26 September 2017
Carlo R.W. De Meijer

Blockchain Observations

Carlo R.W. De Meijer - MIFSA

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UBS and the Utility Settlement Coin

03 September 2017  |  9084 views  |  0

These are interesting times for blockchain and distributed ledger technology. My last blog of 23 August was about the Microsoft CoCo Platform (see:  Microsoft CoCo Platform: blockchain game changer?) that could become an important trigger for further and more scaled blockchain adoption. And now it was recently announced that another six international banks have joined the UBS's big blockchain-led initiative, the so-called Utility Settlement Coin project  or in short USC, which is intended to “smooth the way” for inter-bank settlements.


The USC project
Already in September 2015 the Swiss bank UBS launched its first Utility Settlement Coin (USC) concept in collaboration with UK-based blockchain company Clearmatics. They  were later joined (August 2016) on the project by BNY Mellon, Deutsche Bank, Santander, broker/dealer ICAP and the financial services firm NEX. Recently we saw the addition of Barclays, HSBC, State Street, Credit Suisse, MUFG and the Canadian Imperial Bank of Commerce.

“They have joined at a time when the project shifts into the next stage of development” Hyder Jaffrey, head of strategic investment and fintech innovation at UBS.

The idea is to develop a new, streamlined payment mechanism for institutional purposes, that could potentially replace clearinghouses and other intermediaries that sits between buyers and sellers of assets.

Swiss bank UBS is now leading a team of ten of the world’s biggest banks aimed to create/develop a digital cash system to effectively process inter-bank transactions via blockchain or distributed ledger technology. This USC would allow financial markets to make payments and settle transactions quickly using blockchain technology, while minimising risks in the payments and settlement process. The idea is that exchanging the digital currency as payment for assets will be a more efficient means of exchange.


What is the Utility Settlement Coin or USC?
The USC project in – in essence – aimed at making it easier for central banks to issue currencies on a blockchain. The USC project is designed to help prepare the way for central bank crypto currencies by making it easier for global banks to conduct a wide variety of transactions with each other using collateralised assets on a custom-based blockchain.

USC will act as a fully asset-backed digital cash instrument that would be cleared and settled via distributed ledger technology such as blockchain. It is the intention that the USC will be completely backed by cash assets through large banks and central banks. The USC will be a collateralized digital coin that banks could use to pay one another or to buy securities more quickly. Unlike bitcoin, the USC would not be its own cryptocurrency. It will be a digital cash equivalent of each of the major currencies backed by central banks, such as the dollar or euro, rather than a decentralized new digital currency such as bitcoin. It would act as a convertible stand-in for major currencies.

The USC would be convertible at parity with a bank deposit in the corresponding currency. Each settlement coin would represent fiat currency like euros and dollars on a one-to-one basis, and would thus be 100% backed by collateral at the domestic central bank. Spending a USC would be the same as spending the real currency it is paired with.


What are the benefits?
“From reducing risk to improving capital efficiency in financial markets we see several benefits of this project," Barclays Investment Bank's Lee Braine .

The USC would use a blockchain-based distributed ledger to record transactions quickly and allow payment tokens to go straight to the owner of the asset being sold, rather than passing through clearinghouses. Blockchain thereby works as a “tamper-proof” shared ledger that can automatically process and settle transactions using computer algorithms, without the need for third-party verification.

“Transfers and ownership could be settled instantly—the promise of blockchain technology”. UBS

As it does not require manual processing, nor authentication through intermediaries, the technology can make payments faster, more reliable and easier to audit. And because the digital coins will be backed by cash at a central bank, which cannot default, the crypto tokens are free from credit risk.


Phased approach
USB and its partners are taking a phased approach for preparing and implementing the USC. The group is now entering the third phase after having thought about the concept (Phase I) and legal and regulatory compliance issues surround decentralising the system (Phase II). That structural work is now almost completed. For now, the banks working on the USC are preparing to test transactions using it (Phase III), to work on the system's security and privacy, and to conduct further discussions with central banks.

Phase II: USC and regulation
The group is in discussions with central banks and regulators. Such a form of digital cash will need to conform to regulatory requirements and be recognised and adopted widely by the markets. The discussions centre on improving data privacy and cyber security in order to appease regulatory concerns.

“We have been in discussions with central banks and regulators and we will continue that over the next 12 months with the aim of a limited ‘go live’ at the back end of 2018.” “It raises questions, and possibilities, over a fundamental market structure principle: who can have access to central bank money and how.” UBS

Phase III: testing phase
The third phase of the USC project is the testing phase and will be the last before a live implementation. This newly commenced phase is expected to last for about 12 months. For that purpose the USC team has created a kind of testnet for the project that seeks to back crypto-tokens with collateral. Part of the group’s third phase revealed the testing of a formal transfer of ownership and an accurate cash equivalents definition for the transfer in an effort to ‘mimic’ what a real-time end-to-end transaction between members would look like.

In that transfer test, the group will explore using a collateralised token, which could simplify the buying and selling of assets to a single, fiat-based transaction conducted on a blockchain, leaving clearing houses aside. In short, the collateralised tokens will be given directly to the owner of the asset, instead of going the traditional network of clearing houses.

Phase IV: go-live
The project involving UBS and other financial firms is far from complete.

UBS and the partnering banks are therefor aiming for a “limited go live” with the USC system at the end of next year. The first live collateralised token exchange using the USC platform could occur as soon as the end of 2018.


Open questions
There are a number of open questions, like whether the technology could handle the volume necessary for the scale of institutional markets run by big banks. Other issues include:

- How many USCs will be brought into circulation?

- Is USC going to work as a real centrally-led independent crypto currency with its own value?

- What will determine its value?

- Will or must central banks also going to use USC?

- Will USC be a competitor of Ripple’s XRP or SETL Coin?

The USC and central banks
What is special with the development of the USC is that this new crypto currency will not be created by a central bank. It will be an own internal p2p network for the realisation of cross border payments. The big question is: will or must central banks also going to use it?

“USC could help eliminate a path forward for central bank digital currencies, one of the reasons HSBC joined to begin with.” “It is a very great step forward in terms of going for more ambitious projects such as central bank digital currencies in the future.” Kaushalya Damasundaram, head of fintech partnership and strategy HSBC

Competition or fragmentation
Another question is: will the USC increase competition between existing cryptocurrencies like Ripple’s XRP, Ethereum’s Ether, LiteCoin, SETLCoin etc.

“If banks of different digital asset groups want to settle trade with one another, they’ll have to make markets between their unique digital assets or trade between their digital assets and a common fiat currency. What a mess!” Brad Garlinghouse, Ripple Lab

Some said it could be that that in the end XRP will be chosen given that MUFG is partnering in both Ripple and the USC.


Going forward
Main goal of the USC Project is wide sector adoption of the blockchain platforms that interoperate with each other.  The USC will most likely be used in the interbank market to start with, enabling banks to repay each other in different currencies “without having to go through the current  cross-border settlement infrastructure and instead rely on the potentially more efficient DLT”. 

The next step will be to enable banks to settle securities transactions via the USC, however this will necessitate all the relevant securities to be transferred to blockchain systems to gain the settlement and verification benefits of the technology.


Forward thinking
While the USC will be limited in scope from the start, the potential impact it could have in the future may be huge. According to its proponents the USC could play an important role in reforming the global financial system.

“Digital cash is a core component of a future financial market fabric based on blockchain technology”, Hyder Jaffrey, UBS director of strategic investment and fintech innovation.

 “It may well inform the way central banks choose to move things forward.” ”We see it as a stepping stone to a future where central banks issue their own (cryptocurrency) at some point.” Hyder Jaffrey, UBS director of strategic investment and fintech innovation.

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