Legacy technology and interoperability could be the stumbling blocks to widespread uptake of distributed ledgers in the financial markets, creating unintended consequences for the efficient functioning of markets, a Federal Reserve Bank governor has warned.
In a speech to a blockchain roundtable in Washington DC, Federal Reserve governor Lael Brainard acknowledged the potential of distributed ledger technology for removing friction in clearing and settlement without the help of intermediaries both within and across borders.
Noting that such a revolution would be akin to the sea changes in markets wrought by the use of computerised book-entry securities systems to streamline custody, clearing, and settlement in the securities markets in the 1970s, Brainard said that the Fed's engagement with the industry over the application of blockchain technology would be guided by the same principles of efficiency, safety and integrity, and financial stability applied in earlier eras of technological upheaval.
"Today, many industry participants are experimenting with distributed ledger technology in controlled, permissioned environments," she said. "If some of these experiments bear fruit, it will be important to address the challenge of how they would scale and achieve diffusion. In addition, determining exactly how the different distributed ledger technologies interoperate with each other, and legacy systems, will be critical. New and highly fragmented 'shared systems' may create unintended consequences even as they aim to address problems created by today's siloed operations.
"Since distributed ledgers often involve shared databases, it will also be important to effectively manage access rights as information flows back and forth through shared systems. There may well be a tradeoff between the privacy of trading partners and competitors on the one hand, and the ability to leverage shared transactions records for faster and cheaper settlement on the other hand. And of course, development of sound risk-management, resiliency, and recovery procedures will be necessary to address operational risks."
Looking more broadly across the full spectrum of developments in the digitisation of finance, Brainard says the Fed has established a multi-disciplinary working group that is engaged in a "360-degree analysis" of fintech innovation.
"We are bringing together the best thinking across the Federal Reserve System, spanning key areas of responsibility, from supervision to community development, from financial stability to payments," she said. "As policymakers, we want to facilitate innovation where it has the potential to yield public benefit, while ensuring that risks are thoroughly understood and managed. That orientation may have different implications in the arena of consumer and small business finance, for instance, as compared with payment, clearing, and settlement in the wholesale financial markets."