Banks have spent the last few years exploring how distributed ledger technology, or the blockchain, can help them cut costs or improve service. A group of banks, led by UBS, think they have found at least part of the answer, and it all begins with the issuance of a digital currency called utility settlement coins.
Hyder Jaffrey, head of strategic investment and fintech innovation at UBS Investment Bank, explains.
What exactly is the utility settlement coin (USC)? Is this a cryptocurrency like bitcoin but specifically for banks?
We think a distributed ledger can help banks better manage risk and increase capital efficiency. By moving post-trade processes onto a distributed ledger banks can reduce settlement risk, counterparty risk and market risk. But in order to do that, the cash that is at the root of everything banks do has to be represented on the ledger. USC is a way of representing cash on a ledger.
We don’t see USC as a cryptocurrency, we see it as “cryptocash”. It isn’t a new currency, it’s a way to represent existing currencies like dollars or pounds or euros on a distributed ledger. If a client presents £100 they will be issued the corresponding value in sterling USC and the value would always remain £100. It means the cash is on the ledger and will always be backed by real cash held at the central bank – in much the same way cash is technically a promissory note that used to be backed by physical gold.
It helps to think of the world of digital currencies as a spectrum. At one end of it you have bitcoin, which is unregulated and operates outside of government control. At the other end you have central bank digital currencies – digital versions of existing currencies. USC is positioned right in the middle, with some of the benefits of bitcoin, such as the real time transfer of value (settlement), while taking on some characteristics of “real money” issued by central banks. It is pegged to those fiat currencies and will always have the same value.
So is USC a stepping stone to central banks issuing digital currencies (CBDC), or can USC and CBDC coexist in the future?
If central banks do issue their own digital currencies there will be no need for USC. But central banks quite rightly are not going to rush into issuing CBDC. Perhaps we might expect a CDBC timeline of 5-10 years, maybe even longer. We don’t want to wait that long to realise the benefits digital currencies can bring to banking, so we are looking to launch USC in 2018. It is essentially a stepping stone to a time when central banks might issue their own digital currencies.
How will clients benefit?
This will help both banks and clients better manage their risk and capital. But USC is exclusively an institutional product. Digital currencies can open up exciting opportunities for retail banking as well, but that is something central banks need to lead. There are still a lot of questions that need to be answered before central banks will be comfortable offering digital currency to retail.
In the meantime we think USC can bring significant benefits to the institutional markets.
Do you see distributed ledger technology as revolutionary in its likely impact on banking? Or is it just another piece of technology that continues a more gradual evolution? And is that change principally about cost reduction and efficiency, or does it also allow banks to serve clients in new and improved ways?
USC can be viewed as an essential facilitator to significant change within institutional banking models. USC combined with other building blocks like digital identity will be transformational. New and highly efficient models for settlement, collateral management, know your customer (KYC), anti-money laundering (AML), reporting, etc. will all be made possible. A further iteration will start to enable new fully digital securities such as digital bonds, equities and derivatives that all live on a Distributed Ledger marketplace.
How important is bank collaboration? Do banks have to work together on a communal currency, as you are with USC, or will they also be useful where banks develop their own? Is there a risk of fragmentation if banks issue their own?
Whilst new, the technology behind USC is now relatively well understood and any gaps are being worked on. The real challenge will be driving the business change side of the solution. Collaboration is crucial for banks to experience the full benefits of moving their business onto a distributed ledger. There are a number of banks out there developing their own ‘coin’ projects but the benefits are limited unless banks work together.
Digital currencies have the potential to provide a new and faster method of value transfer between parties, hence reducing risk dynamics. If only a small number of counterparties recognise or accept a new form of currency the benefits are limited, in which case what is the point?
Currently there are five financial institutions involved in the USC project: UBS, Deutsche Bank, Santander, BNY Mellon and ICAP. We will be looking to extend the membership in coming months. Ultimately the USC will have to be fully independent from all the institutions involved, with its own structure and governance, but none of those details have been finalised yet.
How much of a concern is cyber security around digital cash? Does it make banks more or less vulnerable? Or does it make no difference?
In theory the distributed ledger will provide increased resilience in the face of cyber threats. Its consensus mechanism is designed to make it harder to hack because it increases the number of nodes that need to be controlled in order to control a transaction.
However, while bitcoin and ledgers have been around for some time now, this technology is still relatively new and banks – particularly central banks and regulators – are still getting their heads around how it works. So while in theory cyber security should be better on the ledger, it needs to be tested and proved. We can only say how it works for sure once it is built and has been tested, and that is what we will be doing between now and when USC is officially launched. We will not launch USC until it has been thoroughly tested and we are satisfied it is secure from cyber attacks.
Questions by Solomon Teague