Here’s How the Federal Reserve Could Guide the Digital Financial Revolution

Bajinder Paul is the executive director of information technology at ManTech International and previously served as the associate director of the Federal Reserve System Board of Governors from January 2015 to April 2017.

The digital revolution, powered by blockchain technology, is reshaping the world of business and financial services. During the two years I served as the associate director of the Federal Reserve System Board of Governors, it was clear that the disruptive power and potential of cryptocurrencies and blockchain technology were rapidly advancing to become the defining financial technology issues of our era. That observation is now true in spades.

That said, there remain diverse attitudes both pro and con toward blockchain technology in the financial sphere. The Federal Reserve, the nation’s central bank, has been warily monitoring developments from afar through multidisciplinary working groups—and, from their standpoint, for compelling reasons.

There is strong evidence the traditional banking system is vulnerable to disruption by blockchain and other digital currencies that could result in disruption to today’s financial order on a significant scale.  

At face value, it would appear that the Fed’s concerns should be shared by the general public, which relies on this august financial institution to stabilize prices and market fluctuations while helping to maximize the national rate of employment.

And yet at the same time, the very disruption that alarms central bankers and conventional financial institutions could bode well for consumers. Consider that in the world of remittance transfers—one of the largest flows of capital to developing countries—traditional financial institutions such as iRemit, Western Union and banks rake in close to $40 billion in global aggregate profit. However, new digital asset management platforms built on cryptocurrency and nontraditional financial service providers could enable people to transfer funds in real-time directly and at a fraction of the cost they currently pay to the big banks.

Needed: Fresh Policy for the New Era of Financial Technology

Blockchain is not going away, instead, it is growing in popularity. It is in the best interests of all parties that the Federal Reserve take thoughtful steps toward adapting to this change from both a regulatory as well as a technology perspective.

From a regulatory and oversight perspective, instituting and implementing new policies to conduct effective supervision and regulation of non-traditional financial service providers is essential. This includes policies on standardization, security and interoperability—perhaps established and implemented through the Bank of International Settlements, an international central bank for and owned by central banks.

The foremost policy of concern in this new era must be risk management and cybersecurity. Trust plays a central role in all economic transactions. Before banks and central clearing houses are bypassed, risk management policies and cybersecurity postures for new cryptocurrency platforms must be established. Such policies should emphasize continuous monitoring and periodic outside examination by regulators.

At present, in the absence of government standards and policy, the international banking community including UBS, Barclays, HSBC, Credit Suisse, Deutsche Bank, BNY Mellon and others are working on the “Utility Settlement Coin” to enable faster interbank settlements.

The Federal Reserve cannot fulfill their mission to guide and stabilize macroeconomic performance from the sideline: It must get into the game.

IT Infrastructure and Capabilities Must Be Modernized

The world sends more than $150 trillion in cross-border payments using infrastructure that is outdated. Blockchain enables a direct bank-to-bank frictionless payment system that is fast, secure and near real-time.

These digital asset payment systems serve as an alternative to the vulnerable Society for Worldwide Interbank Financial Telecommunication, better known as SWIFT, infrastructure that is currently used by most banks, including the central bank.

The Federal Reserve must accelerate its adoption of modern technology-based systems—similar to the decentralized, distributed ledger based framework—to ensure safe and sound payment settlements. It should also encourage the adoption of secure, modern IT infrastructures by other financial institutions. This modernization needs to take place sooner rather than later, as the technology gap is widening.

The risks of continued dependence on outdated and vulnerable technology are great and recently exemplified by the hacking and theft of millions of dollars from the Bangladesh central bank by North Korea.  

The digital revolution based on distributed ledger, decentralized, blockchain-based technology is demonstrating enormous benefits to global humanity by providing faster, efficient, cheaper and secure transactions. This technology is enabling equitable opportunities and access to create wealth.  

The displacement of the traditional financial services is likely to continue at an even faster pace. In response, the Federal Reserve, as the nation’s central bank, must ramp up its adoption of change.