There is a new technology making waves in the financial markets. And while the name – distributed ledger technology, or DLT – might sound technical, some say it has the potential to completely change the way the financial markets and banking work. So what exactly is it and why is it important to central banks like the ECB?
What is distributed ledger technology?
Distributed ledger technology is a tool for recording ownership – this could be, for example, ownership of money or of assets, such as property. Nowadays, when banks make transactions – i.e. when ownership of money or financial assets changes hands – they do so via centralised systems, often run by central banks. Banks keep track of their transactions in local databases, which are updated after the transaction has taken place in the centralised system.
A distributed ledger, on the other hand, is a database of transactions that is spread across a network of many computers, rather than stored in a central location. Usually, all the members of the network can read the information, and depending on their permissions, add to it.
The most common type of DLT is called blockchain. The name comes from the fact that transactions are grouped together to form blocks, and these are attached to each other in chronological order to form a chain. The whole chain is protected by complex mathematical algorithms which aim to ensure the integrity and security of the data. This chain forms the comprehensive record of all the transactions included in the database.
What are the potential advantages?
Given that the algorithms keep the data so secure, and also because the members of the network can usually see if a change is made to the record, this technology has the potential to make transactions fraud more difficult.
It could also provide efficiency gains as record-keeping can be automated, thus potentially eliminating human error, and simplifying what can otherwise be very complex processes.
There are some who go so far as to say that DLT could fundamentally change the way the financial markets work by cutting out the middleman. For example, it may be that payments between banks will no longer need to go through intermediaries and/or payments systems. And some think that even your private payments – which currently go via both your bank and the bank of the person you are paying – may be possible without involving your bank at all because individuals could be linked directly to the shared database.
This is viewed by others as unlikely to be the case as there is likely to always be the need for central authorities to perform certain functions, such as monitoring and safeguarding the overall stability of the financial system.
Why is the ECB interested in this technology?
One of the ECB’s key objectives is to ensure that transactions can be made safely and efficiently across the euro area. As part of this objective, we closely monitor how payments are made and the systems that are used to make them. The ECB supports innovation if the developments are safe and efficient and open the same opportunities to everyone in Europe.
In addition to this, the ECB itself runs a number of systems that help move money and assets around Europe. We want these systems to be as efficient as possible, and for that reason we also look for ways to make improvements, while still ensuring reliability as technology advances.
For these two reasons, we always keep abreast of any technological developments that could have an impact on the way transactions are made.
However, while DLT presents a number of interesting possibilities for the future, it is still a relatively new technology and not yet mature enough for us to consider using it in our own systems, which form the backbone of Europe’s financial sector. And as the private sector experiments with the technology, we want to be sure that any new services and products based on DLT do not compromise the safe flow of transactions – so that you can be sure that your money and financial assets are safe and secure as they move from one place to another.
Source: European Central Bank
Published: 19 Apr 2017
The above presentation was created for educational purposes.