In keeping with the vogue for talking up distributed ledgers, Morten Linnemann Bech, Yuuki Shimizu and Paul Wong of the BIS have a go at doing the same in the bank’s latest quarterly review. Luckily, their analysis puts DLT in the context of real-time gross settlement (RTGS) and faster payment advances, and suggests wide-scale use is years away. This is useful.
Sadly, in their optimism, the authors leave out the true scale of legal and social costs and challenges involved (which, as we’ve always, noted remain political, social and oligopolistic in nature). This is less useful.
The piece is entitled “the quest for speed in payments”, so we figured we’d provide some related context of our own.
The main barrier to instant settlement is our reluctance to live in a totalitarian system.
Before the internet and before electronic payments, retail payments were by and large characterised by one simple thing: instant settlement, which benefited the customer.
With the exception of payments to service workers for household work, utility payments or tuition, customers’ relationship with the world of products and goods was instantaneous. You went to a shop. You got your goods. You paid for the goods in cash, cheque, credit or charge card. You walked away with your goods. The trade from your point of view was settled immediately. And it was the retailer that bore the risk if for some reason it hadn’t.
In the best case scenario for the retailer, the cash, credit, cheque provided was legitimate. In the worst case scenario, the cash turned out to be counterfeit, the cheque turned out to be counterfeit, or the credit card/charged card turned out to be bogus. In the not-ideal scenario, the cheque bounced and the credit/charge card went over the pre-agreed limit, posing a risk to the intermediary processor.
Electronic payments helped remove a lot of the risk from the merchant and intermediary side. Fake cards with invented numbers failed to process entirely, and real-time limits rendered maxed out cards redundant. If you were a retail customer you either got your goods instantaneously or you didn’t.
Then came the internet. With this, the nature of instant settlement on the retailer side changed entirely.
All of a sudden the tables were turned entirely. Thanks to electronic payments, customers found themselves in a position buying goods not yet in their hands but wherein payments were settling immediately nonetheless. They were the ones now taking the risk.
Those shoes you want to buy on the internet? Pay now, but if they don’t arrive who bears the risk? You do.
Naturally, this sort of situation created a minefield for the popularisation of online retail. If customers didn’t feel confident about getting what they paid for, the whole online retail sector could be buried before it even took off. As for dispatching goods to customers and having them pay only when products satisfied their expectations, this would only heighten the risk for retailers even more.
Something else had to come to the rescue. That thing was the credit card chargebackas well as the invention of an intermediary process for dispute resolution, wherein an arbitration entity (such as eBay or Amazon) would field complaints from customers if small-scale merchants without national brand recognition failed to perform. This worked. But for it to work properly, lots of new costs had to be introduced. They came in the shape of bureaucratic processes cumbersome enough to prevent customer abuse of retailers, and personal enough to ensure fair judgment on the consumer’s part. Naturally, someone would have to pay for that expense, either with money or with speed.
It is in this context that Real-Time-Gross-Settlement (RTGS) and “faster payments” systems operate. Which is why it’s weird the banking and merchant industry think something like “distributed ledger” technology will help reduce these costs whilst retaining the resilience, security and fairness of the old system.
Because of course the more you automate payments and force instant settlement upon the sector, the more you thrust risk onto the side of the consumer, the retailer or the arbitration intermediary.
As the BIS notes in the quarterly review:
The speed of retail payments is now immediate in some countries thanks to improvements in information and communication technologies, including the ubiquity of smartphones and the internet. Fast payments provide retail funds transfer “in which the transmission of the payment message and the availability of ’final‘ funds to the payee occur in real-time or near real-time on as near to a 24/7 basis” (CPMI (2016b)).
This is all very well and good. But what the analysis misses is that the real world does not settle instantaneously. So unless a transaction is for immediately available goods, i.e. digital goods beamed to consumers directly and/or provided in situ at retail sites, the risk inevitably remains whether the transaction has been processed and settled immediately or not.
Related imbalances can and do sneak up on the RTGS/just-in-time world unexpectedly. When they do, they pose a liquidity threat comparable to bank run.
All of a sudden those shoes which you thought were resolutely settled by the system, turn out not to have been at all. The provider was a fraud. The shoes don’t exist and now neither does the money, because it’s been spent. Or it could be less sinister than that. The merchant over-estimated his capacity to provide the goods, a shipment delay is inevitable and somebody somewhere is going to have to wait and/or get themselves some other shoes. The risk never went away, it was just transferred from the banking system over to the customer.
At first, the systemic risk from this looks like insurance fraud, as a lot of small imbalances build up out of sight and undermine confidence in the system. Once confidence falls far enough and hits a certain unknowable threshold, trust evaporates entirely, and leads to a run on the world of goods and services — in other words, inflation.
The BIS to the contrary argues RTGS made payments final and irrevocable in a way which eliminates settlement risk (even though 2008 proves it didn’t, but that’s another story). Faster payments, it adds, speeds the process up even further. While distributed ledger technology now has the potential to eliminate any remaining settlement blackholes and synchronisation issues creating a near perfect system. The total real-time simulacrum.
But can this ever be the case in a world which transacts at the speed of the transport industry (all the more so if those goods are being produced halfway around the world or in countries without robust legal systems)?
The alternative argument is that settling something today which won’t truly be truly settled for another six months introduces a whole new category of systemic risk, especially if there’s an assumption that every entity involved is automatically squared from the get go (something the old netting system never did). This risk is further heightened in the case of cross-border payments due to sovereign legal, social and cultural idiosyncrasies — all the more so if no-one is standing as a go-between prepared to absorb that risk.
The BIS concludes regarding blockchain:
Blockchain and other distributed ledger technology holds great promise, but projects are currently only in the proof-of-concept phase. The first wide-scale use of distributed ledgers in payments is likely to be years away, as technological, legal and other hurdles will need to be overcome. Central banks and other authorities will continue to play a critical part in furthering greater efficiency and resilience of payments.
That’s a reassuringly realistic timeframe for blockchain adoption, but one which nevertheless still neglects that the true challenge to risk-free instant settlement is a not a technological one, but a social and political one.
Indeed, unless we achieve a global consensus over what constitutes value, effective governance, law, and welfare, as well as fair enforcement of the former — a global totalitarian monoculture of Borg proportions, essentially — those challenges will always remain.