/NIST.FIPS.186-4.pdf.

and ownership positions shared as one common subsequent positions are broadcast to nodes that
ledger that participants agree is correct. Important maintain a copy of the ledger and ultimately accepted
design choices for this ledger include the appropriate as the new version of the ledger.
level of information that should be contained and
shared on the ledger and which participants have the The process of having nodes accept a new version of
ability to read or write to the ledger. Typically, even if all the ledger is commonly referred to as consensus,
nodes have a complete copy of the ledger, it is which is consequently an important part of sharing a
technologically possible that some of the data on the common ledger in a peer-to-peer network.
ledger is encrypted so that only authorized
participants can decrypt and read the underlying Because multiple participants typically have the ability
information. to write to the common ledger, it is possible that two
seemingly valid transactions could be broadcast to the
The protocol in a DLT arrangement can network at the same time. For example, a sender of
funds may be able to submit a payment using funds
define the procedures necessary for the
that are already allocated to a previous payment
asset transfer process
before the sender's previous transaction is reflected in
For DLT arrangements intended for facilitating
the ledger. This possibility is the so- called “double-
payments, clearing, or settlement, the PCS processes
spend problem,” which arises in an environment
are coded into a protocol, which is a syntax and set of
where settlement may not occur instantaneously and
procedures that define how members of the
is not under a single decision maker's control.²⁴
arrangement interact. For a payment transfer, a DLT
protocol may lay out validation checks (for example, DLT arrangements use consensus algorithms or other
verify ownership) and conditionality checks (for similar processes as a way for nodes on the network to
example, access to sufficient funds or credit). For a prioritize one valid transfer over another so that only
securities, commodities, or derivatives transfer, a DLT one transfer is accepted and posted to the common
protocol could provide the conditions around ledger and the other is ultimately rejected.
confirmation, clearing, and settlement.
Specific to protocols and processes for validation of
An important difference in these protocols and transactions, the design of consensus algorithms used
processes between today's financial architecture and a in a DLT arrangement can help to prevent invalid
DLT arrangement is the process for settlement. transactions from being accepted by the system and
Settlement in a DLT arrangement involves the can also make the ledger more tamper-resistant.
updating of the common ledger with the new These processes may also be designed to address
ownership positions of the relevant counterparties. specific aspects of types of transactions. For example,
For a distributed ledger, proposed transactions and transfers over a certain threshold could trigger
additional validation steps or alternative consensus
rules to be applied before the transaction is accepted
in the ledger.
²⁴ In both DLT arrangements and traditional payment systems, the double-spend problem may arise, for example, if identical, duplicate
payments or transfers can be sent even when only one payment or transfer can be valid. In a DLT arrangement, an example would be multiple
simultaneous attempts to transfer a digital asset with the same serial number or unique identifier. Note that a related but not identical
problem can occur if a party attempts to make two valid transfers, but owns an insufficient amount of a digital asset to settle both transfers.

The design of a DLT arrangement's protocols, however, consent to its terms. These agreed-upon smart
can have consequences for the scalability and contracts can be used in conjunction with a distributed
performance characteristics of the overall DLT ledger to self-execute based on information received
arrangement. For example, the choice of consensus in the distributed ledger or from other sources. For
model may affect the rate at which transactions can be example, several companies developing DLT products
processed and considered final by the arrangement. are exploring the use of smart contracts to model
For this reason, the industry is currently researching a corporate debt issuances. In these simulations, a debt-
number of consensus algorithms that it hopes will issuing company specifies the parameters of the
reduce this latency and increase the scalability of DLT contract, such as its par value, tenor, and coupon
arrangements. payment structure. Once assigned to an owner, the
smart contract would automatically make the required
Application programming interfaces can coupon payments until the bond reaches maturity.
improve usability of DLT arrangements

Application programming interfaces (APIs) are a set of DLT implementation can be considered from
routines, protocols, and tools for building software a legal entities perspective in addition to a
applications. An A P I specifies how software technology perspective
components should interact, and within a DLT As noted in the beginning of section 3, the extent to
arrangement APIs can enable the addition of new which DLT will have an impact on the financial
features or enhancements not native to the architecture may become clearer as the technology
distributed ledger protocol itself. For example, they matures. Some proponents of DLT point to the
could communicate directly with the underlying possible use of the technology to automate and even
protocol of a distributed ledger to effect transfers and replace functions traditionally played by financial
gather information. APIs can also provide user- institutions and FMIs. Nonetheless, information
friendly interfaces that make using the technology technology is only one factor that typically influences
easier for a broader set of potential users. These the function and organization of PCS processes. Other
applications can be customized to meet the needs of factors include business, coordination, and network
particular asset types or markets. As the number of economics as discussed in section 5. Legal issues, as
DLT arrangements using different protocols increases, discussed in section 6, also loom large.
APIs may play a critical role in improving usability and
interoperability between different protocols and From a fundamental perspective, certain types of legal
between protocols and legacy systems. entities appear necessary to carry out ordinary PCS
activities even as some of their functions and
Smart contracts may be used in D LT
operations may adjust with the advent of new
arrangements to automate certain transfers technologies.
based on pre-specified events agreed to by
counterparties to a transaction
For example, CCPs for derivatives are inherently
Smart contracts are coded programs that are used to
designed to be the buyer to every seller and the seller
automate pre-specified transactional events based on
to every buyer when they are used to centrally clear
agreed upon contractual terms. Like with traditional
either exchange traded or over-the- counter
contracts, a smart contract depends on participants'
derivatives. In order to effectively carry out the CCP

function, some type of central legal entity appears to intermediaries may not be technologically necessary
be necessary; this type of entity is essentially a to make the use of DLT feasible, but their use could
financial intermediary.²⁵ result from the economics of issuing and managing
securities, including the need to meet regulatory
With respect to CCPs for cash securities trades, there is requirements.
discussion of whether concepts like real-time clearing
and settlement of such trades would make Financial institutions acting for their own accounts and
unnecessary, the use of CCPs to guarantee trades on behalf of clients may wish to hold and trade digital
between trade execution and final settlement. This is a assets and to manage various risks. Some of these
logical possibility and could be a case of technology types of intermediaries have emerged already to
used in a way that makes the need for a settlement provide services to Bitcoin users, even though Bitcoin
guarantee obsolete. However, markets will likely need is an open system in which anyone may hold the crypto
to evaluate the costs and benefits of the types of currency directly. More generally, third-party service
changes that financial institutions and FMIs would providers currently provide a wide range of technology
need to implement for real-time clearing and and other services to financial institutions and their
settlement as well as the financial issues involved in clients, which creates an “ecosystem” of financial and
faster settlement such as liquidity management.²⁶ non-financial entities that are frequently involved in
producing and delivering PCS services. Overall, the
It may also happen that if there is a business case for economics of intermediaries will likely continue to be
real-time settlement in the securities markets, DLT more complex than a simple problem of technology or
would be only one of the technologies considered for technology costs.
implementation.
A particularly important and traditional issue in PCS
Additionally, traditional financial assets such as economics is the need for groups of firms and
securities are typically a liability of a legal entity, such individuals to coordinate PCS activity to reduce the
as a government or corporation. In a DLT arrangement, costs and risks of clearing and settlement. In addition
decisions about what type of entities can issue what to legislation and regulation, governments and the
instruments on a distributed ledger may be important private sector have historically established rule-setting
to provide a firm legal foundation for DLT activity. bodies, clearing houses, and specialized financial
Moreover, entities such as custodians may be needed institutions to address the need for multilateral rules
to effectively control and manage the issuance of and functions.²⁷
digital assets – potentially from a significant number
and wide range of issuers – onto distributed ledgers, Depending on the era, the jurisdiction, and the
much like how securities custodians have been used problem being addressed, some of these multilateral
since the 1970s to immobilize securities certificates organizations have also been given roles as financial
and issue book-entry securities against them. Such intermediaries. Although technology has been one
²⁵ Even in the pre-2008 environment of voluntary central clearing of standardized over-the-counter derivatives, CCPs existed and performed
important functions such as clearing interest rate swaps for major dealers.
²⁶ For information on the issues considered by the industry on the plan to shorten the settlement cycle of U.S. equities from three days after
trade date (i.e., T+3) to T+2, see Industry Steering Committee (2015), White Paper: Shortening the Settlement Cycle: The Move to T+2,
http://www.ust2.com/pdfs/ssc.pdf. For additional information on the initiative to move to T+2, see the industry T+2 website at
http://www.ust2.com/.
²⁷ Associations of financial institutions have also been used to establish model master agreements used in bilateral clearing.

contributing factor in determining the design of a technology and operations that are critical in a
particular PCS arrangement, the fundamental need for production environment, such as scalability or
coordination has often required joint action through security, may not be fully understood or addressed.
new or existing legal entities to, at a minimum, provide Much of the industry has been working on PoCs in
organization and governance. 2016, usually for particular asset classes and use cases.
Some of these PoCs are referenced below.
4 Potential opportunities for D LT in
PoCs that show potential may move into the pilot
payments, clearing, and settlement
phase in which the technology could be used for real
Industry participants and technology firms are
transactions. Pilots have a limited duration, defined
increasingly exploring ways to develop and deploy DLT
objectives and milestones, and typically also limit the
arrangements for use in payments, clearing, and
number of participants in order to determine how the
settlement. Although the technology has the potential
technology works in production. Technologies that are
to provide a new way of storing, recording, and
successful in the pilot phase may then move toward
transferring digital assets, at present most industry
the production stage. Technologies at this stage have
participants are looking at ways to integrate the
the full set of features necessary to facilitate the
technology into existing systems and institutions.
storage, recordkeeping, and transfer of the asset being
Many models may alter or eliminate some roles of
considered. The final stage of the development
current intermediaries in payments, clearing, and
process is broad adoption of the technology by
settlement but may not necessarily eliminate the need
participants in the payments, clearing, and settlement
for coordination or centralization of certain functions
system. At the time of the FR research team's
by trusted intermediaries. These trusted
interviews, most of the DLT experimentation was at
intermediaries could still be needed to play important
the PoC stage. There have been some announcements
roles in addressing frictions beyond what DLT may be
of the intent to put distributed ledger technology into
able to accomplish or may be able to use DLT
production.
arrangements to improve or evolve how they
accomplish their respective missions.
Potential applications of DLT in payments,
Path to adopting new technology clearing, and settlement
The path to adoption of any new technology, including Information collected through interviews with
DLT, typically follows several stages of development, industry stakeholders indicates that firms have several
beginning with a “proof of concept.”²⁸ common motivations behind efforts to develop and
deploy DLT arrangements:
These PoCs are simple, experimental uses of the • Reduced complexity (especially in multiparty,
technology on a very small scale in a controlled cross-border transactions)
environment (for example, nonproduction) and are • Improved end-to-end processing speed and
often used to help researchers understand the availability of assets and funds
potential and limits of a technology for a specific • Decreased need for reconciliation across multiple
purpose. At this stage, some important aspects of the record keeping infrastructures
²⁸ Scott Campbell (2013), "POC vs. Pilot vs. Production," January 25, https://www.citrix.com/blogs/2013/01/25/poc-vs-pilot-vs-production/.
See also National Defense Industrial Association 2008, "Engineering for System Assurance", Version 1.0, pp. 84,
http://www.acq.osd.mil/se/docs/SA-Guidebook-v1-Oct2008.pdf.

• Increased transparency and immutability in various independently managed ledgers, would allow
transaction record keeping market participants to reduce processing delays and
• Improved network resiliency through distributed operational costs.Specific use cases that have received
data management public attention include clearing and settlement in
• Reduced operational and financial risks equities markets as well as international commodities
markets. For example, several large exchanges are
DLT is essentially asset-agnostic, meaning the exploring DLT-based solutions to improve existing
technology is potentially capable of providing the post-trade processes for clearing and settling trades
storage, recordkeeping, and transfer of any type of made on exchanges. These exchanges are developing
asset. This asset-agnostic nature of DLT has resulted in PoCs to track ownership of digital representations of
a range of possible applications currently being securities in order to potentially combine the trade
explored for uses in post-trade processes. The and post-trade processes for asset transfers into one
following section describes a set of “use cases” step. For commodities markets, a DLT arrangement is
identified during the industry interviews and in development to potentially allow for more efficient
transfers of commodity “certificates” tied to specific
discusses, among other uses, post-trade clearing and
physical assets such as precious metals.
settlement, cross-border payments, and financial
inclusion. For each potential use, the industry has
Both examples connect with legacy payments systems
noted a set of existing frictions that might be
for the payments leg of an asset transfer. Thus,
addressed by DLT technology and developed one or
interoperability between the DLT arrangement and
more PoCs to explore major issues in developing and
legacy systems becomes an area of focus because final
applying the technology further. The PoCs also suggest
settlement is tied to the completion of both legs of a
that DLT arrangements may introduce new challenges
securities or commodities transfer (as discussed in
to potential uses, and as a result, sections 5 and 6 will
section 6.3). The industry has been focusing on ways to
discuss questions that will need to be addressed in
make those connections, including the establishment
order to transition from the PoC stage to widespread
of escrow accounts that interact with or are within a
adoption.
DLT arrangement. These escrow accounts would hold
onto one side of the transaction until confirmation
Securities, commodities, and derivatives
that the other side is executed.
transactions
Many organizations are particularly interested in The potential for DLT to reduce frictions in the clearing
identifying which aspects of post-trade processing and settlement of securities has led many industry
could benefit from DLT's potential to reduce participants to explore this technology as a way of
information transfer times from trade execution to reducing middle and back office costs. For example,
settlement, and thus to increase the speed and many such costs are driven by procedures that must be
efficiency of the operations that influence the length done manually or duplicated at multiple firms. During
of settlement cycles. In theory, the distributed and securities trades, all parties typically keep duplicative
consensus forming aspects of DLT could allow for records of the trade details, requiring costly
multiple parties to agree on the terms of trades in a reconciliation between firms. DLT arrangements are
fraction of the time required with existing processes. being developed to, among other things, share the
In addition, some contend that eliminating other c o s t s o f m a i n t a i n i n g s u c h r e c o r d ke e p i n g
frictions in clearing, such as reconciliation across infrastructures.

Cross-border payments settlement for payments. Frictions may also include
Numerous firms have identified the slow, indirect, and problems in exception processing and reconciliation.³¹
expensive settlement of cross-border payments as a
Some startups are attempting to alleviate some of
current point of friction that could be alleviated
these frictions by using DLT and more direct
through the application of DLT arrangements.
transacting as a replacement for intermediaries, which
potentially reduces the number of steps to complete
Currently, electronic cross-border payments are
c ro s s - b o rd e r p ay m e nt s a n d e n a b l e s d i re c t
effected by credit (and sometimes debit) transfers that
relationships between counterparties. Developers
convert funds from bank to bank through a series of
argue that certain attributes of DLT, such as the ability
correspondent banking relationships, often with an
to share ledgers across geographic distances and time-
assessment of multiple fees.²⁹
zones, could reduce the number of intermediaries
Although actual message communication between needed to effect cross-border payments. By reducing
banks, using “straight- through-processing,” can take the number of intermediaries, certain regional banks
place in near real time, correspondent banks may not may be able to directly access the network, resulting in
act on messages promptly, and settlement may take a more transparent and efficient cost structure for
longer. Exception processing can take even longer. cross-border payments. Some of these cost savings
According to one report, the settlement times for could then potentially be passed onto their customers.
cross-border payments can take up to five days for the
most common currency pairings, generally with In addition, a particular industry development of note
limited clarity regarding the total amount of fees to be is the Inter ledger Protocol (ILP) which allows
charged and the timing of settlement.³⁰ transactions to flow across different ledgers and
creates connection points between two or more digital
Depending on the jurisdiction and the banks involved, ledgers. In effect, the protocol defines a set of
costs are generally passed on to the end-users and may procedures for proposing a payments path and
be deducted from the face amount of the funds cryptographically escrowing funds across a series of
transferred. For the end-user, the frictions include the interoperable ledgers and then subsequently
predictability of settlement timing and costs, as well as executing the escrowed transactions once the
the general opaqueness of correspondent banking recipient of the payment validates or acknowledges
networks. For small to medium-sized banks that offer receipt of payment. The ILP is being developed as an
such services to their customers but often lack the open standard and is intended to improve
relationships to directly process cross-border interoperability and streamline the process for
payments, the frictions include the reliance on larger transferring digital assets by enabling entities in
institutions, the associated costs of maintaining different countries with different payment systems to
relationships, and the associated fees and timing of more easily transact with one another.
²⁹ Committee on Payment and Market Infrastructures (2016), Correspondent Banking, http://www.bis.org/cpmi/publ/d147.pdf.

³⁰ McKinsey and Company (2015), "Global Payments 2015: A Healthy Industry Confronts Disruption," October, pp. 23-24,
http://www.mckinsey.com/~/media/McKinsey/dotcom/client_service/Financial%20Services/Latest%20thinking/Payments/Global_paym
ents_2015_A_healthy_industry_confronts_disruption.ashx.
³¹ Lipis and Adams (2014), SWIFT Institute, "Cross-Border Low Value Payments and Regional Integration: Enables and Disablers," November,
https://www.swiftinstitute.org/wp-content/uploads/2014/11/SWIFT-Institute-Working-Paper-No-2014-005-Cross-border-LVP-Regional-
Integration-Lipis_v4-FINAL.pdf. See also The World Bank (2015), "Withdrawal from Correspondent Banking; Where, Why, and What to Do
About It," November, http://documents.worldbank.org/curated/en/113021467990964789/pdf/101098-revised-PUBLIC-CBR-Report-
November-2015.pdf.

Adoption of this or a similar protocol could spur the origins of the asset and the history of transactions
further innovation and adoption of DLT-based systems across participants. Having a connection as a node in
for the cross-border payments use case.³² the network, a supervisor would receive transaction
data as soon as it is broadcast to the network, which
Financial inclusion could help streamline regulatory compliance
Financial inclusion is another challenge both procedures and reduce costs. At the same time,
domestically and abroad that some are attempting to however, since not all of a service provider's
address with DLT. Some of the potential benefits of transactions with a customer, or information about a
DLT for cross-border payments described above might customer, might be on one or any distributed ledger,
also be able to help address issues involving cross- certain regulatory requirements could be difficult to
border remittances as well as challenges in providing meet by simply providing access to a ledger.
end-users with universal access to a wide range of Notwithstanding such questions, however, the
financial services. Access to financial services can be industry is actively exploring this use case.
difficult, particularly for low-income households,
because of high account fees, prohibitive costs Industry approaches to adopting DLT
associated with traveling to a bank.³³ Developers As mentioned at the beginning of this section, the
contend DLT may assist financial inclusion by financial industry's focus thus far has been on
potentially allowing technology firms such as mobile experimentation and the development of PoCs.
phone providers to provide DLT-based financial Stakeholders have taken different approaches to
services directly to end users at a lower cost than can developing these PoCs, all with the objective of
(or would) traditional financial intermediaries; achieving adoption of distributed ledger technologies
expanding access to customer groups not served by in payments, clearing and settlement. Some firms are
ordinary banks, and ultimately reducing costs for retail exploring the development of DLT solutions within
consumers. specific markets or asset classes and are designing DLT
arrangements that are tailored to a particular use case.
Information-sharing Other firms are developing DLT frameworks as a
According to interviews, the ability of DLT to maintain general purpose, open source technology that can be
tamper-resistant records can provide new ways to configured and deployed in a wide array of settings.
share information across entities such as independent The strategies employed broadly fall into the following
auditors and supervisors. As an example, DLT categories:
arrangements could be designed to allow auditors or
supervisors “read-only access” to certain parts of the Projects by financial institutions. Many global financial
common ledger. This could help service providers in a institutions have at least one DLT- related initiative.
DLT arrangement and end users meet regulatory Several have formed dedicated teams to study and
reporting requirements more efficiently. Developers experiment with the technology and/or established
contend that being given visibility to a unified, shared innovation labs in order to understand the potential
ledger could give supervisors confidence in knowing costs and benefits of DLT arrangements, as applicable
³² See https://interledger.org/interledger.pdf for more details.

³³ Committee on Payment and Market Infrastructures and The World Bank (2016), Payment Aspects of Financial Inclusion,
http://www.bis.org/cpmi/publ/d144.pdf. See also Federal Deposit Insurance Corporation (2016), FDIC 2015 National Survey of Unbanked
and Underbanked Households, October, https://www.fdic.gov/householdsurvey/2015/2015report.pdf.

to their businesses. FMIs and similar organizations are addition, these multilateral partnerships are acting
also involved to varying degrees in these efforts. Some as catalysts for future discussions related to
have published papers on this topic.³⁴ common ledger operability standards and enabling
the testing of PoCs. By joining consortia, firms are
• Product development by technology firms: able to lower development costs and test solutions
Technology companies are experimenting with together instead of in silos. Some consortia have
their own DLT product offerings. For example, membership fees and are driven by the need to
some firms are looking to expedite settlement, generate commercial solutions, while others are
whereas others are seeking technical solutions for focused exclusively on developing a unified code
issuing securities in a cryptographically secured, base and open standard.
digital form and trading them securely on a shared • Hosting or supporting business development
platform. programs for startups. By offering or co-
• Partnerships between technology firms and sponsoring programs such as an accelerator or
financial institutions. Several large financial incubator, which can include providing funding,
institutions are investing in or collaborating business consulting services, or even physical
directly with DLT startups in ways that are mutually equipment, some financial institutions are seeking
beneficial. For example, financial institutions may to steer the future of promising startups early on.
provide the capital, regulatory expertise, and
access to depositors that startups need to grow. In 33As described in section 2, a complex network of
return, financial institutions benefit from access to participants is involved in PCS. Each of these
innovative financial technology, with which they participants plays one or more critical roles in the
may experiment within or alongside their existing smooth functioning of the financial system. Any
systems with limited disruption to operational or changes to the technology underlying the PCS
organizational practices. processes, therefore, would likely affect this entire
• Block chain-as-a-Service (BaaS) partnerships. network of participants. To that end, many of the
BaaS refers to a model for the provision of DLT aforementioned efforts to achieve wider adoption of
systems or services where technology companies the technology are attempting to build acceptance
charge fees for centrally hosting the computing among the existing network of intermediaries and
infrastructure, typically in a cloud environment, their ecosystem that is at the heart of the PCS activity,
and codebase necessary for DLT systems, making it including financial institutions, market infrastructures,
easy for other firms to deploy and test DLT systems end users, and service providers. Although the DLT
with limited overhead. Established technology community has generated much excitement, there
firms are competing to be the leading provider of remain certain challenges for the technology to take
BaaS services. hold in payments, clearing, and settlement.
• Participation in consortia. Consortia are helping
industry participants mutualize the costs and risks
associated with developing DLT arrangements. In
³⁴ Depository Trust and Clearing Corporation (2016), "Embracing Disruption: Blockchain White Paper," white paper, January,
http://www.dtcc.com/news/2016/january/25/blockchain-white-paper. See also SWIFT and Accenture (2016), "SWIFT on distributed
ledger," April, https://www.swift.com/insights/press-releases/swift-and-accenture-outline-path-to-distributed-ledger-technology-
adoption-within-financial-services. See also Euroclear and Oliver Wyman (2016), "Blockchain in Capital Markets," February,
http://www.oliverwyman.com/content/dam/oliver-wyman/global/en/2016/feb/BlockChain-In-Capital-Markets.pdf.

5 Challenges to adoption and industry will need a critical mass of participants for any
application of the technology to be successful.
implementation: business, technical, and
Network effects are derived from the fact that each
financial design issues
additional user of a network increases the benefit of
As noted above, the industry is at an early stage of
the network for existing users. This effect can often
development regarding DLT. As the industry continues
lead to a problem for early adoption because the net
to experiment, a number of business, technical, and
benefits for early adopters may be negative without
financial design challenges must be addressed before
sufficient participation, leading to a possible lack of
DLT can become a practical solution for some aspects
adoption. Indeed, many of the interviewed firms
of payments, clearing, and settlement. This section
explicitly recognized network effects as a critical factor
summarizes some challenges the industry must
that will influence the adoption of DLT for PCS
address in order to reach broad adoption of DLT.
processes. The industry is trying to address these
effects in various ways, as mentioned in section 4.
Business issues These efforts include establishing consortia to
Cost-benefit considerations of potential use cases facilitate cooperation on issues related to the
The previous section referenced several use cases for technology and partnerships between start-ups and
DLT that the industry is exploring. A key challenge is established FMIs that help coordinate decision-
identifying appropriate use cases where the potential making for a particular market segment.
reduction in costs of operational and financial
inefficiencies would justify the cost of the investment Technical issues
and operational changes needed to implement DLT. In Viable technology solutions
addition, the longer term operating costs of DLT would In addition to finding a business case, the industry
need to be favorable relative to current or plausible must also be comfortable that the technology can
alternative technologies. Some see potential in a c h i eve s u ff i c i e nt s ca l e o f o p e rat i o n s a n d
targeting markets that today have significant interoperability with legacy systems and other DLT
operational inefficiencies, such as highly decentralized arrangements. Both must be considered when
and disorganized post-trade operations. Others see developing a viable DLT solution.
opportunities for spillover benefits such as an
opportunity to standardize business processes Scalability
alongside DLT implementation. Still others have As mentioned in section 1.1, U.S. PCS systems process
targeted markets where the transition to a DLT hundreds of millions of transactions daily. Consensus
arrangement may have relatively lower costs because algorithms and cryptographic verification introduce
of certain efficiencies already in place, such as markets latency and limit the number of transfers that some
where assets are already in digital form. Importantly, D LT arrangements can process concurrently.
evaluations of these use cases involve a comparison of Additionally, ledgers that add transactional histories
other viable alternatives to address the frictions on top of one another, such as block chains, may
present in the markets where DLT is being considered. challenge storage capacity over time. Design choices,
such as the choice of consensus algorithm, can
Network effects mitigate some of these concerns. For example, some in
Fundamentally, if broad adoption of DLT is to take the industry are considering limiting permissions to
place in payments, clearing, and settlement, the write to the common ledger to only atrusted central

intermediary as in current arrangements, reducing In the short run, a reasonable amount of coordination,
latency by eliminating the need for consensus communication, and interoperability between
altogether. Nonetheless, electronic payments proposed DLT arrangements with existing systems and
technology must have the scalability needed to providers will be necessary for benefits of DLT to be
provide fast and reliable service to the market or it is realized. Standards-based APIs and interoperability
unlikely to be acceptable to financial institutions or protocols can serve as a needed bridge between
public authorities.³⁵ emerging and existing systems. As DLT arrangements
seek to improve the speed and efficiency of the
transfer and exchange of value, it is critical that access
Interoperability
to and interoperability with these arrangements are
Interviews with firms suggest the future will not be
equally fast and efficient. As transactions are
characterized by a single DLT arrangement. Instead,
potentially processed more quickly within a given DLT
multiple DLT arrangements will likely be developed
arrangement, other systems that depend on
and deployed based on the needed functionality and
information such as confirmation of transaction
on the required regulatory and market stipulations of a
settlement may be exposed to risk if there are delays in
specific business case. Certain legacy systems may also
or barriers to these systems' ability to access such
continue to exist. Given that the broader financial
information.
system will continue to have a diverse set of
participants interacting within a single financial Standards development
market or across different financial markets, the ability Standards development is another critical area for the
for participants to process transactions smoothly successful adoption of DLT. Standards are important
among the relevant systems will be critical to the for providing a base layer of interoperability across
continued efficient functioning of the broader different DLT arrangements and legacy systems. If
financial system. organizations eventually interact with multiple DLT
arrangements, open industry standards can also help
As now, intermediaries, businesses, and households to lower implementation and integration costs and
would still need to interact with a (potentially large) en s u re co n s istent ex p ectatio n s ab o u t h ow
number of systems to conduct their PCS activities in a information from D LT-based arrangements is
DLT arrangement. Interoperability across DLT structured and accessed. Indeed, the industry is
arrangements or between DLT arrangements and contemplating ways of achieving common standards.
legacy systems is likely to be an important factor in One challenge, however, is that many applications of
d e t e r m i n i n g t h e e x t e n t o f D LT a d o p t i o n . DLT are still being developed and tested, and the
Intermediaries may help address this problem for industry may not have sufficient information at this
businesses and households; nonetheless, frictions and point to develop appropriate standards. This is typical
costs rise as the complexity of connections to and use of emerging technologies in the PoC stage.
of different systems increase. Moreover, the likely co-
existence of legacy and new DLT arrangements adds Beyond interoperability, APIs may be required to
further complexity and fragmentation. enable DLT arrangements to make requests to
³⁵ See generally, Federal Financial Institutions Examination Council (2004), FFIEC Information Technology Handbook, "Operations Booklet,"
July, http://ithandbook.ffiec.gov/it-booklets/operations/introduction.aspx. See also SWIFT and Accenture (2016), "SWIFT on distributed
ledger," April, https://www.swift.com/insights/press-releases/swift-and-accenture-outline-path-to-distributed-ledger-technology-
adoption-within-financial-services.

external systems to achieve enhancements that are The ability to maintain the secret nature of private keys
not core to the DLT arrangement itself. A robust set of and achieve the desired security properties of public
APIs may also help organizations to realize the key encryption is a complex and challenging
operational efficiencies of DLT arrangements without undertaking, which depends on a variety of factors
requiring dramatic changes to IT architecture in the including the strength of the cryptography and the
short-term. From this perspective DLT arrangements protocols used for key generation, storage,
are not merely an end product, but can be viewed at distribution, revocation, and destruction. Reflecting
least in part as a platform developers can build upon. these challenges, numerous standard setting and
Building open APIs in common, industry-standard regulatory bodies have established detailed guidance
languages, and enhancing software development kits and minimum requirements for enterprise use of
lowers the barriers for organizations and their cryptographic keys and the design of cryptographic key
development teams to enter the DLT industry, acting management systems.³⁶
as a potential catalyst to interoperability.
Applying the requirements and guidance to DLT
C r y pto g ra p h i c key a n d a c c e s s d ata arrangements will be an important step for such
arrangements to become viable. Beyond specific key-
management
management issues, organizations that employ DLT
Effective management of cryptographic keys and
will still need to consider best practices in information
access credentials is a particularly important business
security that extend well beyond cryptography.
issue in the context of DLT because, unlike many other
applications of this type of cryptography, users can
potentially suffer immediate and irrevocable Information management
monetary losses without recourse if keys or access The introduction of DLT brings the promise that
c r e d e n t i a l s a r e l o s t o r c o m p ro m i s e d . Ke y participants share common information on a ledger
compromises may lead to economic losses associated with a history that is extremely difficult, if not
with account takeover and fraud. Lost keys may render impossible, to alter. It is fundamentally important that
data unreadable or inaccessible, resulting in the the common information be correct.
permanent loss of the value secured by the
cryptography. The ability to bind the identity of public This requirement can be difficult to achieve if many
keys to individual or corporate identities is also an participants can write to the ledger. For example,
important privacy-related aspect of digital signature decisions regarding who can create new assets and
arrangements in which users are subject to legal how information that is input to the system is checked
requirements such as those associated with anti- for accuracy are fundamental. Also, the designers of a
money-laundering compliance. DLT arrangement must determine how errors and

known fraudulent account take-overs are handled and
resolved.
³⁶ U.S. Department of Commerce, National Institute of Standards and Technology (2013), A Framework for Designing Cryptographic Key
Management Systems, August, http://nvlpubs.nist.gov/nistpubs/SpecialPublications/NIST.SP.800-130.pdf.See also U.S. Department of
Commerce, National Institute of Standards and Technology (2016), Recommendation for Key Management, January,
http://nvlpubs.nist.gov/nistpubs/SpecialPublications/NIST.SP.800-57pt1r4.pdf. See also International Organization for Standardization
and International Electrotechnical Commission (2005), Information Technology - Security Techniques - Code of Practice for Information
Security Management, June, http://www.slinfo.una.ac.cr/documentos/EIF402/ISO27001.pdf. See also Federal Financial Institutions
E xa m i n a t i o n C o u n c i l ( 2 0 1 6 ) , F F I E C I n f o r m a t i o n Te c h n o l o g y H a n d b o o k , " I n f o r m a t i o n S e c u r i t y, " S e p t e m b e r,
http://ithandbook.ffiec.gov/media/216407/informationsecurity2016booklet.pdf.

An additional challenge is the determination of exactly a securities custodian. Further, design choices need to
what information to share. This issue is especially be made to determine whether either type of book-
challenging when information, possibly including entry security is issued directly to the ultimate holder,
customer information, is shared among competitors. with transfers of the security requiring changes in the
registration of the security, or whether securities can
Relevant privacy laws and regulations must also be be held in a fungible form that can be held and
satisfied. Participants will have to agree on the extent transferred through a series of intermediaries.³⁷
of information that is shared and whether the
complete set of information will still need to be Over time, DLT may provide opportunities to re-visit
entrusted to a central institution, such as a the traditional choices for the design, holding, and
clearinghouse. Failure to agree on the level of this transfer of securities. For example, one new
“differentiated privacy” could be one challenge in development appears to be the concept of
reaching a critical mass of users. “tokenization,” in which coded data are intended to
represent a security on some type of ledger and to
Financial design issues enable rapid and easy transfers by owners or their
The use of DLT technologies may raise basic issues intermediaries, but not to be the security itself or the
about how financial instruments are designed and, in bundle of rights and obligations the security
some cases, the role and need for financial represents. One aspect that will not change is that the
intermediaries. The design of a DLT arrangement securities themselves will by definition continue to be
could take many forms and involves decisions about liabilities of the ultimate issuer of the securities.
the nature of the digital assets in the system, the

entities that can issue the digital asset and how they do Intermediaries that carry electronic securities on their
so, and the roles that intermediaries will ultimately books will presumably continue to have rights and
play regarding the issuance, storage, recordkeeping, responsibilities with respect to those securities. If
and transfer of the digital assets. Some of these issues systems with tokens representing securities are
echo debates from the development of book-entry developed, and the tokens are not designed or
securities and electronic payments over the past five intended to be securities, then questions may arise
decades. about the status of the tokens, what they represent,

and how they are treated when holdings or transfers
go awry. The legal status of digital assets is discussed
Financial instruments
further in 6.1.1.1 below. Related questions exist for
As discussed in section 4, some of those interviewed
physical commodities, although the legal framework
are considering electronic representations of
may be different and the role of physical underlying
securities that can be held and transferred on DLT
assets must be taken into account.
arrangements. Securities may be originally issued in
electronic form or in paper form, and regardless of Monetary instruments
issuance method, traditional design choices are Similar points can also be made about monetary
applicable to book-entry securities which are instruments. In the case of what might be called book-
“immobilized” or “de-materialized” through the use of entry money, financial intermediaries issue deposit
³⁷ Securities Transactions Settlement, 69 FR 12921 (March 18, 2004), https://www.federalregister.gov/documents/2004/03/18/04-

5981/securities-transactions-settlement.

liabilities that holders treat as assets and use to make bank. The liabilities of the bank held on the ledger
payments and store wealth. Traditionally, each could be registered to each holder individually but
intermediary issues its own liabilities, and the might also be issued in “bearer form” and owned by
completion of payments from one party to another whoever holds the liability. Design choices would
when each holds their monetary instruments at a presumably be influenced by the benefits and costs of
different institution typically involves a specific change the different types of arrangements. When multiple
in the amount of the account ledger (the monetary banks are involved and have customers who want to
liability at each institution) held by each party. In make payments across the banks, a mechanism would
principle, the use of D LT could involve the be needed to communicate and settle transactions
establishment of a common ledger for each bank, with between institutions in order to complete payments.
links between ledgers designed to process payments
between ledgers. However, if multiple institutions are Financial intermediaries
involved in the transfer of payments, some way to Another design choice for both securities and
settle the payments between them will be needed. monetary instruments would be the types of
The general options for conducting such settlements institutions that would be allowed to issue these
are well known. Either banks settle using adjustments liabilities and act as intermediaries. In some cases,
to their claims on each other or settle using claims on a institutions may be needed to act as custodians.
third-party financial intermediary, such as a Regulatory frameworks have been established and
correspondent or central bank. enhanced over time to address these questions and to
help foster safe and efficient systems for issuing and
Interbank settlement using a commodity such as gold transferring securities and money. To the extent new
is a historical possibility, but is unlikely within the entrants into these processes come forward with new
current monetary regimes. types of design concepts, those entrants may need to
interpret and review regulatory issues.
The design of monetary instruments that parallel
some of the original properties of banknotes is also a Some have raised the possibility that DL technology
possibility. Historically, commercial banks issued may make financial intermediaries obsolete. One
banknotes that were negotiable instruments, that is, cannot rule out long-run changes in the roles and
they were essentially the property of the holder of the responsibilities of intermediaries in financial markets
note, without a clearing and settlement process in and the demand for their services. However,
which account balances were adjusted at a central intermediaries play important roles in matching
intermediary with each payment. Certain kinds of pre- borrowers and savers in the economy, providing safe
paid cards are currently designed in this way, and the monetary instruments that form the basis of the
debate over the design of prepaid cards and electronic payment system, aggregate financial activity and
money in the mid-1990s has lessons for today.³⁸ more. It is far from clear that these functions will all
become obsolete in the foreseeable future.
In the case of DLT, each bank could presumably
maintain its own ledger for its customers to use to
make payments directly between one another without
needing to send payment instructions through that
³⁸ Committee on Payment and Market Infrastructures (2015), Digital Currencies, http://www.bis.org/cpmi/publ/d137.pdf.

6 Challenges to adoption and increase efficiencies or to mitigate a particular risk,
merely shifts the risks among actors in the PCS process
implementation: risk management
or increases the overall risks in the conduct of PCS
In addition to the challenges identified above,
activities. The extent to which a particular solution
questions also arise about the way in which the
affects the fundamental design of the financial system
implementation of DLT would fit into the risk-
as well as day-to-day activities is likely to affect this
management frameworks that already exist to
assessment. For example, on the one hand, if a
promote safety and confidence in payments and
solution reduces the cost of clearing, but does so by
securities transfer processes.
shifting financial and operational risk to end-users of a
system or by reducing the ability of specialized
Legal, settlement, operational, and financial risks are
intermediaries to manage risk, difficult decisions may
inherent in the conduct of PCS activities. With the
be needed about the trade-off between the benefits of
current design of the financial markets, such risks are
greater efficiency and the associated costs and risks.
typically concentrated at intermediaries such as banks
On the other hand, if a solution unambiguously would
and FMIs, which, in turn, specialize in managing and
reduce costs and risks to financial markets over the
controlling these risks. For example, today's FMIs
long run, it may face short-term challenges to
establish rules and manage risks through a centralized
adoption, but may also have clear long-run strategic
governance structure, help eliminate certain risks (for
benefits to the markets.
example, provide for legally defined settlement finality
and delivery versus payment), mitigate and measure
others (for example, credit and liquidity risks), reduce Legal considerations
costs of clearing and settling transactions between The legal framework (for example, statutes,
and among multiple parties (for example, netting), and regulations, policy, and supervision) governing
provide a level of transparency to the market. financial markets and the conduct of PCS activities is
However, a tradeoff may arise because FMIs also well-established. Much of the existing legal
typically concentrate much of the conduct of PCS environment, however, is organized and implemented
activities, and therefore risks, into a single or handful in a manner consistent with the current financial
of central entities. market architecture, which has a complex network of
participants that perform a variety of functions and are
Much of the focus of the policy and regulatory regulated, supervised, and overseen by a diverse
environment, therefore, has been on ensuring that group of regulators. The relevant laws, regulations,
these intermediaries appropriately and adequately andsupervisory policies are aimed at achieving broad
manage risks, so that they may run effectively even in objectives such as market transparency, safety and
times of stressed market conditions. soundness of financial institutions, and the efficient
and effective functioning of the broader financial
A key consideration that may affect the assessment system, and are not generally intended to favor a
and adoption of any DLT solution is whether a change particular electronic technology.³⁹
to one aspect of the PCS process, even if it is meant to
³⁹ Some laws and regulations have been designed to reduce the use of paper in PCS systems following, for example, the “paperwork crisis” of
the 1960s and 1970s. Some legal frameworks have also had implicit biases toward paper notices and other documents since these were the
accepted communications or authentication technologies when the frameworks were adopted.

Even so, the laws and regulations applicable to PCS can rights and obligations associated with digital tokens
affect the manner in which, speed by which, and and assets may not be clearly defined in today's legal
extent to which any implementation or configurations framework. Many ownership interests in assets, such
of DLT for a particular use case can be adopted by as negotiable instruments and securities, are already
regulated entities or new entrants to the financial represented using physical or book- entry records, and
system. It is therefore important to consider how the the corresponding legal frameworks are robust and
legal framework may differ depending on the have developed over time.
configurations of DLT, as the industry further develops
DLT use cases. Careful legal analysis must be done to understand how
ownership of digital tokens on a distributed ledger fit
Legal basis of certain DLT components into the current legal frameworks and what gaps need
Distributed ledgers to be filled by contractual agreements or new laws and
As DLT matures, the legal basis for certain components regulations.
of the technology, which may not be contemplated in Smart contracts
the current legal framework for PCS activities, will DLT has also raised the possibility of writing terms and
merit careful consideration. One of the purported conditions between parties into computer code to be
benefits of DLT is that it provides an auditable record executed automatically. In order for these “smart
of information that is simultaneously updated and contracts” to be enforceable, they must have a sound
distributed among participants.₄₀ legal basis. Contract law is an established set of rules
that govern the basic principles of contracting,
Businesses using and trusting the records that are including formation, amendment, termination, and
stored on shared ledgers must consider the legal basis dispute resolution. Some classic contract doctrines,
for these records. Users of these records will need to such as voiding unconscionable contracts, or
be assured of their reliability as an authoritative source amending contracts due to changed circumstances,
of the underlying obligations and the enforceability of conflict with the automatic execution of smart
those obligations. Shared ledgers should be designed contracts. If smart contracts proliferate, judges and
to provide these assurances under existing laws, or, juries will have to review them to determine their legal
alternatively, statutes and rules may need to be basis and evidentiary status.
a d j u s t e d t o a c c o m m o d a t e D L T- e n a b l e d
recordkeeping. Complex applications of smart contracts could
potentially allow for traditional organizations, such as
Digital representations of assets businesses and nonprofits, to be run through rules
Digital representations of a physical asset, such as encoded as smart contracts. The legal status of
tokens, as well as natively issued digital assets are also organizations that are run on smart contracts is
key components of a DLT arrangement. The ownership unclear.⁴¹
⁴⁰ An example of how using a DLT-enabled shared ledger may be inconsistent with existing laws has been highlighted in the following article:
Jenny Cieplak and Mike Gill (2016), "How Distributed Ledgers Impact Post-Trade in a Dodd-Frank World," Coindesk, July 9,
http://www.coindesk.com/distributed-ledger-cftc-post-trade-dodd-frank/.
⁴¹ For example, the Decentralized Autonomous Organization (DAO) was a smart contract running on the Ethereum block chain that acted as a
venture capital fund. Participants pledged ether, the Ethereum block chain's native crypto currency, to the DAO in exchange for tokens, which
represented voting shares in the organization. Curators (well-known members of the community) were to select projects seeking funding
and put them up for a vote, with token holders receiving votes proportional to the amount of ether they pledged.

If “management” of an organization is conducted currency world, the New York State Department of
automatically by code, legal systems will have to Financial Services' “Bit License” is one such example
determine who to hold accountable if laws are broken for institutions that play roles related to storing,
and disputes arise. The legal frameworks around recordkeeping, and transfer services.⁴² In DLT
corporations and other business associations would arrangements, intermediaries might provide services
have to adapt to the concept of distributed around the storage, recordkeeping, and transfer of
management. more-traditional financial assets but not other
traditional functions of banking such as household and
Licensing business lending (so-called narrow banks). It may be
As discussed in section 2, PCS innovation can emerge useful to explore the pros and cons of a special banking
from new technology, changes to the existing market charter with requirements that differ from traditional
structure, or both. The emergence of DLT is likely to banking licenses based on the more limited scope of
augment the existing market structure to include new services provided⁴³.
participants that provide PCS services. Some of these
participants are specific technology firms or software Compliance with BSA/AML
companies that partner with existing financial Compliance with the Bank Secrecy Act (BSA) and anti-
intermediaries to implement a DLT arrangement. money-laundering (A M L) requirements is the
Others may augment or even replace the services of responsibility of a variety of intermediaries, including
existing financial intermediaries. Although it is too but not limited to banks, money services businesses,
soon to predict what corresponding change in market and securities broker-dealers. AML compliance
structure might emerge as a result of DLT, one includes transaction monitoring, know your customer
challenge for any emergent firm that takes on a requirements, and reporting of suspicious activity to
traditional financial intermediary role is the likely need the U.S Department of the Treasury's Financial Crimes
to acquire some type of charter or license to provide and Enforcement Network (FinCEN). As DLT matures
services or conduct activities that involve the holding and the types of intermediaries in existence
and transferring of assets on behalf of households and potentially change, the appropriate government
businesses. The nature and form of such charters or agencies may need to provide guidance on the
licenses remains an open question as lawmakers and application of existing law to any new intermediaries
regulators may consider whether existing financial or PCS processes.⁴⁴ In fact, this process was followed
institution licenses are sufficient, or alternative when FinCEN issued new guidance with respect to the
licenses may need to be developed. In the crypto BSA's application to virtual currency exchangers.⁴⁵
⁴² N ew Yo r k S ta te D e p a r t m e nt o f F i n a n c i a l S e r v i ce s ( 2 0 1 5 ) , F i n a l B i t L i ce n s e Re g u l a to r y Fr a m ew o r k , J u n e 2 4 ,
http://www.dfs.ny.gov/legal/regulations/bitlicense_reg_framework.htm.
⁴³ The Office of the Comptroller of the Currency has sought comment on similar ideas. See Office of the Comptroller of the Currency (2016),
Supporting Responsible Innovation in the Federal Banking System: An O C C Perspective, March,
http://www.occ.gov/publications/publications-by-type/other-publications-reports/pub-responsible-innovation-banking-system-occ-
perspective.pdf. See also Office of the Comptroller of the Currency (2016), Recommendations and Decisions for Implementing a Responsible
Innovation Framework, October, https://occ.gov/topics/bank-operations/innovation/recommendations-decisions-f or-implementing-a-
responsible-innovation-framework.pdf.
⁴⁴ In the United States, the AML authority responsible for interpreting the BSA and its implementing regulations is FinCEN:
https://www.fincen.gov/.
⁴⁵ U.S. Department of the Treasury, Financial Crimes Enforcement Network (March 18, 2013), FIN-2013-G001, "Application of FinCEN's
Regulations to Persons Administering, Exchanging, or Using Virtual Currencies," https://fincen.gov/statutes_regs/guidance/pdf/FIN-2013-
G001.pdf.

Governance In this example, the debate centered on whether the
Effective, accountable, and transparent governance Ethereum community should claw back a large
arrangements are critical to the risk management of amount of ether that was transferred by an unknown
PCS systems. Ideal governance arrangements are clear participant from the DAO's address to a separate
and transparent, promote the safety and efficiency of address. With no single accountable decision-making
the system, and support the stability of the broader authority, philosophical differences arose about
financial system. Sound governance arrangements whether to retain a known illegitimate action in order
would continue to be necessary for DLT arrangements to preserve the inalterability of the common ledger or
in order to determine the rules regarding functionality, to attempt to essentially reverse the action because it
risk management, and access to the network, as well was known to be illegitimate. This debate led to a
as which entities are responsible for maintaining and division that resulted in uncertainty for the network
modifying the protocol. The methods by which and volatility in the value of ether.⁴⁶
governance arrangements take effect may differ
depending on the design of the DLT arrangement. Two Closed permissioned systems
extremes in the design of DLT arrangements are Conversely, closed systems, and particularly those in
discussed below. which participants are differentiated based on the
roles they play and functions they are permitted to
Open permissionless systems perform, may involve one or more institutions that
Open and permissionless systems, discussed in section have ownership rights over the arrangement. To that
3.1, may require distributed governance end, this type of arrangement could create a more-
arrangements, in which consensus could be used to centralized governance structure for granting access
determine any changes to the network's protocol or to the system arrangement, making significant
functions. It is not clear, however, the extent to which decisions such as rules or technology upgrades on
such arrangements would address significant behalf of the arrangement, as well as determining
unforeseen issues or the potential need to change permissions to write changes to the ledger. Such
significant rules once they are put into motion. The arrangements are likely to be more recognizable as
potential lack of clear, transparent, and predictable traditional corporate or F M I governance
governance, particularly in an open and arrangements than computer protocols for open and
permissionless DLT arrangement, could potentially permissionless arrangements. Permissioned systems
have a negative effect on the stability of the network may also employ governance arrangements that allow
and broader financial system, especially if it at any for distributed (potentially delegated) governance for
point the network interacts significantly with some aspects of the network and centralized
regulated entities in the traditional financial system. governance for others. Importantly, as with the
traditional corporate or F M I governance
The 2016 hack of the Decentralized Autonomous arrangements, uncertainty could be reduced around
Organization (DAO) demonstrated the challenges of responsibility, accountability, and liability for decisions
having a decentralized governance arrangement that related to the system. The flexibility of the governance
requires consensus of the network to deploy changes. arrangement to adjust over time might also increase.
⁴⁶ For additional information on the DAO hack, see Dan Goodin (2016), "Bitcoin Rival Ethereum Fights for its Survival after $50 million Heist,"
June 21, http://arstechnica.com/security/2016/06/bitcoin-rival-ethereum-fights-for-its-survival-after-50-million-heist/.

Settlement finality the asset in rigorous versions of DvP. Not only must
A key risk in entering into any financial transaction is finality be clear and certain for both legs, but each leg's
the risk that settlement will not take place as expected. finality should be conditional on the finality of the
Failure to settle as expected can be due to a number of other. This interdependency can be a challenge in a
factors, such as a counterparty's default, an situation where the payment and asset delivery legs
operational issue, or uncertainty about when may not be occurring on the same network, platform,
settlement is considered final and irrevocable. This or ledger and where no intermediary exists to provide
section discusses two types of uncertainties in assurance for settlement finality. Should a
settlement finality that a DLT arrangement might counterparty default on its obligations after only one
introduce. of the legs of the transaction settles, there could be an
open question regarding the status of the transaction.
In post-trade clearing and settlement, settlement At a minimum, such designs for DvP deserve rigorous
finality is currently a legally defined moment, typically scrutiny, and may require extra layers of risk
supported by a statutory, regulatory, and/or management.
contractual framework underlying a given financial
transaction. Parties to a transaction and their Financial risk
intermediaries rely on the definition and timing of Counterparties to a financial transaction may also face
finality when they update their own ledgers to effect credit or liquidity risks arising in each step of the
settlement, determine the ownership of assets, and payment, clearing, or settlement processes. Credit risk
measure and monitor various risks. In contrast, in is the risk that a counterparty may be unable to fully
some versions of DLT arrangements, multiple parties meet its settlement obligations when due or at any
are permissioned to update a shared ledger, and those point through the duration of the exposure.
parties must agree to a particular state of the ledger
through the consensus process. Settlement finality in Liquidity risk is the risk that a counterparty will have
this world rests on probabilistic finality, whereby the insufficient funds to meet its financial obligations
longer a transaction is considered settled by the when due but may do so at some point in the future.
system participants, the less likely this transaction will Although these two risks are distinct concepts, they
be reversed (or dropped). This approach to finality are often related.³⁷
contrasts with the traditional approach of defining an
unambiguous and transparent moment of finality. In a financial system with financial intermediaries that
With a probabilistic approach to finality, legal liability have responsibilities for facilitating the payment,
may be difficult to assign or be ambiguous in such a clearing, or settlement processes and sometimes even
network, and the uncertainty has implications for the guaranteeing settlement of a transaction on behalf of
balance sheets of participants as well as the rights of its customers or participants, much of this credit and
their customers and creditors. liquidity risk between the original counterparties is
assumed and managed centrally by the intermediary.
Settlement finality is even more complicated when Tools for managing credit risks range from those that
considering both legs of a financial transaction, for eliminate credit risk (for example, requirements that
example, the delivery of an asset against payment for
⁴⁷ Committee on Payment and Settlement Systems and Technical Committee of the International Organization of Securities Commissions
(2012), Principles for Financial Market Infrastructures, http://www.bis.org/cpmi/publ/d101a.pdf, page 19.

payment obligations be fully prefunded) to those that remaining unaffected entities would be able to
mitigate and manage credit risk (for example, allowing maintain an accurate ledger and, therefore, continue
for posting of collateral at reasonable haircuts, or the system's operations. Further, some interviewed
discounts from market value). Whether an FMI firms suggested that individual firms or system might
participant is required to fully prefund a payment be able to employ DLT to store backup copies of data
within legacy systems in a technologically diverse
account or post collateral in order to complete a
system in order to strengthen resilience against
transaction affects the participant's own liquidity.
cyberattacks.³⁹
Similarly, how a DLT arrangement is designed to
handle counterparty credit risk could have a significant
impact on the participants' liquidity needs. DLT arrangements must also address the same risks as
existing PCS systems and, although the current
Operational risk procedures and controls used to address these risks
appear to be generally relevant for DLT, modifications
The risk of operational failures or disruptions threaten
may be required in order to make these currently used
the successful settlement of financial transactions,
risk-mitigation strategies applicable to a distributed
irrespective of whether the underlying payment,
environment. Similar to traditional PCS systems, one
clearing, or settlement processes are supported or of the biggest concerns with DLT solutions is endpoint
facilitated by an intermediary or through a security. As with any system where vulnerabilities can
decentralized and automated technological platform. potentially exist within both software and hardware
Possible operational failures include errors or delays in components, DLT may face increased exposure to
processing, system outages, insufficient capacity, cyber-attacks through its distributed network of
fraud, and data loss and leakage. Therefore, system participants, or endpoints, which are validating
resiliency and security are critical components of transactions and writing to the blockchain. Endpoint
managing operational risk. security remains an ongoing challenge for which no
easy technological solution may exist.
Safety and integrity in clearing and settlement is
critical for broader financial stability which is a key Additionally, the strength issue of cryptography is
reason that major clearing and settlement systems are particularly important for D LT arrangements.
regulated. Hence, a fundamental threshold test for Cryptography can be used not only to protect data but
new technologies will be whether they can be also to serve as a way to manage rights and access to
deployed and operated safely, with the requisite high data. Although layered approaches to security, known
degree of resiliency and security across a wide range of as Defense in Depth, would be expected for any
adverse scenarios.³⁸ Many of the interviewed firms organization using DLT or any other technology, if the
suggest that the distributed data storage aspect of DLT sy s t e m ' s e n c r y p t i o n i s c o m p ro m i s e d , D LT
provides greater resilience and data integrity than arrangements may be particularly vulnerable. Not only
traditional centralized clearing and settlement is the strength of the encryption important, but so too
systems do. If one or several entities that hold a copy of are the procedures and controls surrounding the
the distributed ledger experience a failure, the security of encryption keys and any key management
⁴⁸ Lael Brainard (2016), "The Use of Distributed Ledger Technologies in Payment, Clearing, and Settlement," speech delivered at The Institute of
I n t e r n a t i o n a l F i n a n c e B l o c kc h a i n Ro u n d ta b l e , Wa s h i n g to n D.C . , A p r i l 1 4 , h t t p s : / / w w w. fe d e r a l r e s e r v e . g o v /
newsevents/speech/brainard20160414a.htm.
⁴⁹ Committee on Payments and Market Infrastructures and Board of the International Organization of Securities Commissions (2015),
Guidance on Cyber Resilience for Financial Market Infrastructures, http://www.bis.org/cpmi/publ/d146.pdf. See also National Institute of
S ta n d a r d s a n d Te c h n o l o g y ( 2 0 1 4 ) , Fr a m e w o r k f o r I m p r o v i n g C r i t i c a l I n f r a s t r u c t u r e C y b e r s e c u r i t y, Fe b 1 2 ,
https://www.nist.gov/sites/default/files/documents/cyberframework/cybersecurity-framework-021214.pdf.

processes used. Furthermore, because risks and identifies both the opportunities and challenges facing
threats are continually evolving, the procedures and its long-term implementation and adoption. In the
controls to secure DLT systems must also continually context of payments, DLT has the potential to provide
assess risk, improve, and adapt, which may be new ways to transfer and record the ownership of
particularly challenging in an open and permissionless digital assets; immutably and securely store
system. Ultimately, these and other security concerns information; provide for identity management; and
will have to be fully addressed before DLT can achieve other evolving operations through peer-to-peer
widespread adoption. networking, access to a distributed but common
ledger among participants, and cryptography.
However, these same design properties may also help Potential use cases in payments, clearing, and
DLT address certain resiliency and security risks that settlement include cross-border payments and the
are present in traditional systems. For example, some post-trade clearing and settlement of securities. These
experts suggest that DLT arrangements can be created use cases could address operational and financial
without the reliance on centralized databases that are frictions around existing services. Nonetheless, the
typically susceptible to disruptive cyber-attacks. By industry's understanding and application of this
using certain distributed ledger arrangements, it may technology is still in its infancy, and stakeholders are
be possible to reduce or avoid the risk of extensive and ta k i n g a va r i e t y o f a p p ro a c h e s to wa rd i t s
prolonged system outages (and even permanent development. Given the technology's early stage, a
losses of data) in a manner different from the number of challenges to development and adoption
traditional approach of systems that rely on remain, including in how issues around business cases,
centralized databases. Instead, identical and widely technological hurdles, legal considerations, and risk
dispersed databases that are hard to impact management considerations are addressed.
simultaneously may be able to assist one another in
recovering from a cyber-attack. Nonetheless, there are Finally, as a recent innovation, DLT has the potential to
a number of important factors to consider that also drive change to the financial market structure in
underlie such suggestions, including the difficulty of ways that take advantage of the new technology.
simultaneous attacks on all of the databases in a Although it is too soon to predict what these changes
distributed network, the difficulty of corrupting data may be, the way that the industry finds use cases and
stored on a DLT, the ability to quickly propagate data to addresses the challenges identified in this paper will
compromised sites, and the ability of a compromised provide clarity over time. As the technologies and
site to quickly begin using the refreshed data. For DLT experimentation with these technologies continue to
to be successful, careful and ongoing analysis of the develop, it will be important to thoroughly understand
security considerations will be critical. how these changes apply broadly. Understanding the
potential range of DLT adoption and its link to
7 Summary changing the financial market structure is an area for
This paper has examined how DLT can be used in the future research.
area of payments, clearing and settlement and
David Mills, Kathy Wang, Brendan Malone, Anjana Ravi, Jeff Marquardt, Clinton Chen, Anton Badev, and
Timothy Brezinski are/were with U.S. Federal Reserve Board. Linda Fahy, Kimberley Liao, Vanessa
Kargenian, Max Ellithorpe, and Wendy Ng are/were with U.S. Federal Reserve Bank of New York. Maria
Baird is/was with U.S. Federal Reserve Bank of Chicago.


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Distributed ledger technology

in payments, clearing, and settlement

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Working Papers may be quoted without additional permission.

ISSN: 0971-1023 | NMIMS Management Review Distributed ledger technology in payments,

ISSN: 0971-1023 | NMIMS Management Review Distributed ledger technology in payments,

ISSN: 0971-1023 | NMIMS Management Review Distributed ledger technology in payments,

ISSN: 0971-1023 | NMIMS Management Review Distributed ledger technology in payments,

ISSN: 0971-1023 | NMIMS Management Review Distributed ledger technology in payments,

Solutions to these inefficiencies, in turn, took the form

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Figure 3: Two simple examples of node connectivity structure

An entity's ability to participate in a DLT arrangement, Participants in a DLT arrangement can be

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improve usability of DLT arrangements

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²⁹ Committee on Payment and Market Infrastructures (2016), Correspondent Banking, http://www.bis.org/cpmi/publ/d147.pdf.

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³² See https://interledger.org/interledger.pdf for more details.

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money-laundering compliance. DLT arrangement must determine how errors and

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the nature of the digital assets in the system, the

decades. about the status of the tokens, what they represent,

³⁷ Securities Transactions Settlement, 69 FR 12921 (March 18, 2004), https://www.federalregister.gov/documents/2004/03/18/04-

ISSN: 0971-1023 | NMIMS Management Review Distributed ledger technology in payments,

ISSN: 0971-1023 | NMIMS Management Review Distributed ledger technology in payments,

ISSN: 0971-1023 | NMIMS Management Review Distributed ledger technology in payments,

ISSN: 0971-1023 | NMIMS Management Review Distributed ledger technology in payments,

ISSN: 0971-1023 | NMIMS Management Review Distributed ledger technology in payments,

ISSN: 0971-1023 | NMIMS Management Review Distributed ledger technology in payments,

ISSN: 0971-1023 | NMIMS Management Review Distributed ledger technology in payments,

ISSN: 0971-1023 | NMIMS Management Review Distributed ledger technology in payments,

ISSN: 0971-1023 | NMIMS Management Review Distributed ledger technology in payments,

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