The South African Reserve Bank (SARB) on April 6 released a report on its financial technology research project Project Khokha 2 (PK2), which looked at the benefits and risks of using distributed ledger technology (DLT) and trialling DLT for interbank payments settlement.

SARB governor Lesetja Kganyago said PK2 explored the implications of tokenisation in financial markets through a proof-of-concept that issued, cleared and settled SARB debentures, which is a debt security, using DLT.

“PK2 built on Project Khokha 1, which was the initial financial technology (fintech) policy exploration and technical trial in the use of DLT for interbank settlements. PK1 explored the use of DLT for interbank settlements by successfully replicating some functions of the South African real-time gross settlement system on DLT.”

Specifically, PK2 is aimed at issuing, clearing and settling SARB debentures on DLT using two settlement options – a wholesale central bank digital currency (wCBDC) as a form of central bank money and a wholesale settlement token (wToken) as a form of private money issued by commercial banks.

“Several central banks have opted to further explore the viability of tokenised central bank money in financial markets. Such exploration, although largely conceptual at this stage, is important given the growth in technological innovation and the use of new forms of payment instruments facilitated by the rapid pace of innovation,” Kganyago said.

PK2 explored and expanded on how settlement in central bank money and commercial bank money can happen on DLT.

“The debenture token market benefitted from having a riskless settlement asset in the form of a wCBDC used for settlement. This reduced the settlement risk, particularly that payment might fail or might be uncertain owing to riskiness in the settlement asset,” he said.

Further, the wCBDC prototype developed in PK2 was also the preferred asset in other instances. It served as the reserve asset guaranteeing the value of the wholesale stable coin issued by commercial banks, and it was used to make payment to debenture token holders upon the maturity of the debenture.

The role of the central bank in the tokenised debenture market was, therefore, similar to the current role played by the central bank, Kganyago pointed out.

BENEFITS AND RISKS

The project outcome explores the implications of DLT-driven innovation through practical exploration. It is important to interrogate the efficiencies and benefits that new technology may introduce, he said.

In the context of DLT-based platforms in financial markets, potential efficiencies relate to increased transparency in the holding of securities, a potential reduction in costs owing to automation and the removal of multiple manual reconciliation processes across a network of intermediaries.

One of the primary risks stems from the lack of regulatory certainty as the existing legal and regulatory frameworks for financial markets were not designed for trading, clearing or settling on DLT, he added.

“Innovation should be done in a way that the financial system is taken forward to benefit society as a whole, including contributing to achieving objectives such as improving efficiency, lowering barriers to entry for financial activity and addressing any challenges restricting access to meaningful financial services.

“The insights gained through practical exploration should lead to greater regulatory clarity, for innovators and regulators, and should be in the broader interest of ensuring a level playing field for all market participants,” Kganyago noted.

Two DLT networks were created for the debenture token market. The one network, Khokha Hub, served as a token trading platform and enabled the issuance of, and trade in, debenture tokens.

The other network, wCBDC Zone, enabled the issuance of wCBDC on a private platform owned and operated by the SARB. Industry participants set up nodes to the relevant DLT networks to purchase SARB debentures.

“The wCBDC was used to purchase SARB debentures in the primary market and the wToken was used to purchase SARB debentures on a peer-to-peer basis in the secondary market,” the SARB fintech unit explained.

As an experimental research project, PK2 followed an exploratory approach in the design and development of the prototypes built in the proof-of-concept. The objective of the technical trial was to highlight the policy and/or regulatory implications of the application of DLT in the financial markets.

“PK2 has demonstrated that building a platform for a tokenised security would impact on the existing participants in the financial market ecosystem, as several functions currently being performed by separately licensed market infrastructures could be carried out on a single shared platform. This has the potential to reduce both costs and complexity,” the SARB fintech unit highlighted.

Further, the report, produced in partnership with the Intergovernmental Fintech Working Group and financial industry participants, highlights several legal, regulatory and policy implications that need to be carefully considered in the application of DLT to financial markets.

PK2 also underscores how interoperability can be achieved between different DLT networks in the case of a multiple-DLT network design in the future.

“PK2 has added valuable insights on the application of DLT in financial markets and the use of central bank money for wholesale settlement on DLT. The learnings from PK2 provide a solid basis for further analysis and collaboration to unpack the future of trading, clearing and settling in a way that leverages the benefits of technology and maintains the safety, integrity and stability of South Africa’s financial markets,” the SARB fintech unit said.

“Central banks, regulators and policymakers can, and must, play an active role in shaping a potential move to DLT-based markets through playing with purpose, playing in a collaborative way, pondering the implications of innovation, promoting responsible innovation for the public good and informing an appropriate policy and regulatory response,” Kganyago concluded.