Lael Brainard of FED Examines Lessons From Use of Financial Technology

Giving the example of bitcoin, he established the inappropriateness of cryptocurrencies (owing to their volatile nature) to fulfill the classic functions of money. Cryptocurrencies pose challenges associated with speculative dynamics, investor and consumer protection, and money-laundering risks. These issues mainly result from the lack of a strong governance and questions about the applicable legal framework for some cryptocurrencies. Owing to their limited use, cryptocurrencies do not currently pose a threat to financial stability. However, if they were to achieve wide-scale use, the effects could be broader. To address the challenges posed by cryptocurrencies, advocates suggest that central banks should create their own digital forms of currency. Although central bank digital currencies may be able to overcome some of the particular vulnerabilities that cryptocurrencies face, they too have significant challenges related to cybersecurity, money laundering, and the retail financial system. No compelling evidence has demonstrated the need for a FED-issued digital currency, said the FED Governor. A multiplicity of mechanisms—including electronically used debit and credit cards, payment applications, and the automated clearinghouse network—are likely to be available for American consumers to make payments electronically in real time. Thus, it is not obvious what additional value a FED-issued digital currency would provide over and above these options, added Mr. Brainard.

He also discussed the potential of the underlying distributed ledger technology (DLT) for strengthening traditional financial instruments and markets. The financial industry is making steady progress in this area, as some projects could be live in some form this year. Many of the use cases focus on the areas of post-trade clearing and settlement of securities transactions, cross-border payments solutions, and trade finance. The common thread running through these use cases is the presence of operational "pain points" that generate inefficiencies and delays for users and raise concerns about the confidentiality of transactional information. The industry must develop distributed ledgers that adhere to laws, regulations, and policies that protect important information of the parties and their customers, added Mr Brainard. The industry has been working on approaches to help address concerns related to the loose governance around the maintenance, security, and reliability of the technology for cryptocurrencies. Some of these approaches involve encrypting data on the ledger so that the ledgers can still be copied across all the nodes in the network, but an entity cannot look at any element of that ledger except for transactions in which it has been involved. Other approaches include zero-knowledge proofs or ring signatures that allow entities to validate transactions without seeing confidential information. Still others are looking at platforms that connect multiple ledgers rather than having one ledger that is copied across all nodes in the network.

While questions remain about the usefulness and viability of each of these approaches, it is important to underscore that preserving confidentiality is an important area of research. Although the governance arrangements may need to evolve over time, one thing that is clear is that strong governance arrangements will be required to provide the coordinated operational and financial risk management for the critical clearing and settlement operations that underpin the financial markets. One challenge going forward will be to understand the implications that the confidentiality tools and different approaches to consensus under consideration may have on the resilience of the distributed ledger. Given that resiliency is a key potential benefit of DLT over existing platforms, it is critical to understand the trade-offs between resiliency and a consensus method that focuses on operational speed, or between resilience and confidentiality. He concluded that FED is "dedicated to continuing to monitor industry developments and conduct research in these vital areas. I remain optimistic that the financial sector will find valuable ways to employ distributed ledger technology in the area of payments, clearing, and settlement in coming years."

Related Link: Speech

Keywords: Americas, US, Banking, Securities, Fintech, Regtech, Virtual Currencies, Crptocurrencies, DLT, FED