September 12, 2018 7:07 PM
A recent Bank of Canada working paper argues for a trustless blockchain securities settlement system.
The Bank of Canada (BoC) recently published a working paper titled Blockchain-Based Settlement for Asset Trading on its website. The paper, authored by Jonathan Chiu and Thorsten Koeppl, explores the potential benefits and risks of securities settlements on a blockchain. The authors conclude that given the proper technological specifications and incentives, blockchain-based securities settlements could offer modest market gains.
The authors express confidence that proof-of-work (PoW) blockchain-based settlements would be faster and more flexible than existing methods, but they also see risk in that participants could fork the chain to avoid financial losses. Additionally, they point out that PoW is costly, though they still see a net gain:
“Gains from moving to faster and more flexible settlement are in the range of 1 to 4 basis points relative to existing legacy settlement systems.”
The authors go on explore the technical specifics of an ideal blockchain system to prevent settlement fails, guarantee immutability, and ensure fast transaction times.
One concern they raise is over mining as a public good. As explained by Investopedia, a public good “is a product that one individual can consume without reducing its availability to another individual, and from which no one is excluded.”
As it applies to blockchain-based settlements, the authors explain that “once there is a sufficient amount of mining activities, settlement fails can be prevented independent of the total number of transactions, making settlement a free resource.”
The issue with public goods is that because everyone has access to that resource, no one is incentivized to pay for it, which then leads to an under-funding of that resource. This is known as the “free-rider problem.” However, with blockchain-based securities settlements, this could be a huge issue – paying miners is what incentivizes them to participate and guarantees the immutability of transactions.
For this reason, the authors of the BoC report assert that a securities settlement blockchain would need to make fast settlement scarce by limiting block time and block size, and then charging transaction fees. Doing these things would create artificial congestion and render mining a club good (or force people to pay to have access). However, they specify that block time and block size should be limited in proportion to the expected net trade surplus, as to not make transactions too expensive but still incentivize honest miners:
“We find that a block time equal to about 27 minutes is optimal together with a very large block size. This would be a vast improvement relative to the existing settlement regime, which has a settlement cycle of T + 2. Using our calibration, we find that the gains from moving to faster settlement fall in the neighborhood of about 1 to 4 bps [basis points]: investors would still prefer a permissionless blockchain even if one subsidized a legacy settlement system by this amount.”
The report describes the basic incentive model of most PoW blockchains but simply in more traditional economic terms. This framing is interesting because the authors, writing for Canada’s central bank, seem to make an economic argument that a trustless blockchain system offers security advantages over permissioned blockchains (which tend to be more popular among major financial institutions). They do state, however, that given proper legal and economic incentives, a permissioned blockchain would also probably work.
Alison is an editor and occasional writer for ETHNews. She has a Master’s in English from the University of Wyoming. She lives in Reno with her pooch and a cat she half likes. Her favorite things to do include binge listening to podcasts, getting her chuckles via dog memes, and spending as much time outside as possible.
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