Four of the world’s biggest banks and one of the largest brokers in the world have teamed up to create a new blockchain based currency, the Utility Settlement Coin, which would be used to clear and settle financial market trades. UBS, Deutsche Bank, Santander and BNY Mellon, as well as the broker ICAP, are lobbying Central Banks to get on board with the idea and they hope for a USC commercial launch by early 2018.
When the concept of the USC first made mainstream headlines in late August, the reports mainly stuck to the basic facts in the joint press release, as outlined above, and few analysts and commentators endeavored to go deeper into the details. It’s in these details, however, where the real story lies.
The benefits, as advertised
The aim of this disruptive new technology is to speed up clearing and settlement processes in financial markets, by opening up access to resources and systems so far exclusive to central banks: the real-time gross settlement (RTGS) system (used for high-value transactions that need to be settled instantly), and central bank-issued cash.
By switching clearing and settlement to a blockchain based system, the banks could restructure and cut costs on their back office operations, by eliminating the need for trade processing and record keeping; this would allow them to put both time and resources to better use. Or as UBS’s Hyder Jaffrey put it: “What that allows us to do is to take away the time these processes take, such as waiting for payment to arrive. That frees up capital trapped during the process.”.
The benefits of faster, cheaper clearance and real-time settlement could also conceivably “trickle down” to clients, allowing the banks to provide their services for a better price. After all, the scale of the problem USC aims to do away with is significant: The total cost to the finance industry of clearing and settling trades is estimated at $65bn-$80bn a year, according to a report by Oliver Wyman.
Another projected advantage of the new system is the transparency and “provability” that is inherent in the blockchain technology. The distributed ledger means that every user has a copy of all the transactions, constantly and automatically updated, thereby minimizing the possibility of human error, record manipulation and tampering. In this sense, the USC could increase security and eliminate the need for trust in transactions.
The nuts and bolts
The USC, developed by Clearmatics Technologies, is a hybrid of a digital currency and a settlement system. It implements blockchain technology and would be entirely backed by cash assets held at a central bank. It will be convertible at parity with all the main currencies including USD, EUR, GBP and CHF. The blockchain technology is indeed the most important and innovative element of this system, as it enables the users to record and distribute details about the ownership and the transfer of assets, optimizing traditional processes. The bank consortium believes that USC will become an “industry standard” to clear and settle financial trades over blockchain, used officially between major financial institutions.
Many have described the USC as a “bitcoin for banks”, a reference to the cryptocurrency that has polarized public and expert opinion over the last years. However, unlike bitcoin, the USC is not a new decentralized standalone currency, but rather a digital counterpart of the existing major currencies, backed by Central Banks; UBS has made it clear that using the USC would be equivalent to using the real corresponding currency. The only thing bitcoin actually has in common with the USC is that they both use the blockchain technology. What this means in practical terms, is that the new “coins” will be stored on a network of computers, and after all of them confirm that a transaction has indeed taken place, the details will be recorded in the “chain”, in computer code. This chain, or distributed ledger, will be constantly updated with all new transactions and the records, securely encrypted, will be accessible by everyone in the system; they are however tamper-proof, timestamped and cross-verified by the entire network. As shown in the diagram below, this new system eliminates the need for a central authority or regulator.
Traditional clearance and settlement process vs. distributed ledger technology
The USC can be seen as “cash” only within this settlement system, and even then the role it plays is more akin to a token, or an accounting unit. However, this “currency” element sets this venture apart from numerous other attempts to use the blockchain technology to reduce costs in the financial industry. And as the consortium behind the USC is lobbying central banks to accept their system as a universal clearing platform, they hope this will give them a decisive advantage: “Digital cash is a core component of a future financial market fabric based on blockchain technologies. There are several digital cash models being explored across the Street. The Utility Settlement Coin is focused on facilitating a new model for digital central bank cash.”, said Hyder Jaffrey, head of fintech innovation at UBS.
Criticism and Risks
The concept, as presented, promises optimized efficiency for all parties involved and a modernized, streamlined new settlement system that cuts costs and frees up frozen capital. A number of potential risks and complications, however, start popping up when one takes a closer look at the premises and assumptions that the USC is founded on, as well as the possible consequences that might follow, should these requirements be met.
Initial doubts concern the realistic chances that such a concept could really be implemented, and successfully make the transition from theory into practice. For the USC to work, it would take more than four banks to accept and adopt it; broad industry acceptance would be an essential requirement. That seems particularly challenging in a time when competing concepts abound: There’s already competition from projects like Citibank’s Citicoin, Goldman Sachs’ SETLcoin, while only recently several major Japanese banks announced they are working on their own blockchain settlement system, similar to the USC, and the European Securities and Markets Authority, as well as the Bank of Russia, are also developing their versions. A recent World Economic Forum report revealed that by 2017, 80% of all global commercial banks will have initiated projects using the blockchain technology. It’s hard to imagine a smooth road ahead for the USC to prevail as the global industry standard.
Assuming this first hurdle is successfully overcome, more serious concerns would arise. Apart from potential vulnerabilities that arise from the fact that the USC, as presented, would be a digital “currency”, backed by a basket of fiat currencies, in turn backed and controlled by Central Banks, the operational problems go beyond that. As Bloomberg’s Matt Levine wrote, regarding the true nature of the USC’s stated functional aim, “You don’t get your dollars any faster; you just get your pseudo-dollars faster. To get the dollars faster, you’d need to speed up the Fed’s central-ledger technology. But for many purposes — for example, just doing more transactions with other banks — the pseudo-dollars are just as good as dollars. If every bank signs on for this, then they can go out and buy more securities with their pseudo-dollars, and rarely need to bother with the Fed.”
The consortium proclaims that the USC will be entirely backed by Central Bank assets, and therefore would, in essence, be a Central Bank Coin, with the all the guarantees and assurances that involves. However, the platform itself would be owned and operated privately, while the blockchain “self-verifying” capabilities give banks a technical excuse to circumvent existing processes, allowing them to settle without having to pledge collateral at central banks as they do today. Concerns over abuse of the system, as well as possible security breaches of such a global scale, take center-stage, since at the end of the day, all the risk of potential recklessness is outsourced to the underlying “backer”, the Central Banks and ultimately the tax payers; perhaps a moment of deja-vu, echoing the build-up to the post-2008 bailouts.
This article originally appeared on Mountain Vision, and was written by Chief Investment Officer Dirk Steinhoff.