Recently, there were a lot of debates about the potential benefits of the blockchain technology, to improve the world payments – especially international payments. It is a business where a lot of different parties have to reach consensus to route the payments, as well as perform currency conventions, and deploy and manage liquidity in different jurisdictions, all of this subject to the various regulatory constraints.
The high complexity of payments networks
One of the significant problems that blockchain can tackle is the high complexity of payments networks, caused by the fragmentation of the financial industry itself, which actually makes it impractical for individual banks to deal directly with all of the other banks in the world.
For instance, at the time when a bank gets a payment instruction from a client, it needs to find a correspondent bank that is willing to take the funds and terminate the payment of the client locally at the receiving bank. To do that, the correspondent bank has to have a nostro or vostro account with the receiving bank, ideally with enough pre-funded liquidity in order to complete the payment on behalf of the client.
But, when this happens, the receiving bank will have no other way to verify that the incoming transfer from the correspondent bank, in fact, corresponds to the original client that sends the money. That is the reason why a SWIFT message from the sender is required so that the receiving bank can understand what the aim of the incoming funds is, do proper due diligence or anti-money laundering checks on the payment, as well as inform the receiver of the funds.
All the involved parties which have different ledgers do not share a single version of the truth, and the communication between all these parties will be slow, and error-prone, many times relying on manual interventions by back-office teams. Moreover, someone will have to perform currency conversion at either end, and different parties have to manage liquidity levels at nostro/vostro accounts, which involve settling against central bank accounts.
The assurance of Blockchain
The significant promise of Blockchain is precisely providing that single version of the truth which is missing in the picture above.
Indeed, a right, as well as smart contract-enabled blockchain will provide a simple ledger and transactional engine where balances can be maintained and transacted upon and where payments can live as single, as well as everyday digital objects which make messaging and reconciliation not necessary.
With the use of smart contracts, different parties cannot just register tokenized funds, as well as payments, but they can make some rules which are applying to every of the aspects of then end-to-end payments processes, in that way eliminating errors and misunderstandings, increasing transparency and audibility, as well as reducing fraud and cyber risk.
At the moment, the most of the decentralized solutions which has been proposed usually focus on improving payments processes, either by digitizing the messaging layer, or eliminating it by creating singe, as well as digital representations of payments that have the ability to enforce transactions of property ledger, associated to another with a sort of inter-ledger protocol.
When someone tries to scale such systems, a critical problem arises, mainly when some large payments issued by corporate clients are at stake: management of liquidity.
Indeed, the fast and overnight payments rely on pre-funded nostro accounts, so the correspondent bank has the cash on hand, to terminate the payment, in that way eliminating any settlement risk. When such kind of nostro accounts has to be rebalanced over the course of the business day, some large sums of money have to be moved through central banks.
A low velocity of liquidity internationally ends up when there is tying up liquidity at nostros at levels which are higher than it is indispensable. It can be a massive problem due to the vital opportunity costs of such funds – mounting from tens or many of basis points to tens of percentage points in emerging economies.
The possibility to have digitally native tokens which act as a store of value within the same ledger where payments, as well as commercial bank balances and nostro balances, are stored represents a fundamental, revolutionary solution for improving the situation.
Through this, there is also a possibility of implementing token-based secondary markets for liquidity exchange, which also enable liquidity providers to trade between each other, with much less friction and improved transparency, as well as reduce the levels of liquidity which is deployed in nostro account in different places, because of the much higher capital velocity.
With such tokens, as well as with the use of smart contracts, participants can post available liquidity, in certain geographies as collateral, to borrow liquidity in some places where it is more urgently needed.