Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C. Distributed ledger technology in payments, clearing, and settlement David Mills, Kathy Wang, Brendan Malone, Anjana Ravi, Jeff Marquardt, Clinton Chen, Anton Badev, Timothy Brezinski, Linda Fahy, Kimberley Liao, Vanessa Kargenian, Max Ellithorpe, Wendy Ng, and Maria Baird 2016-095 Please cite this paper as: Mills, David, Kathy Wang, Brendan Malone, Anjana Ravi, Jeff Marquardt, Clinton Chen, Anton Badev, Timothy Brezinski, Linda Fahy, Kimberley Liao, Vanessa Kar- genian, Max Ellithorpe, Wendy Ng, and Maria Baird (2016). “Distributed ledger technology in payments, clearing, and settlement,” Finance and Economics Discussion Series 2016-095. Washington: Board of Governors of the Federal Reserve System, https://doi.org/10.17016/FEDS.2016.095. NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors. References in publications to the Finance and Economics Discussion Series (other than acknowledgement) should be cleared with the author(s) to protect the tentative character of these papers. Distributed ledger technology in payments, clearing, and settlement1 David Mills, Kathy Wang, Brendan Malone, Anjana Ravi, Jeff Marquardt, Clinton Chen, Anton Badev, Timothy 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 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 responsibility 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. Table of Contents 1 Overview ....................................................................................................................................... 3 1.1 The Federal Reserve’s interest in DLT ........................................................................................... 3 1.2 Organization of this paper ............................................................................................................ 4 2 Payments, clearing, and settlement ............................................................................................. 4 2.1 Essential elements of a financial transaction................................................................................ 5 2.1.1 Payments processes .............................................................................................................. 5 2.1.2 Securities, commodities, and derivatives post-trade processes ........................................... 5 2.1.3 Roles of financial intermediaries in payments, clearing, and settlement ............................ 6 2.2 Innovations in payments, clearing, and settlement ..................................................................... 8 2.3 Opportunities for new innovations in payments, clearing, and settlement ................................. 9 3 Distributed ledger technology .................................................................................................... 10 3.1 Entities can be connected on a peer-to-peer basis via nodes .................................................... 10 3.2 Participants in a DLT arrangements can be permitted to play different roles or functions ....... 12 3.3 Ownership of an asset can be stored on a ledger within the DLT arrangement ........................ 12 3.4 DLT arrangements can use cryptography to facilitate PCS processes ........................................ 12 3.5 Transactions histories and current states of ownership can be distributed across the nodes of the DLT arrangement .................................................................................................................. 13 3.6 The protocol in a DLT arrangement can define the procedures necessary for the asset transfer process ........................................................................................................................................ 13 3.7 Application programming interfaces can improve usability of DLT arrangements .................... 14 3.8 Smart contracts may be used in DLT arrangements to automate certain transfers based on pre- specified events agreed to by counterparties to a transaction .................................................. 14 3.9 DLT implementation can be considered from a legal entities perspective in addition to a technology perspective .............................................................................................................. 15 4 Potential opportunities for DLT in payments, clearing, and settlement .................................... 16 4.1 Path to adopting new technology ............................................................................................... 16 4.2 Potential applications of DLT in payments, clearing, and settlement ........................................ 17 4.2.1 Securities, commodities, and derivatives transactions....................................................... 17 4.2.2 Cross-border payments ....................................................................................................... 18 4.2.3 Financial inclusion ............................................................................................................... 19 1 4.2.4 Information-sharing ............................................................................................................ 20 4.3 Industry approaches to adopting DLT ......................................................................................... 20 5 Challenges to adoption and implementation: business, technical, and financial design issues 21 5.1 Business issues ............................................................................................................................ 22 5.1.1 Cost-benefit considerations of potential use cases ............................................................ 22 5.1.2 Network effects ................................................................................................................... 22 5.2 Technical issues ........................................................................................................................... 22 5.2.1 Viable technology solutions ................................................................................................ 22 5.2.2 Standards development ...................................................................................................... 23 5.2.3 Cryptographic key and access data management .............................................................. 24 5.2.4 Information management ................................................................................................... 24 5.3 Financial design issues ................................................................................................................ 25 5.3.1 Financial instruments .......................................................................................................... 25 5.3.2 Monetary instruments ........................................................................................................ 26 5.3.3 Financial intermediaries ...................................................................................................... 26 6 Challenges to adoption and implementation: risk management ............................................... 27 6.1 Legal considerations ................................................................................................................... 27 6.1.1 Legal basis of certain DLT components ............................................................................... 28 6.1.2 Licensing .............................................................................................................................. 29 6.1.3 Compliance with BSA/AML ................................................................................................. 30 6.2 Governance ................................................................................................................................. 30 6.2.1 Open permissionless systems ............................................................................................. 30 6.2.2 Closed permissioned systems ............................................................................................. 31 6.3 Settlement finality ...................................................................................................................... 31 6.4 Financial risk ................................................................................................................................ 32 6.5 Operational risk ........................................................................................................................... 32 7 Summary ..................................................................................................................................... 34 2 1 Overview Digital innovations in finance, loosely known as fintech,