Distributed ledger technology, like Bitcoin’s blockchain, has the potential to transform cross-border payments, boost financial inclusion, and lessen the unintended consequences of anti-money laundering enforcement. Ripple, a fintech company using distributed ledger technology, made headlines recently, as did the appearance of a new cryptocurrency, Zcash. If you’ve gotten swept up in the enthusiasm around emerging financial technologies (fintech), you may think that the creaking system of international transfers in fiat currencies, and the problems of global financial exclusion associated with it, will soon come to an end. However, as we’ve said before, these innovations may not have as much of an impact as you expect.
Ripple and Zcash are making waves
Ripple has announced that a consortium of 12 large global banks are trialling their currency-neutral clearing system based on a distributed ledger-secured digital asset, XRP, to facilitate cross border payments at the international level. We’ve blogged before about the potential of Ripple’s technology, which could make international transactions cheaper, more secure, and almost instantaneous. This trial is an important step in the right direction and a good example of how banks are seeking to integrate fintech into their existing business models.
The arrival of Zcash is similarly exciting. This bitcoin-inspired cryptocurrency tweaks the Bitcoin model by layering on additional levels of privacy, which should make it more amenable to global financial services companies. To date, banks have been hesitant to embrace the Bitcoin platform in part because it relies on a public ledger that prevents users from keeping information about their trades confidential. Zcash solves this by using ‘zero-knowledge proofs’ that can verify transactions without revealing underlying data. However, the enhanced privacy afforded by Zcash poses a challenge for financial regulators, as would-be criminals seeking to obscure their transactions may also find it appealing.
The global financial system has even bigger challenges
Ripple claims that, by using its system, banks can save ‘up to 60 percent’ of payment processing costs, and clear in less than 5 seconds transactions that used to take days. If the widespread adoption of Ripple as the global payments’ rail were just around the corner, then, this would be a pretty big deal. The increased speed and lower unit cost of international payments would enable more minor transactions to take place across currency borders, potentially creating new types of international businesses, especially in poor countries. Zcash, if it were widely adopted, could have a similar effect.
However, the global payments system faces bigger challenges than high payments processing costs and slow transaction speeds. In a 2015 CGD report, we detailed the way in which ‘de-risking’ by banks is constraining the global financial system, leading to widespread account closures for money transfer and humanitarian organisations, and a decline in correspondent bank relationships. When banks cite their reasons for ending these relationships they tend to emphasize concerns about general profitability and the higher cost of complying with both anti-money laundering and countering the financing of terrorism (AML/CFT) and heightened prudential regulations rather than the speed or cost of processing payments.
Distributed ledger technology could lessen these problems, but it can’t solve them
Ripple’s system can help lower compliance costs by rendering transactions between accounts simple bilateral affairs, thereby allowing financial institutions to bypass the byzantine network of “nested” correspondent banking and foreign exchange dealing relationships. Settling via a different cryptocurrency could do something similar. This doesn’t help much, though, unless banks can be sure that counterparties at the far end of a transaction can be reliably identified. More broadly, global banks must be certain that their client financial institutions have procedures in place to comply with AML, “Know Your Customer,” and sanctions requirements. In too many cases, global banks lack this confidence, particularly in countries where they do not believe financial supervisors are doing their job.
Solving this problem will require political as well as technical solutions. We identified steps towards these solutions in our report, and have been heartened to see progress recently. As we noted in the report, creating an enabling regulatory environment for new technology is an important part of addressing concerns about de-risking, but more difficult political actions will also be required to solve the problem.