Introduction
This article aims to set the stage for a deeper investigation into the role of central banks like the RBA. We examine the infrastructure based mechanisms central banks use to maintain financial stability and how current systems offer limited support to the non-financial sectors.
The core of the article proposes how blockchain can enhance these existing financial systems using a programmable settlement layer. It details blockchain’s potential applications in risk management and regulatory compliance, emphasising its capacity for atomic settlements, tokenisation, collateral management and enhancing transparency.
Finally, it addresses potential challenges in blockchain implementation and concludes with a strategic reflection on the necessity of adopting blockchain for broader economic stability, arguing against the immediate need for CBDCs while advocating for a robust, centralised infrastructure maintained by trusted entities like the RBA.
Context
I am a Co-Founder of NotCentralised, a venture studio in the emerging tech space. In a previous life, I was a quantitative researcher turned structurer and then trader of exotic derivates at global institutions like Bank of America Merrill Lynch and the Royal Bank of Scotland.
Last year, NotCentralised had the honour of being selected to be part of the Reserve Bank of Australia’s CBDC Pilot. During the pilot, the Reserve Bank of Australia (RBA) executed an experiment where M0, the monetary base, was affected through the minting of tokens on a private instance of Ethereum where these tokens were legal liabilities equal to cash. Our contribution to the pilot was the development of a novel framework called Layer-C that enables integrated risk management with selective disclosure and digital escrows for the construction industry and the wider economy.
Note: Our participation in the CDBC Pilot was entire funded by NotCentralised. There was no commercial relationship between NotCentralised or the Reserve Bank of Australia
Let’s define a problem worth solving
What does the RBA do and why are financial institutions much more stable than many other participants of the wider economy?
To answer this question, we must first understand the role of the RBA in the context of financial institutions and the way in which these institutions engage in financial transactions.
First of all the RBA issues money, sets monetary policy and maintains financials stability amongst other things. To maintain financial stability, the RBA serves a select group of financial institutions by offering them access to ESA (Exchange and Settlement Accounts). Access to an ESA account allows the institutions to hold money at the RBA, lend and borrow at the RBA overnight rate and offers account holders the ability to efficiently meet financial obligations with other ESA account holders. By controlling the rate at which ESA account holders can access liquidity the RBA is able set interest rates across the wider economy. To increase financial stability, the RBA maintains systems that ensure swift money transfers and messaging protocols with a high integrity ledger.
The mechanisms the RBA offers financial institutions to streamline their settlements requirements are the RTGS (Real-Time Gross Settlement), RITS (Reserve Bank Information and Transfer System) and AIF (Automated Information Facility). Each system offers its users distinct benefits which complement the requirements to meet financial obligations at scale and with high throughput. In order for users to efficiently maintain these systems and operate safely within the financial system, the RBA sets high compliance requirements and has great oversight of each of the institution’s financial activities. Consequently, the financial institutions must be highly sophisticated and able to fund the related operating and compliance costs. Further to the RBA’s facilities, financial institutions rely on rich legal constructs like ISDA agreements to set the parameters over margin requirements and collateral. To meet obligations linked to ISDA agreements, financial institutions are obliged to maintain custom, costly and sophisticated system that integrate to their ESA accounts and other transfer mechanisms.
Please note that the risk management systems and facilities these financial institutions have access to are not only necessary due to the complexity of the risks they are exposed to, but also because they bring transparency and robustness to the management of financial obligations. Although not all participants of the wider economy are exposed to complex financial risks, all members of an economy have financial obligations and require systems to manage them.
Unfortunately, the wider economy doesn’t benefit from these types of systems and protocols meaning that the financial system across non-financial institutions is much less stable. The consequences can be seen clearly with the frequency of defaults in the construction industry.
Consider that while individual participants in a supply chain might face simple risks, connecting these risks through the supply chain can make the overall system’s risk highly complex and fragmented.
Additionally, one could argue that the wider economy has a much more complex supply chain configuration than the networks of sophisticated financial institutions. Although most of these complications stem from the lack of sophistication of the participants, the much larger number of participants cannot be neglected. Finally, hypothetically speaking even if the all the participants of an economy were sophisticated, current technologies do not make it feasible for the RBA to have oversight of the entire economy.
Now to the problem.
How do we create systems that achieve higher degrees of financial stability across the wider economy?
Blockchains are akin to integrated banking system that can be used by the economy as a whole. Through blockchain as a contractual settlement layer, commercial relationships can be modelled, booked and monitored in real-time, similar to the facilities offered by the RBA. In addition to the features of the RBA facilities, blockchain offers a a highly scalable and auditable infrastructure simplifying and streamlining compliance requirements across complex supply chains.
To clarify, adopting blockchain technology at the Central Bank does not mean creating a CBDC. We don’t need a new type of money to gain the advantages of blockchain, such as programmable transfers and settlements, which can immediately benefit the broader economy more than issuing a Central Bank’s digital currency would. Annexing a blockchain enabled transfer and settlement layer richer than the NPP would bring great standardisation and integrated risk management benefits to the wider economy.
On the one hand we speak of the importance of financial inclusion, i.e. access to banking, but we neglect the importance of access to risk management systems that are currently only available to the well capitalised due their high costs.
Financial stability is not about inclusion, it’s about risk management…
Technical benefits of a blockchain based settlement layer:
- Programmabality: The RBA could leverage smart contracts to automate the settlement process and offer digital escrows. They could be used to automatically trigger payments once certain conditions are met, without the need for manual intervention.
- Auditable Selective Disclosure: Through zero-knowledge-proofs obfuscated information about transactions on a blockchain can be viewed by all participants with the necessary permissions. This level of type transparency could improve the auditability of transactions and reduce the potential for fraud.
- Efficiency and Speed: Blockchain technology could enable near-instantaneous settlements, as opposed to the end-of-day settlement that is common with some traditional systems. This would improve liquidity management for participating institutions and reduce counterparty risk.
- Immutability: Once a transaction is recorded on a blockchain, it cannot be altered or deleted. This feature would provide an indisputable record of all transactions, enhancing the security and integrity of the financial settlement process.
- Interoperability: A blockchain-based settlement system could be designed to be interoperable with other payment systems, both domestic and international, facilitating cross-border transactions and reducing the complexity and costs associated with them.
- Decentralisation: By using a blockchain, the RBA could distribute the ledger across multiple nodes, which could be controlled by trusted parties such as banks or other financial institutions. This would reduce the risk of a single point of failure and increase the resilience of the settlement system against cyber-attacks and operational disruptions.
Blockchain Implementations and Economic Benefits
Integrating a blockchain solution to the current RBA stack could be potentially done through a bridging mechanism linked to the ESA accounts. Holders of these accounts could be offered methods to lock AUD held in the ESA and automatically mint their own respective stable coins in the RBA hosted blockchain. Although this mechanism could be technologically similar to a CBDC, the proposed method is very different as a legal construct because it does not require an alteration of the existing forms of money and therefore does not change the monetary base M0.
Once each ESA holder has minted their own cash-backed stable coins, they would be able to leverage the multiple benefits of smart contracts like atomic settlements. Atomic settlement is the capability of system to either settle a multilateral transaction in its entirety or not at all settle. Combining this with the capability of tokenising assets brings an additional layer of financial stability linked to the risk of settlement issues. Simply put, the importance that the Australian economy places on reducing risks for certain assets is similar to the costs involved in operating the ASX, including daily operations and necessary collateral. The real costs would include the cost of managing the settlement risk of every traded asset and service in an economy including real estate, commodities, derivatives, goods and services just to name a few.
The blockchain ecosystem has shown the value of validation through proof of stake mechanisms. Traditional markets have used versions of proof of stake where collateral is used to secure the validity of specific operations, for example the clearing and settlement of financial instruments. Through blockchains, the wider economy could benefit from the enhanced security of staking and collateral in much more efficient ways.
Collateral is expensive since it locks liquidity in segregated pools. By design, this segregation disables the use of liquidity making it unavailable for investments into growth or efficiencies. Through the application of blockchain based proof of stake techniques for tokenised assets, the economy could allocate collateral in much more dynamic and surgical ways than methods currently available, therefore increasing economic and financial stability.
Wholesale Relationship
Historically, Central Banks have only had direct relationships with financial institutions, unless we count cash as a relationship of course. Our proposal for implementing blockchain doesn’t change this configuration. Financial Institutions that hold ESA accounts could be the only parties able to open pseudo anonymous wallets for their own customers where each institution is responsible for KYC and AML. This way, ESA holders are responsible for setting controls and compliance procedures which apply to their customers’ actions. Please note the similarities with omnibus accounts in tradition finance.
Smart contracts on programmable and immutable ledgers are perfect tools for the implementation of compliance procedures. Furthermore, the standarisation across technology stacks and programming languages that blockchains bring enable the development of innovative fintech solutions by the startup community while still being controlled by compliance procedures of mature and robust financial institutions.
Final thoughts
I believe that it is of strategic importance for the Australian economy to offer better rails that maintain economic and financial stability across the entire economy.
As previously mentioned, CBDCs are not necessary since digital money within ESAs can be “bridged” through mechanisms similar to those used in cash backed stable coins. In doing so, the Central Bank would not affect M0 nor its legal liabilities related to it.
Although there are benefits to CBDCs, the more pressing benefits come from the adoption of blockchains across the wider economy. The choice we must make is if the Australian economy should settle on:
- Fragmented systems offered by private companies
- Community driven systems that could be difficult to maintain by a central counterpart
- A proven infrastructure maintained by a trusted party benefitting the common good… hint hint: the RBA.
