Digital economies: the impact on financial market infrastructures

Alan Marquard, chief strategy and development officer at CLS, says technologies such as AI, ML and cloud will be important in defining the future role of financial market infrastructures in a digital economy.

By Heather McKenzie

Club@Sibos: Governments around the world are launching or investigating digital economy strategies. What do you believe are the main benefits of a digital economy?

Alan Marquard: The digital economy is already here. As the pace of innovation in the private sector continues at unprecedented rates, it’s critical for governments and regulatory bodies to keep pace with this change. Emerging technologies not only accelerate the speed of front- and back-office applications and lower costs; they have the potential to facilitate new business solutions that create value by releasing cost, capital, and liquidity tied up in current processes and architecture.

What role do you think market infrastructures can, or should, play in the development of digital economies?

Many emerging technologies, such as blockchain and machine learning (ML), derive their value through economies of scale and network effects. Financial market infrastructures (FMIs) are natural incubators to achieve the minimum viable ecosystems needed for the successful delivery of products and services utilising such technologies. Not only do FMIs have experience building networks, they are trusted by both their members and regulators to establish common standards, governance and legal frameworks, and provide comprehensive risk management. For certain networks, particularly those in financial markets where the value of transactions on a network may be significant and the consequences of incidents can be severe, participants will demand the operational oversight, resilience and security standards akin to those that are currently required of FMIs. These aspects are particularly critical given many innovative technologies increase connectivity between financial institutions and are intended for cross-border use. No matter how smart the technology, the market is not likely to hand responsibility for the operation of critical functions to unknown or unproven entities.

What barriers exist in creating digital economies? How do you think these can be overcome?

There are several barriers, but I’ll focus on two.

First, we have observed that not all market participants are ready to utilise new technologies in production environments at the same pace. No participant is in a position to discard their current technology infrastructure and replace it wholesale, so there will always be integration effort, and this places a dependency on budget, resources, immediate return on investment and risk appetite (better the devil you know). This could limit the potential gains for early adopters, given many new technologies derive value through network effects. This problem will be overcome in due course; however, in the interim, we see value in offering participants options to ease the transition. For example, CLSNet (our bilateral payment netting service for FX trades that do not settle in CLSSettlement – our FX settlement service) will leverage distributed ledger technology (DLT) based on Hyperledger Fabric. However, we are initially offering participants the option to connect via traditional Swift-based channels as this is currently the preferred choice for users of the service. We will continue to work with clients to ensure we provide sufficient flexibility to accommodate firms’ preferred connectivity models, including DLT, as they evolve.

Second, greater regulatory and legal certainty is needed for broad adoption of certain innovative products and services in financial services, such as crypto-assets and cloud computing. Traditional financial services firms are simply unwilling to make substantial investments or undertake resource-intensive migration efforts until further clarity is reached. This is a difficult challenge, because it is important that regulators and policy-makers do not rush to create new regulations, which could have the unintended effect of stifling innovation.

What steps should infrastructures take to prepare for a digital economy?

FMIs should actively explore how emerging technology can be used to add value to their existing products and services, as well as address new business challenges. Perhaps it is already a cliché to point out that just because you have a hammer, doesn’t mean everything is a nail. Not every challenge can and should be “solved” with a blockchain or artificial intelligence. It is important for an FMI to always focus on the business process problem it is addressing for its clients and then to see whether emerging technology helps solve that problem.

Which technologies do you think are the most promising for the future role of infrastructures in a digital economy? What is CLS’s experience of such technologies?

Several technologies will be important in defining the future role of FMIs, such as blockchain, AI, ML and cloud computing. It is too early to tell how most of these will transform the role of infrastructures, but certainly there has been a lot of speculation about the use of permissioned distributed ledgers and digital assets or tokens.

With respect to blockchain in particular, a Bank of England staff paper from 2017 characterises the technology as both a “radical innovation” (one that has high impact), as well as a “systemic innovation” (one that affects the entire value chain and not just one or a few components). It is too early to know for certain how blockchain might affect the post-trade sector, whether the impact will be radical and/or systemic. In the near term, it is more likely that FMIs and intermediaries can leverage the technology to lower operating costs without significantly changing their business models. But in theory, the technology introduces the potential to fundamentally alter the structure of the industry over time via decentralisation.

CLS has been exploring the potential use of blockchain since late 2015, around the time when we became founding members of the Hyperledger Project. We plan to launch CLSNet – a bilateral payment netting solution that uses a permissioned DLT-based platform. Earlier this year, we announced a joint proof of concept with IBM to develop LedgerConnect, a managed platform to provide access to multiple DLT-based services to financial institutions. We are also investors in R3 and plan to work on new products and services to bring value to our members.

What qualities do you think financial market infrastructure CEOs will need in a digital economy? How do you think digitisation will transform the way infrastructure employees will work?

Whereas technology companies live by the mantra “move fast and break things”, this approach is not appropriate for incumbent institutions, particularly FMIs responsible for critical payments, clearing and settlement activities. But on the other hand, incumbent FMIs simply cannot “stand still and do nothing”. CEOs and management teams will need to adopt a prudent approach to innovation – “move smart and improve things”.

This is the approach we’ve taken. Our first DLT-based service does not involve critical activities. We continue to explore how emerging technology can enhance post-trade processes and reduce frictions and costs for our clients, while at the same time, ensure these initiatives align with key policy objectives such as risk mitigation, reliability, efficiency and security.

Certainly technology must be core to the strategy of an FMI: business and technology strategies can no longer be loosely connected. Technology not only underlies the business strategy, but is often the main focus of the business strategy. A CEO must be inquisitive and well-versed in all relevant aspects of the technology that may affect their business.