What are the main takeaways?
Why is the decentralized netting described in the papers groundbreaking?
Commercial banks currently have limited control over how their payments with other commercial banks in a domestic region are netted. A third party such as the central bank or central payment system operator makes netting decisions for wholesale interbank payments on their behalf. While netting algorithms have improved, today commercial banks often delay making payments until the end of the day (suboptimal for the group) and their management of liquidity intraday suffers (suboptimal for each individual bank).
What if a commercial bank was more in control of their payment netting – by decentralizing netting decisions out to the commercial banks themselves? Commercial banks have a more complete view of their own liquidity and risk profiles at a given time than central operators who have incomplete information. Improving signaling amongst each of commercial banks could lead to more efficient offsetting between the banks.
There are also many decentralized netting applications beyond commercial bank payments across capital markets and insurance – decentralized netting may prove to be a more effective way to net.
The value of netting for enterprises
The best settlement (of money, or other assets) is often the one that you don’t make. For non-urgent payments or settlements, companies and financial institutions prefer to offset transactions. Netting can occur bilaterally (between two firms) or multilaterally (between many counterparties like FX netting through CLS).
The practice saves costs by reducing the number of transactions that occur, lightening the operational burden. Additionally, with payments, instant settlement requires the full availability of liquidity. With interbank payments, having excess central bank reserves available elicit opportunity costs as reserves are lower yielding than other assets. There is an inherent compromise commercial banks face between paying immediately (providing liquidity now) versus allowing a longer time window for incoming payments to offset.
Netting that occurs over a standard time frame affords firms predictability with settlement. Further, the more time that passes between settlement cycles, the more trades that can accumulate to offset each other. This time delay is an advantage if settlements net evenly – but if settlements are biased in one direction, large exposures to counterparties may develop. The larger the outstanding obligations between counterparties, the more systemic the credit or default risks become – that is why central banks have favored Real Time Gross Settlement interbank payment systems in the modern age.
But how can you net without a central operator involved?
In Phase 2 of an ongoing exploratory wholesale payment project Jasper, the Bank of Canada Payments Canada, and R3 explored a centralized netting queue for a liquidity savings mechanism with blockchain technology. Within another wholesale payment project, Project Ubin Phase 2 (technical whitepaper here), the Monetary Authority of Singapore asked the blockchain platform teams involved to develop a decentralized liquidity savings mechanism.
Now, the NEW R3 Report “A Proposal for a Decentralized Liquidity Savings Mechanism with Side Payments” is the first time that decentralized netting in the context of liquidity savings mechanisms with side payments has been explored in depth. The basic premise of the decentralized approach outlined in the paper is that netting proposals are made by and agreed upon by the counterparties rather than the central operator.
Central operators cannot make entirely accurate welfare assessments or set system parameters to maximize social welfare – they have no way of assessing the importance of payments beyond the coarse priority categorizations the systems currently allow. Neither can they assess an individual bank’s cost of liquidity provision, which varies across banks and throughout the day.
A decentralized approach allows individual participants to make netting proposals that reflect, in real time, their own current conditions. Banks with existing unsettled payment obligations would announce these obligations to their respective obligees. System participants would collect information about netting opportunities through a recursive scanning algorithm, and competitive proposals from each bank would reflect market conditions. This structure would allow for continuous net settlement, allowing real time netting of positions between counterparties.
Traditional Netting ——>>>>>> Decentralized Netting
Decentralized netting has the potential to decrease both the liquidity required and time window for netting.
What about other decentralized netting applications?
There are two other recent reports that explore other applications for decentralized netting. Within commercial and specialty insurance, the R3 Report “Modernizing Commercial and Specialty Insurance Accounting With Blockchain Technology” shows how decentralized netting may be applied within insurance. Decentralized netting in capital markets, specifically with derivatives, was explored in the R3 Report “Implementing Derivatives Clearing on Distributed Ledger Technology Platforms.”
The specific architecture of a bilateral or multilateral netting algorithm would depend on the particular needs of stakeholders within a particular industry or asset class. Some benefits that are likely to be shared across use cases include:
The retail-focus and non-enterprise bent of much of the cryptocurrency community has resulted in insufficient consideration of netting in the design of almost all blockchain-based platforms, specifically those that retain vestiges of public broadcast. While individuals (the retail market) do often net payments (You: “Hey you owe me 10 dollars” Me: “No I paid for your ice cream last night I only owe you 5”), these retail relationships involve fewer transactions. As a result blockchain architectures built strictly for retail use will not have advanced netting capability.
For thousands of daily transactions and hundreds of billions of notional value on the scale of wholesale payments or capital markets transactions, platforms need to be built for-purpose. Due to its unique peer-to-peer data sharing approach and seamless interoperability without forming channels and data siloes, Corda is the only blockchain platform today that is capable of complex multilateral netting.
For blockchain technology adoption to occur across wholesale payments, capital markets, and insurance use cases, decentralized netting would likely have to be an improvement over how central operators offset trades today. Corda has begun to demonstrate that netting algorithms that put control in the trading counterparty’s hands themselves may be a better way.
How can you get involved?