333308566-Distributed-ledger-technology-in-payments-clearing-and-settlement


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FinanceandEconomicsDiscussionSeries
Pleasecitethispaperas:
Mills,David,KathyWang,BrendanMalone,AnjanaRavi,Je Marquardt,Clinton
Chen,AntonBadev,TimothyBrezinski,LindaFahy,KimberleyLiao,VanessaKar-
genian,MaxEllithorpe,WendyNg,andMariaBaird(2016).\Distributedledger
NOTE:Sta workingpapersintheFinanceandEconomicsDiscussionSeries(FEDS)arepreliminary

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 r
esponsibility 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.

istributed ledger technology in payments,
clearing, and settlement
David Mills, Kathy Wang, Brendan Malone, Anjana Ravi, Jeff Marquardt,
Clinton Chen, Anton Badev,
Tim
othy
Brezinski
(Federal Reserve Board)
Linda Fahy, Kimberley Liao,
Vanessa Kargenian, Max Ellithorpe, Wendy Ng
(Federal Reserve Bank of New York)
Maria Baird
(Federal Reserve Bank of Chicago)
��1 &#x/MCI; 0 ;&#x/MCI; 0 ; &#x/MCI; 2 ;&#x/MCI; 2 ;Table of Contents
Overview
1.1
The Federal Reserve’s interest in DLT
1.2
Organization of this paper
Payments, clearing, and settlement
2.1
Essential elements of a financial transaction
2.1.1
Payments processes
2.1.2
Securities, commodities, and derivatives post
trade processes
2.1.3
Roles of financial intermediaries in payments, clearing, and
��2 &#x/MCI; 2 ;&#x/MCI; 2 ;4.2.4
Information
sharing
4.3
Industry approaches to adopting DLT
Challenges to adoption and implementation: business, technical, and financial design issues
5.1
Business issues
5.1.1
Co
benefit considerations of potential use cases
5.1.2

Overview
Digital innovations in finance,
loosely
known as fintech, have garnered a great deal of attention
across
the financial industry
istributed ledger technology
(DLT)
one such innovation
that
has
been cited as
a means of transforming
payment, clearing, an

For example, technology research firm Gartner, which monitors emergi
ng technologies, estimates that it will be five to ten
years until DLT achieves “mainstream adoption.” See Gartner (2016), “Hype Cycle for Emerging Technologies.”

��4 &#x/MCI; 0 ;&#x/MCI; 0 ;has a public policy interest in understanding and monitoring the development of innovations that could
affect
the struc
tural design
and functioning
of financial markets
Further, as a regulator and supervisor
of financial institutions involved in PCS activities, an operator of
retail and large
value
payment and
Many
proponents
in the fintech community have suggested that the widespread deployment of DLT
may bring fundamental changes to
not only
the
technology
architecture of financial markets
but also
the
financial market structure
This view stems from the perceived potential f
or DLT
to facilitate certain PCS
processes
in ways that
are not currently
achievable
without the aid of financial intermediaries
that are
entrusted
by market participants,
including
households
and businesses,
with
ensuring that
their
transactions are settl
ed successfully
on an on
going basis
As
the
first step in analyzing the potential

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, operationa
l,
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


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.
For purposes of this paper, a financial inte
rmediary 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 fun
ds, securities, and derivatives).
��5 &#x/MCI; 0 ;&#x/MCI; 0 ;impact of DLT on
how
activities in payments, clearing, and settlement
are conducted
, t
his section
discusses
the essential
elements
of
PCS
processes
and
how these processes
have evolved
with
previous
innovation
,
including how they have shaped
the roles that
financial
intermediaries
, such as financial
institutions and infrastructures,
currently
play.
2.1
Essential
elements
of a financial transaction
In its simplest form, t
he
clearing

. Effective September 2014, the Committee on Payment
Settlement Systems changed its name to the Committee on
Payments and Market Infrastructures.

��6 &#x/MCI; 0 ;&#x/MCI; 0 ;intermediaries
, such as payment systems, securities settlement systems (SSSs), central securities
depositories (CSDs), and central counterparties (CCPs), which specialize in particular PCS functions.

A “securities settlement system” is defined in the PSR policy as an entity that enables securities to be tr
ansferred 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 “centra
l counterparty” is

In s
ome cases, one entity may perform multiple PCS functions, such as securities clearing and settlement, as well as
safekeeping and custody.
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

��7 &#x/MCI; 0 ;&#x/MCI; 0 ;transactions for the markets they serve, oft
en on a multilateral basis
In doing so, FMIs
can
allow
participants to manage their risks more effectively and efficiently and may reduce certain risks.
The transfer process is typically organized with the FMI as a central hub through which banks or bro
ker
dealers interact with one another.
Because banks and broker
dealers may be active in multiple financial

derivatives, or other financial transactions. 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

wever, FMIs may also concentrate risks and create interdependencies between and among FMIs and participating
institutions.
��8 &#x/MCI; 0 ;&#x/MCI; 0 ;FMIs
may
cross jurisdictional boundaries
as shown by the connections of FI 6 and FI 7 in
figure
which
adds another layer of legal and operational complexity.
Figure
2: Ex
ample of a
more
complex
hub and spoke structure
with
multiple
FMI
s, FIs, and jurisdictio
2.2
Innovations in
ayments,
learing
and
ettlement

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 Ban
k of England, held in Chicago, Illinois, November 6, 2014,
https://www.federalreserve.gov/newsevents/speech/powell20141106a.pdf

Trade execution takes place before PCS
processes, but is referenced here for illustrative purposes.
��9 &#x/MCI; 0 ;&#x/MCI; 0 ;Often, the introduction of a new technology necessitate

An important element of any CCP design is the legal mechanism for the CCP to become the counterparty to its pa
rticipants’
trades (such as through novation 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.
Federal Reserve System (2015), “Strategies for Improving the U.S. Payment System,” white paper, January 26,
https://fedpaymentsimprovement.org/wp
content/uploads/strategies
improving
payment
system.pdf


Distributed ledger technology
In the strictest sense, a
distributed ledger
is a
type of
database that is shared across
nodes
in a

One specific type of distributed ledger is a
blockchain, 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 “blockchain technology” are often treated as syn
onyms in the industry even though blockchain is actually a
specific type of distributed ledger.
��11 &#x/MCI; 0 ;&#x/MCI; 0 ;DLT
also enables a single party to maintain its database records across multiple nodes, for purposes
including increased
operational
resiliency.
Figure
represents
two examples of
this peer
peer connectivity
In contrast to the hub
and
spoke
model of
figure
1, in which each entity maintains its own independent ledger, each node in
figure
3 has
a copy of
common ledger.
Further, although t
he connectivit
y of the nodes is the same

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.
��12 &#x/MCI; 0 ;&#x/MCI; 0 ;3.2
Participants in a DLT arrangements can be permitted to play different roles or
functions
Regardless of whether a
DLT arrangement
is open or closed
,
participant
nd therefore the nodes they
maintain)
may be differentiated by
the roles they
are permitted
to
play or functions they
are permitted
to
perform.
DLT arrangements in which the participants are allowed to perform all activities are often
called
“permissionless.”
Those that restrict participants’ activities are often referred to as
“permissioned.”
For example,
for
certain
DLT arrangements,
some
participant
s may
only be permitted to
have
nodes that
send and receiv
asset transfers
for existing asse
Other
participant
s may have the
ability to issue new assets.
Still others may have permissions to validate transactions (as discussed

Public key infrastructure (PKI) is the name given to the set of entities and procedures that govern the creation, distrib
ution,
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 contr
ol.
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 Technology (2001),
Introduction to Public Key Technology and
the Federal PKI Infrastructure
,
http://nvlpubs.nist.gov/nistpubs/Legacy/SP/nistspecialpublication800
32.pdf

��13 &#x/MCI; 0 ;&#x/MCI; 0 ;of this process, ownership of an asset, including the ability to transfer it
to other parties, often depends
on having access to the correct private keys.
Additionally
, cryptography may be used to encrypt transactional information on the ledger such that
only certain participants can
decrypt
the details of each transaction. Since
most DLT arrangements
require some level of distribution of records on the ledger, cryptography employed for this purpose can
be an important tool in instances where some degree of privacy is necessary.
Finally, cryptography can also be used to facilitate
the consensus process discussed in 3.6.
3.5
Transactions histories and current states of ownership
can be
distributed across the
nodes
of the
DLT arrangement
n a DLT arrangement, information regarding records of ownership and transaction histories can be
distributed across the
nodes

U.S. Department of Commerce, National Institute of Standards and Technology (2013),
Digital Signature Standards (DS
,
http://nvlpubs.nist.gov/nistpubs/FIPS/NIST.FIPS.186
4.pdf

��14 &#x/MCI; 0 ;&#x/MCI; 0 ;payment before the sender’s
previous transaction is reflected in the ledger
This
possibility
is the so
called “double
spend problem,” which arises
in an environment
where

In both DLT arrangements and traditional payment systems, the double
spend problem may arise, for example, if identi
cal,
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.
Not
e that a related but not identical problem can occur if a party attempts to make two valid transfers, but owns an insufficien
amount of a digital asset to settle both transfers.
��15 &#x/MCI; 0 ;&#x/MCI; 0 ;parameters of the contract, such as its par value, tenor, and coupon payment structure. O
nce assigned
to an owner, the smart contract would automatically make the required coupon payments until the
bond reaches maturity.
3.9
DLT implementation can be considered from
a legal entities perspective in addition
to a
echnology
perspective
As noted in
the beginning of section 3, the extent to which DLT will have an impact on the financial
architecture
may become clearer as the technology matures
. Some proponents of DLT point to the
possible use of the technology to automate and even replace functions tr
aditionally played by financial
institutions and FMIs. Nonetheless, information technology is only one factor that typically influences
the function and organization of PCS processes.
Other factors include business, coordination, and

Even in the pre
2008 environment of voluntary central clearing of standard
ized over
the
counter derivatives, CCPs existed
and performed important functions such as clearing interest rate swaps for major dealers.
For information on the issues considered by the industry on the plan to shorten the settlement cycle of U.S. equitie
s 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/

��16 &#x/MCI; 0 ;&#x/MCI; 0 ;Financial institutions acting for their own accounts and on behalf of clients may wish to hold and trade
digital assets
and to manage various risks.
Some of these types of intermediaries have emerged already
to provide services to
itcoin users, even though
itcoin is an open system in which anyone may hold
the cryptocurrency directly.
More generally, third
party service
providers currently provide a wide range
of technology and other services to financial institutions and their clients, which creates an “ecosystem”
of financial and non
financial entities that are frequently involved in producing and delivering PCS
service
Overall, the economics of intermediaries will likely continue to be more complex than a simple
problem of technology or technology costs.
A particularly important and traditional issue in PCS economics is the need for groups of firms and
individuals to
coordinate PCS activity to reduce the costs and risks of clearing and settlement.
In
addition to legislation and regulation, governments and the private sector have historically
established
rule
setting bodies, clearinghouses, and specialized financial in
stitutions to address the need for
multilateral rules and functions.
Depending on the era, the jurisdiction, and the problem being
addressed, some of these multilateral organizations have also been given roles as financial
intermediaries.
Although technol
ogy
has been one
contributing
factor
in
determining
the
design
of a
particular PCS arrangement
, the fundamental need for coordination has often required joint action
through new or existing legal entities
to,
at a minimum
provide organization and governan
ce.
Industry participants and technology firms are increasingly exploring ways to develop and deploy DLT

Associations of financial institutions have also been used to establish model master agreements used in bilateral clearing.
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

��17 &#x/MCI; 0 ;&#x/MCI; 0 ;of the industry has been working on PoCs in 2016, usually
for
particular asset classes and use cases.
Some of these PoCs
are
referenced below.
PoCs that show potential may move into the pilot pha
se
in which
the technology could be used for real
transactions.
Pilots
have a limited
duration, defined objectives and milestones,
and
typically also
limit
the
number of participants in order to
��18 &#x/MCI; 0 ;&#x/MCI; 0 ;Specific use cases that have re
ceived public attention include clearing and settlement in equities
markets as well as international
commodities
market
For example, several large exchanges are
exploring DLT
based solutions to improve existing
post
trade
processes
for
clear
ing

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


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/Glo
bal_payments_2015_A_healthy_industry_confronts_disruption.ashx

��19 &#x/MCI; 0 ;&#x/MCI; 0 ;associated fees and timing of settlement for payments. Frictions may also include problems in exception
processing and reconciliation.
Some startups a
re attempting to alleviate some of these frictions by using DLT
and more direct
transacting
as a replacement for intermediaries, which potentially reduces the number of steps to
complete cross
border payments and enables direct relationships between counte
rparties.
Developers
argue that certain attributes of DLT, such as the ability to share ledgers across geographic distances and
time
zones
could reduce the number of intermediaries needed to effect cross
border payments.
By
reducing the number of intermed
iaries, certain regional banks may be able to directly access the

Lipis and Adams (20
14), 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
Cross
border
LVP
Regional
Integration
Lipis_v4
FINAL.pdf
. See also
The World Bank (2015), “Withdrawal from
Correspondent Ban
king; 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


See
https://interledger.org/interledger.pdf
for more details.
Committee on Pa
. See also
Federal Deposit Insurance Corporation (2016),
FDIC 201
5 National Survey of
Unbanked and Underbanked Households
, October,
https://www.fdic.gov/householdsurvey/2015/2015report.pdf

��20 &#x/MCI; 0 ;&#x/MCI; 0 ;4.2.4
Information
sharing
According to interviews, the ability of DLT to maintain
tamper
resistant records can provide new ways to
share information ac
ross entities such as independent auditors and supervisors.
As an example,
DLT
arrangements could be designed to allow auditors or supervisors
read
only access
to certain parts of
the common ledger.
This
could
help
service providers in
a DLT arrangement
and end users

Depository Trust and Clearing Corporation (2016), “Embr
acing 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
accentur
outline
path
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
Capital
Markets.pdf

��21 &#x/MCI; 2 ;&#x/MCI; 2 ;access to depositors
that
startups need to grow. In return,
financial institutions
benefit from
access to innovative
financial technology
, with which they
may
experiment within or alongside
their existing systems
with limited disruption to operational or organizational practices
lockchain
ervice (BaaS)
partnerships
BaaS
refers to a model for the provision of DLT
systems or services where technology companies charge fees for centrally hosting the
computing
infrastructure
, typically in a cloud environment,
and codebase necessary for DLT
systems, making it easy for other firms to deploy and test DLT systems with limited overhead.
Established tech
nology
firms are competing to be the leading provider of BaaS se
rvices.
Participat
ion
in consortia.
Consortia are helping industry
participants mutualize the costs and
risks associated with developing DLT arrangements. In addition, these multilateral partnerships
are acting as catalysts for future discussions related
common ledger operability standards and
enabling the testing of
PoCs
. By joining consortia, firms are able to
lower development costs and
test solutions together instead of in silos. Some consortia have membership fees and are driven
by the need to
generate commercial solutions
while others are focused exclusively on
developing a unified code base and open standard.
Hosting or
supporting
business development programs for startups
By offering or co
sponsoring
programs such as an
accelerator
or incu
bator
,
which can include providing funding,
business consulting services, or even physical equipment,
some financial institutions are seeking
to steer the future of promising startups early on
As described in section 2,
a complex network of participants
is
involved in
PCS
Each of these
participants plays one or more critical roles
in
the smooth functioning of the financial system.
Any
changes to the technology underlying the
PCS
processes, therefore, would
likely
affect this entire
network of participant
To that end, many of the aforementioned efforts to achieve wider adoption of
the technology are
attempting to build acceptance among
the existing network of
intermediaries
and
their ecosystem that is at the heart of the PCS activity
including
financial
institutions
, market
infrastructures,
end
users,
and
service providers
. Although the DLT community has generated much
excitement, there remain certain challenges for the technology to take hold in payment
, clearing, and
Challenges to adoption
and implementation
usiness
, technical,
and
financial design
issues
As noted above, the industry is at an early stage of development regarding DLT.
As the industry
continues to experiment, a number of
business
, technical,
and financial design
challenges
must be
addressed before DLT can become a practical solution for some aspects of payment
, clearing
and
��22 &#x/MCI; 0 ;&#x/MCI; 0 ;5.1
Business issues
5.1.1
Cost
benefit con
siderations of
potential
use cases
The previous section referenced several use cases for DLT that the industry is exploring. A key challenge
is identifying appropriate use cases where the
potential reduction in
costs of operational and financial
inefficien
cies would justify the
cost of the
investment and operational changes needed to implement
DLT. In addition, the longer term operating costs of DLT would need to be favorable relative to current
or plausible alternative technologies.
Some see potential in t
argeting markets that today have significant
operational inefficiencies, such as highly decentralized and disorganized post
trade operations. Others
see opportunities for spillover benefits such as an opportunity to standardize business processes
alongside
��23 &#x/MCI; 0 ;&#x/MCI; 0 ;trusted central intermediary
as in current arrangements
, reducing latency by eliminating the need for

See generally, Federal Financial Institutions Examination Council (2004),
FFIEC Information Technology Handbook
,
. See also
SWIFT and
Accenture (2016), “SWIFT on distributed ledger,” Apr
il,
https://www.swift.com/insights/press
releases/swift
and
accenture
outline
path
distrib
uted
ledger
technology
adoption
within
financial
services

��24 &#x/MCI; 0 ;&#x/MCI; 0 ;of DLT are still being developed and tested, and the industry may not have sufficient information
at this
point
to develop appropriate standards.
This is typical of emerging technologies in the PoC stage.
Beyond interoperability,
APIs may be required to enable DLT arrangements to make requests to external
systems to achieve enhancements that are not core to the DLT arrangement itself.
A robust set of APIs
may also help organizations to realize the operational efficiencies of DLT a
rrangements without
requiring dramatic changes to IT architecture in the short
term. From this perspective DLT arrangements
are not merely an end product, but can be viewed at least in part as a platform developers can build
upon. Building open APIs in com
mon, industry
standard languages, and enhancing software
development kits lowers the barriers for organizations and their development teams to enter the DLT
industry, acting as a potential catalyst to interoperability.
5.2.3
Cryptographic key
and access data
agement
Effective
management of cryptographic keys
and access
credentials
is
a particularly important business
issue in the context of DLT
because
,
unlike many other applications of this type of cryptography, users
can potentially suffer immediate and irr
evocable monetary losses
without recourse
if keys
or access
credentials
are lost or compromised.
Key compromise
may lead to economic losses associated with
account takeover and fraud
ost keys may render data unreadable
or inaccessible
, resulting in the
permanent loss of the value secured by the cryptography.
The ability to bind the identity of public keys
to individual
or
corporate identities is also an important
privacy
related
aspect of digital signature
arrangements
in which
users are subject to legal requirements such as those associated with
anti
money
laundering
compliance.
The ability to maintain the secret nature of private keys and achieve the
desired
security properties of
public key encryption is a complex and challen
ging undertaking
which depends on a variety of factors
including the strength of the cryptography and the protocols used for key generation, storage,
distribution, revocation
and destruction.

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
, Jan
uary,
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 Examination Council
(2016),
FFIEC Information Technology Handbook
, “Information Security
,”
September,
http://ithandbook.ffiec.gov/media/216407/informationsecurity2016booklet.pdf

��25 &#x/MCI; 0 ;&#x/MCI; 0 ;common information be correct. This requirement can be difficul
t to achieve if many participants can
write to the ledger.
For example,
decisions regarding
who
can create new
assets
and how information
that is input
to the system
is
checked for accuracy are
fundamental. Also, the designers of a DLT
arrangement must
determine h
ow errors
and
known fraudulent account take
over
s are handled and
resolved.
An additional challenge is the determination of
exactly
what information to share. This issue is especially
challenging when information
, possibly including
customer
formation,
is shared among competitors.
Relevant privacy laws and regulations must also be satisfied.
Participants will have to agree on the

Securities Transactions Settlement, 69 FR 12921 (March 18, 2004),
https://www.federalregister.gov/documents/2004/03/18/04
5981/securities
transactions
settlement

��26 &#x/MCI; 0 ;&#x/MCI; 0 ;transfers go awry.
The legal status of digital assets is discussed further in 6.1.1.1 below.
Related
questions exist for physical commodities, although the legal frame
work may be different and the role of
physical underlying assets must be taken into account.
5.3.2
Monetary instruments
Similar points can
also

Committee on Payment and Market Infrastructures (2015),
Digital Currencies,
http://www.bis.org/cpmi/publ/d137.pdf


��27 &#x/MCI; 0 ;&#x/MCI; 0 ;Some have raised the possibility that DL technology may
make financial intermediaries obsolete.
One
cannot rule out long
run changes in the roles and responsibilities of intermediaries in financial markets
and the demand for their services.
However, intermediaries play important roles in matching borrowers
and
Challenges to
dopti
and implementation
risk management
In addition to the challenges identified above, questions also arise
about
the way in which the
implementation of DLT would fit into the risk
management frameworks that
already exist
to promote
safety and confidence i
n payments and securities transfer processes.
��28 &#x/MCI; 0 ;&#x/MCI; 0 ;supervisory policies are aimed at achieving broad objectives such as market transparency, safety and
soundness of financial institutions, and the efficient and effective functioning of the
broader financial
system, and
not
generally
intended to favor a particular
electronic
technology.
Even so, the laws and regulations applicable to PCS
can affect the manner
in which
, speed
by which
, and
extent to which any implementation or configura
tions of DLT for a particular use case can be adopted by
regulated entities or new entrants to the financial system. It is therefore important to consider how the
legal framework may differ depending on the configurations of DLT, as the industry further de
velops DLT
use cases.
6.1.1
Legal basis of certain DLT components
6.1.1.1
Distributed ledgers
As
DLT
matures, the legal basis for
certain
components of the technology
, which may not be
contemplated in the current legal framework for PCS activities, will merit careful
consideration
ne of
the
purported
benefits of
DLT
is that it provides an auditable record of information that is
simultaneously updated and distributed
among participants.
usinesses us
ing
and trust
ing
the records
that are stored on shared ledgers
must
consider
the
legal basis for the
se records.
Users of these records
will need to be assured of their reliability as an authoritative source of the underlying obligations and
the enforceability of those obligations.
Shared ledgers should be designed to provi
de these assurances
under existing laws, or, alternatively, statutes and rules may need to be adjusted to accommodate DLT
enabled recordkeeping
6.1.1.2
Digital representations of assets
Digital representations of a physical asset,
such as
tokens
as well as natively issued digital assets are
also key components of a DLT
arrangement
The ownership rights and obligations associated with digital
tokens and assets may not be clearly defined in today’s legal
framework
any ownership interests in
asset
s, such as negotiable instruments and securities, are already represented using physical or book
entry records,
and
the corresponding legal frameworks are robust and have developed over time.
Careful legal analysis must be done to understand how ownership
of digital tokens on a distributed
ledger fit into the current legal frameworks and what gaps need to be filled by contractual agreements
or
new laws and regulations.
6.1.1.3
Smart contracts
DLT has also raised the possibility of writing terms and conditions betw
een parties into computer code
to be executed automatically.
In order for
these
smart contracts
” to be enforceable
, they must have
sound
legal basis.
Contract law is an
established
set of rules that govern the basic principles of
contracting, including
formation, amendment, termination, and dispute resolution.
Some classic

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 fram
eworks 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.
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/


��29 &#x/MCI; 0 ;&#x/MCI; 0 ;contract doctrines, such as voiding unconscionable contracts, or amending contracts
due to
changed
circumstances, conflict with the
automatic execution
of smart contracts.
f smart con
tracts proliferate,
judges and juries will have to review them
determine their
legal basis and evidentiary status.
Complex applications of smart contracts
could potentially
allow for
traditional
organizations
, such as
businesses and nonprofits,
to be
un through rules encoded as smart contracts.
The legal status of
organizations
that are run on smart con
tracts
is unclear.
If “management” of an organization is
conducted automatically by code, legal systems will have to determine who to hold accountable
if laws
are broken and disputes arise.
The legal frameworks around corporations and other business
associations
would
have to adapt to the concept of distributed management
6.1.2
Licensing
As discussed in
section 2
PCS
innovation can emerge from new
technology, changes to the existing

For example, the Decentralized Autonomous Organization (DAO) was a smart contract running
on the Ethereum blockchain

The Office of the Comptroller of the Currency has sought comment on simila
r ideas. See Office of the Comptroller of the
Currency (2016),
Supporting Responsible Innovation in the Federal Banking System: An OCC Perspective
, March,
http://www.occ.gov/publications/publications
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.g
ov/topics/bank
operations/innovation/recommendations
decisions
for
implementing
responsible
innovation
framework.pdf

��30 &#x/MCI; 0 ;&#x/MCI; 0 ;6.1.3
Compliance with BSA/AML
ompliance with the Bank Secrecy Act (B
SA) and
anti
money
laundering (AML) requirements
is the
responsibility of a variety of intermediaries, including but not limited to banks, money services
businesses, and securities broker
dealers. AML compliance includes transaction monitoring, know your
ustomer requirements, and reporting of suspicious activity to the U.S Department of the Treasury’s
Financial Crimes and Enforcement Network (FinCEN). As DLT matures and the types of intermediaries in
existence potentially change,
the appropriate government
agencies may
need to provide guidance on
the application of existing law to any new intermediaries or PCS
processes
In fact, this process was
followed when FinCEN issued new guidance with respect to the BSA’s application to virtual currency
exchangers.
6.2
Governance
Effective, accountable, and transparent governance arrangements are critical to the risk management of
PCS
systems
. Ideal governance arrangements are clear and transparent, promote the safety and
efficiency of the
system
, and support the stabil
ity of the broader financial system.
Sound
governance
arrangements would continue to be necessary for
DLT arrangement


U.S. Department of the Treasury, Financial Crimes Enforcement Network (March 18, 2013), FIN
G001, “Application of
FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies,”
https://fincen.gov/statutes_regs/guidance/pdf/FIN
G001.pdf


��31 &#x/MCI; 0 ;&#x/MCI; 0 ;common ledger or to attempt to essentially reverse the action because it was known to be illegitimate.
This debate led to a division that resulted in uncertainty

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
million
heist/

��32 &#x/MCI; 0 ;&#x/MCI; 0 ;Settlement finality is even more complicated when considering both legs of a
financial transaction, for

Committee on Paymen
t 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.
, page 19.
��33 &#x/MCI; 0 ;&#x/MCI; 0 ;degree of
resiliency
and security
across a wide range of adverse scenarios.
Many of the
interviewed
firms suggest that the distributed data storage aspect of DLT
provides greater
resilience and data
integrity
than
traditional centralized clearing and settlement systems
do
. If one or several entities that
hold a copy of the distributed ledger experience a
failure, the remaining unaffected entities would be
able to maintain an accurate ledger and
therefore
continue the system’s operations.
Further, some
interviewed
firms suggested
that individual firms or system might be able to employ DLT to store backup
copies of data
within legacy systems
in a technological
ly diverse system
in order to strengthen resilience
against
cyber
attacks
DLT
arrangements
must
also
address
the same risks
existin
g PCS systems
and
,
though
the
current
procedures
and
controls
used to address these risks appear to be generally relevant for DLT
,
modification
may be required in order to make these
current
used risk
mitigation strategies
applicable
to a distributed environment
imilar to
traditional PCS systems,
one of the big
gest concerns
with
DLT
solutions is endpoint security.
As
with any system where
vulnerabilities can potentially
exist
within both
software and hardware components,
DLT
may
face
increased
exposure
to cybe
attacks
through its
distributed


Committee on Payments and Market Infrastructures and Board of the International Organization of Securities Commissions
015),
Guidance on Cyber Resilience for Financial Market Infrastructures
,
http://www.bis.org/cpmi/publ/d146.pdf
See also
National Institute of Standards and Technology (2014),
Framework for Improving
Critical Infrastructure Cybersecurity
, Feb 12,
https://www.nist.gov/sites/default/files/documents/cyberframework/cybersecurity
framework
1214.pdf

��34 &#x/MCI; 0 ;&#x/MCI; 0 ;databases in a distributed network, the difficulty of corrupting data stored on a DLT, the ability to
quickly propagate data to compromised sites, and the ability
of a compromised site to quickly begin
using the refreshed data.
For
DLT
to be successful
,
careful and on
going analysis of
the
security
consideration
s will be
critical
Summary
This paper
has
examine
how
DLT
can be used in the area of payments, clearing a
nd settlement and
identif
ies
both the opportunities and challenges facing its long
term implementation and adoption.
In
the context of payments,
DLT has the potential to provide new ways to
transfer and record the
ownership of digital assets; immutably and
securely store information; provide for identity
management; and other evolving operations through peer

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