How Payments Law Can Help Drive Innovation, by Jessie Cheng
Distributed financial technologies (DFT) and protocols are gaining a foothold in important payment and settlement applications in global markets. The software developed by Ripple is one example of an enterprise solution for financial institutions that improves the efficiency of their cross-border payments. However, robust DFT must be paired with clear commercial rules that define and govern, with certainty and predictability, how the technology is being used to make payments. As discussed further below, business lawyers and technologists alike should take note that commercial rules, as well as requisite payments law expertise to craft them, are critical to transforming DFT from an experimental pilot to an enterprise solution for financial institutions to move real value around the world.
DFT arrangements vary significantly across functionality and processes, design and interfaces, and nature of service. For banking lawyers or others interested in learning more about the details around DFT and how it can be used for payments, a practical illustration of how financial institutions can use one particular DFT — Ripple’s solution — for their cross-border payments, in comparison to relying on intermediaries through global correspondent networks, is available here. In essence, this technology allows financial institutions with no direct relationship to establish trust and coordinate their actions, without relying on intermediaries like global correspondent banks and domestic payment systems.
Additionally, financial institutions can use virtual currencies like XRP, the digital asset native to the Ripple Consensus Ledger, as a bridging tool that streamlines liquidity for their interbank foreign exchange transactions. More details are available in Ripple’s announcement of a successful pilot of this use case among 12 global banks in October 2016. Using XRP in this way allows financial institutions to reduce the costs, enhance the transparency, and extend the global reach of their cross-border payments — without the end-user payer or payee themselves necessarily having any contact with XRP.
Fundamentally, these applications of DFT to cross-border payments create new paths for value to more efficiently flow between payers and payees around the world. Developments like these can have positive policy implications from financial inclusion and economic growth standpoints, such as those highlighted in an April 2017 speech by IMF First Deputy Managing Director David Lipton. From a business and operational perspective, a 2016 study by the Federal Reserve Board of Governors on DFT (specifically, distributed ledger technology) in payments, clearing, and settlement reports the views among proponents of the technology on its transformative potential:
Information collected through interviews with industry stakeholders indicates that firms have several common motivations behind efforts to develop and deploy [distributed ledger technology] arrangements:
- Reduced complexity (especially in multiparty, cross-border transactions)
- Improved end-to-end processing speed and availability of assets and funds
- Decreased need for reconciliation across multiple recordkeeping infrastructures
- Increased transparency and immutability in transaction recordkeeping
- Improved network resiliency through distributed data management
- Reduced operational and financial risks
Applications of DFT to financial services, however, also come with risks. For technologists or others interested in learning more about the infrastructure supporting global financial markets, a 2012 report on Principles for Financial Market Infrastructures (PFMI) by the Committee on Payment and Market Infrastructures (CPMI) and the International Organization of Securities Commissions sets out, as a general matter, the framework for addressing risks inherent in financial market infrastructures, designed to help ensure safety, efficiency, and resilience. Certain risks specific to DFT like distributed ledger technologies are discussed in a February 2017 report on Distributed Ledger Technology in Payment, Clearing and Settlement by the CPMI (the 2017 CPMI Report). From a legal risk point of view in particular, the report notes:
Having a well-founded, clear, transparent, and enforceable legal basis is a core element of payment, clearing, and settlement arrangements. [Distributed ledger technology] can increase legal risks if there is ambiguity or lack of certainty about an arrangement’s legal basis.
Thus, clear and well-developed commercial rules, drafted with precision and detail, ensure that the legal underpinnings of DFT arrangements are sound. These commercial rules might arise from legislation, such as Article 4A of the Uniform Commercial Code, which has been adopted by the 50 states and generally governs the rights and obligations of parties to a funds transfer. Article 4A generally permits financial institutions involved in a transaction to supplement or vary its terms by contract. These private-sector contracts are an alternative way to craft commercial rules. In this way, DFT companies can establish commercial rules for their financial institution customers that provide greater specificity than is possible in state legislation — that are tailored to the particular DFT’s processes and enhancements over existing technologies, such as atomicity (as opposed to sequential processing), speed, and transparency — as well as international reach. For this reason Ripple, with input from a group of global banks, has developed such a commercial framework tailored to transactions over its solution.
It is only when a particular DFT is paired with effective commercial rules — rules that are thoughtfully tailored to the technology and crafted with awareness of payments law — that it can lead to more robust, resilient, and effective financial products and services. Technical documentation might specify the mechanical processes occurring over the technology; however, it is commercial rules anchored in payments law that give meaning and legal significance — e.g., when an obligation to pay arises and when it is discharged — to the steps in that process.
To illustrate how payments law can drive innovation in this way, consider settlement finality. The 2017 CPMI Report defines settlement finality as follows, though formulations may vary: “the legally defined moment at which the transfer of an asset or financial instrument, or the discharge of an obligation, is irrevocable and unconditional” and may not subsequently be voided, including by bankruptcy or insolvency of a party. Financial institutions using DFT to transact with each other require a clear and well-defined point in time at which payment between them has finally and irrevocably been made, backed by a strong legal basis. With effective commercial rules, an institution sending the payment using the technology can be confident that it has paid its counterparty and no longer needs to concern itself with that payment obligation. Likewise, an institution receiving a payment over the technology can be confident that the transaction, once settled, cannot be canceled; it may go ahead and efficiently use the money to satisfy its other obligations.
When commercial rules are poorly crafted or nonexistent for a given DFT, the result can be unclear or unintended outcomes for the financial institutions using the technology, which in turn creates risks for the broader market. However, when these rules are effectively drafted, the clarity and certainty they bring can mitigate risks, as well as actively drive global market implementation.
Jessie Cheng is presently deputy general counsel at Ripple, where she advises on regulatory and commercial matters with respect to cross-border payments and banking, distributed financial technology, and digital currencies. Previously, Ms. Cheng was counsel and officer in the legal group of the Federal Reserve Bank of New York, providing legal advice to the financial services areas of the Bank, including funds transfer services, international currency distribution, and central bank and international account services. Before joining the Bank, she practiced law as an associate at the New York law firm Wachtell, Lipton, Rosen & Katz. A member of the American Bar Association, Ms. Cheng currently serves as Vice Chair of the Payments Subcommittee of the ABA Business Law Section’s Uniform Commercial Code Committee. She holds a B.A. from Yale University and a J.D. from Columbia School of Law.
This post is part of an online symposium entitled “Blockchain: The Future of Finance and Capital Markets?” You can read all the posts here.