Since the dawn of the 20th century, evolutions in communications technology have resulted in our financial systems becoming increasingly interconnected and interdependent.
Early attempts at electronic fund transfers still relied on net settlement systems: Banks aggregated their balances with one another before settling up at the end of each business day. If, for example, Bank of America Corp (NYSE: BAC) transferred $10 million to Wells Fargo & Co (NYSE: WFC), and Wells Fargo sent $10 million to HSBC (NYSE: HSBC), these amounts would be aggregated and the ledger would only reflect the money travelling from Bank of America to HSBC, without any information as to the intermediate step.
As the volume of economic activity grew, it became imperative to design a financial messaging protocol that would facilitate the transfer of money or securities in real-time. So financial institutions, central banks and government agencies came together to build real-time gross settlement systems (RTGS) capable of clearing and settling payments between banks on a per-transaction basis. RTGS systems enable instant settlement, thus facilitating predictable cash flows and real-time auditability. This greatly reduces the credit risk of both individual institutions and the financial system as a whole.
Now, RTGS systems are legacy. In their day, they contributed significantly to the modernization of finance, but they must once again be revamped to keep up with the increasing interconnectedness of the global economy.
Real-Time Gross Settlement
When the U.S. Federal Reserve launched Fedwire in the 1970s, it was the first attempt by central banks to replace the netting systems of the day with RTGS systems that would ensure fast, irrevocable settlement for high-value fund transfers between participating financial institutions. Traditional RTGS systems are a marked improvement over earlier netting-based systems. However, they are unable to facilitate cross-border financial communication in real time.
Each central bank is responsible for operating their own RTGS system, and while certain nations share a single system – such as the TARGET2 system used by Eurozone economies – cross-border interoperability is largely non-existent. Fintech firms offering peer-to-peer payment platforms, such as Paypal Holdings (NASDAQ: PYPL) and Venmo, do give individuals an opportunity to send and receive payments with the same quick finality available to banks but are a costly option for international money transfer.
Moreover, billions of people in developing countries have limited access to both banking services and fintech payment providers, many of whom are unavailable in their area. They also face their own inefficiencies when using remittance providers to send money across borders to their families.
Just as the explosion of intra-national economic activity in the mid-20th century necessitated a move from net settlement to RTGS systems, so too the expansion of international trade demands a cross-border financial messaging system that offers enhanced speed, transparency and cost-efficiency for transactions both large and small. Blockchain technology is the key to transforming our financial infrastructure in a more inclusive, transparent and resilient direction.
First, however, it needs to overcome the resource constraints preventing blockchains from scaling.
The Road To RTGS On Public Blockchains Is Obstructed By Technical Limitations
Decision-makers in the private and public sectors alike are noticing the fact that blockchain technology is uniquely positioned to address the shortcomings of legacy payment systems, and to drive efficiency and financial inclusion across the globe. According to Denis Beau, First Deputy Governor of the Banque De France, blockchain “could help remedy the current limits of the existing wholesale market infrastructures.” Blockchain could remove the need for correspondent banking, getting rid of the unnecessary friction it introduces into cross-border RTGS systems.
However, the processing capacities of a base-layer blockchains are struggling to meet current demand, let alone become the underlying infrastructure of a global payment system. Proof of Work mining – utilized by first-generation blockchains to achieve consensus and update the state of their ledgers – is too computationally intensive to serve as the basis for a financial messaging protocol that handles thousands, if not millions, of transactions per second.
Despite boasting higher transaction processing speeds, blockchains based on Proof of Stake consensus are contending with their own network constraints and resource limitations unique to each chain. EOS, for example, is Proof of Stake-based and is processing significantly more transactions per second than its competitors. Nevertheless, the limitations of memory and computation on the network make it a costly option for developers building mass-scale applications such as RTGS systems.
With decentralized technologies continuing to draw more users, many teams have turned their attention to building solutions that would enable blockchains to process a significantly larger volume of transactions without compromising on trustlessness, transparency and security. One approach popular in many communities is to create a network of second-layer payment channels that sit on top of the core blockchain. In one such example, the Bitcoin community has adopted the Lightning Network as a means of reducing the transaction load placed on the Bitcoin blockchain and making Bitcoin a suitable medium of exchange.
Lightning users can open payment channels with each other, deposit an initial balance and send funds between themselves continuously. Only after a channel is closed do the parties broadcast the initial and final balances to the entire blockchain.
Yet while channel-based solutions have increased the transaction capacity of Bitcoin and other chains, they take us back to the netting systems of yesterday. Whether for the purpose of real-time financial auditing, regulatory compliance or tax calculations, preserving the data of every intermediate transaction is essential to the functioning of a global financial system. In short, without RTGS systems in place, blockchain technology will not be able to form the foundation of the financial system of tomorrow.
High Throughput And Long-Term Storage - Now Available On Public Blockchains
For the benefits of RTGS systems to be preserved on the blockchain, every transaction must be stored on-chain even as the volume and velocity of transactions grow exponentially. Initially, concerns over public blockchain scalability led many institutions, including the Bank of England and the Bank of Thailand, to prefer permissioned blockchain such as R3 when building out their RTGS solutions.
With the introduction of powerful middleware solutions, such as the DAPP Network, institutions can now build on decentralized networks in a scalable fashion without having to worry about network constraints standing in their way.
Ever since Satoshi Nakamoto subtitled his Bitcoin whitepaper ‘Peer-to-Peer Electronic Cash’, the blockchain industry has been determined to transform electronic fund transfers by building underlying systems with enhanced speed, cost-efficiency, transparency and interoperability. Overcoming the technical barriers of base-layer blockchains would enable the holy grail of international payments systems – real-time gross settlement with both high throughput and long-term storage – to emerge.
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