How Atomic Swaps will enhance interoperability

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How Atomic Swaps will enhance interoperability

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This content is contributed or sourced from third parties but has been subject to Finextra editorial review.

Money has taken on different shapes, sizes, and forms throughout history. Payments have evolved from offline to electronic  in credit cards and electronic wallets.. Instant payments will become the new normal. The volumes in domestic and cross-border payments will increase as instant payment offers financial institutions the opportunity to innovate and meet customer demand. While the number of domestic and cross-border payment systems is growing, it is bringing the challenge of interoperability to support international trade and e-commerce and the move of money at the cross-border level. According to the World Economic Forum, the lack of interoperable payment systems in the context of international transfers add up to a cost of 10% of the transaction value.

The G20, in coordination with The Committee on Payments and Market Infrastructures (CPMI), has determined several focus areas to enhance cross-border payments. One of them is exploring the potential role of new payment infrastructures and arrangements to solve interoperability issues to develop a globally interoperable payment system. Setting up an interoperability framework is the key milestone to achieving the scheme interoperability to reach the critical mass.

In July 2021, the Arab Monetary Fund’s (AMF), BUNA payment system announced its successful experiment with TARGET Instant Payment Settlement (TIPS), a proof of concept that came under block 13 of the G20 roadmap, that seeks to enhance the existing payments ecosystem by pursuing interlinking of payment systems for cross-border payments. In this experiment, BUNA and Banca d’Italia (the Central Bank of Italy) in collaboration with SWIFT, have linked for the first time the instant payment settlement platforms with multi-currency features (TIPS and BUNA) operated by the two organisations.

The conceptual approach for interoperability

The World Bank defines interoperability as a ‘situation in which payment instrument belonging to a given scheme may be used in platforms developed by other schemes, including in different countries’. The Bank for International Settlement (BIS) emphasises `seamless interaction of or more proprietary platforms`. Interoperability is generally implemented in a layered approach to ensure efficient, fast, and secure delivery of financial transactions between schemes, such as business, and technical interoperability, to achieve maximum flexibility. While business interoperability covers the use cases, rule book, operational procedures, settlement, compliance, pricing, and reporting functionalities, technical interoperability covers technical connectivity, messaging, and security components.

We can talk about three different models of interoperability: the bilateral model, the aggregator model, and the hub model. Correspondent banking is the standard implementation of the bilateral model. Since no global standard is available, most cross-border payments are cleared and settled through a correspondent banking network, which is perceived as inefficient and costly by the market. Payment gateways are an excellent example of aggregator models that provides the technical infrastructure to facilitate the transaction flow while not involving in the fund flow.

I will focus here mainly on the hub model where end-to-end payment processing functionality, including settlement, is carried out on the shared platform of the hub. The great success of the digital platform economy positions the hub model to provide connectivity between consumer and seller (such as online marketplaces) to manage end-to-end trade and payment flow. Participants of the platform can leverage economies of scale and network effect by integrating only through the platform. The platform API becomes a single point of connectivity to reach all participants subscribed to the platform. This prevents the participant from building spaghetti-like integration points with each counterparty, which is costly to maintain and difficult to scale. We will now examine each layer of business and technical interoperability for the hub model:

Use case layer

The use case layer usually maps the consumer behaviour and channels to address the ways in which participants or end-users use the service. The use cases such as P2P instant payment, one-click payments on the web or point of sale, and request to pay, are becoming popular in parallel to increasing lifestyle-driven technologies. Instant payments are becoming new normal across the world. There was no demand to establish bilateral interoperability between payment systems in the past, but this has changed as international commerce grows. Many countries have developed their own domestic instant payment systems. By this time, the need to move to the next level is expanding the reach by setting up interoperability with other domestic payment systems. The SEPA (Single Euro Payment Area) Instant Credit Transfer scheme (SCT Inst) is an excellent example of expanding the reach by enabling European countries to send instant payments under the same rule based on an interoperability framework.

The use case layer must handle the identifier of the parties involved, such as participant institutions and consumers, to manage the end-to-end flow. The hub maintains a central reach directory that contains information on reachable parties on the system so the system can route the transaction accordingly. The connected parties are responsible for updating the central reach directory. Bank Identification Code (BIC) or Business Entity Identifier (BEI) generally codes an identifier for participant institutions, and IBAN, email, QR code, or MSISDN[1] is used as an identifier for consumers. The hub is responsible for developing a service for connected participants to map mobile phone numbers (MSISDN) or emails into IBAN.

In short, the use case layer does not introduce any major interoperability challenge as global standards are already used as an identifier and the channel interaction.

Messaging layer

Financial messaging was very fragmented until the ISO 20022 universal standard was launched.

ISO 20022 provides a universal messaging standard to enable interoperability between financial institutions, market infrastructures, and customers. The cross-border payments industry is migrating to ISO 20022 messages to give the participants richer data, improved insights, and increased levels of automation. ISO20022 is a modelling methodology to implement syntax-independent business transactions, and associated message flows with the central dictionary of business items used in financial messaging. ISO20022 uses The Extensible Markup Language (XML) as a simple text-based format for representing structured information: documents, data, configuration, books, transactions, invoices, and much more. XML 1.0 was a recommendation of the World Wide Web Consortium (W3C) and is considered the global Internet standard.

ISO 20022 is an open global standard for financial messaging and provides structured data that can be used for every kind of financial business transaction. In this regard, ISO 20022 creates a common language for payments worldwide. As per SWIFT, almost 200 market infrastructure-driven initiatives are either already implementing ISO 20022 or are considering adopting the standard for payments and securities transformation projects. ISO20022 will solve the harmonisation and interoperability challenges at the messaging layer once adopted by the community.

Compliance and risk layer

The compliance and risk layer has different components such as fraud monitoring, sanction list screening, duplicate checks, KYC, and risk scoring to ensure that the transaction is risk-free and compliant with the regulation and legislation. The lack of an international supervisory body overseeing global payments is still challenging. G20 has made recommendations around implementing international guidelines and principles as building block 4 for aligning regulatory, supervisory and oversight frameworks for cross-border payments.

The compliance layer makes sense mainly for the hub model. In contrast, the bilateral and aggregator model keeps the compliance liability with the participants' side based on originating and destination county's regulations. In the context of the hub model, the compliance & risk layer still does not stand as a showstopper for the interoperability aspect. However, challenges there are at the cross-border level. Until an international body is established, there are many international or intragovernmental organisations such as FSB (Financial Stability Board), CPMI (The Committee on Payments and Market Infrastructures),  International Monetary Fund (IMF) and FATF (Financial Action Task Force), setting up guidelines.

Connectivity Layer

The industry is moving from a message-based integration to an API-based integration model to leverage the API economy to drive innovation based on open architecture. The typical integration alternatives are as follows:

  • API to enable send/receive transaction through hub API getaway. API-based integrations with REST-based protocol allow exchanging data in JSON format in near-real-time. The rise of open banking APIs will help realise the interoperability concept by creating reach to the business services and transactional data with exposed APIs.
  • Gateway application provided to be installed at participant will provide secure connectivity with hub`s platform.
  • Legacy batch integration, where integrations are done by exchanging files via secure file transfer with relatively low frequency.

The global technology standards such as REST, and XML are helping to solve interoperability issues at the connectivity layer.

The other connectivity element is the network layer to transmit the transaction securely between participant and hub. Today the payment systems are mainly setting up their IP- based network or utilising the SWIFT's IP-based global network or internet via a secure channel to enable connectivity.

Today, more than 200 market infrastructures use SWIFT, and about 11,000 institutions across 200 countries and territories are connected through the SWIFT network. In parallel with advanced cybersecurity measures implemented, more or more payment systems move to IP-based networks that will allow greater interoperability on the network layer.

Settlement Layer

The cross-border payments market uses two main settlement models: prefunding and clearing-based. In the prefunding model, the participant deposits money into the counterparty's account, and the end-user transactions are debited instantly from the prefunded amount to credit the recipient account. In the clearing-based model, the end-user transactions instantly reflect the participant and counterparty's technical accounts. However, the money is transferred between parties once the clearing process is completed at a given interval.

The issue is that interoperability for the settlement layer is difficult, as a participant may need another settlement account in the target payment scheme or hub to transact. The instructing party model will allow the payment system to act as instructing party without the participant having direct ownership of the accounts. In this way, a participant in one payment system becomes reachable to a participant in another payment system without setting up a settlement account.

Today, most clearing houses or payment systems cannot open an account at the central hub system due to regulations. In this case, allowing the instructing party to act on the network layer rather than the settlement layer might be a solution. The cases where the hub is positioned as a technical infrastructure provider or instructing party may allow banks and PSPs to maintain one settlement account at their central bank rather than multiple settlement accounts across the different payment systems. This so-called fiduciary account model is where settlement accounts are kept at central bank, and technical accounts are held at the central/hub platform, providing the interoperability service.

The payment transactions are only forwarded to a receiving party when the settlement cycle has been completed to reduce the settlement risk. This model protects the funds from the insolvency of the payment system or central hub. The other settlement account model is called the liquidity bridge model, where a payment system in receiving country holds the accounts.

The settlement layer is the still most challenging layer of interoperability. Hence, the G20 emphasises the importance of setting up an interoperability framework and encourages market infrastructures to study innovative solutions to overcome the challenge. Blockchain is one of the options being discussed in the payment industry as a solution for interoperability.

Blockchain-based settlement

Distributed Ledger Technology (DLT), has the potential to change the payment processing model as an enabler for processing to be done over a distributed system. The key concept of blockchain, tokenisation, allows all types of assets to be mapped into blockchain-based systems. We see examples of tokenisation across markets including  the securities market, real estate, and digital art and more. The growth in digital currencies has added complexity to the interoperability challenge. Interoperability across several DLT platforms, such as Ethereum and Cardano is in demand.

Efficiency within the settlement process is one of the significant benefits of using blockchain technology for payment processing. This move of settlement processes to decentralised technologies decreases the associated transaction costs and reduces involved risks with the intermediaries.

Today, financial assets are mainly settled in the form of free delivery. The seller delivers the asset only after receiving funds from the buyer. This scheme brings settlement and counterparty risks where the parties can default on their obligation. The industry has solved this issue by positioning intermediaries to take care of the settlement process to mitigate the risk. An alternative to free delivery is Delivery Versus Payment (DVP).

A typical DVP process involves the simultaneous delivery of an asset and fund between trading partners under the control of an independent intermediary such as an exchange or clearing house. In this scheme, there is still a counterparty risk on the independent intermediary involved. However, the risk is relatively low compared to the case of free delivery, and involving intermediaries results in increased settlement costs.

Blockchain technology can improve settlement processes substantially. Blockchain makes it possible to reduce counterparty risk and transaction costs by enabling the simultaneous exchange of digital assets without an intermediary. A blockchain technology called atomic swaps allows one tokenised asset to be exchanged for another tokenised asset by removing the need for a third party in the chain.

Atomic swap

We may consider atomic swap as revolutionary technology that has the potential to change financial systems in the coming years. Atomic swap implementation will impact how the money transfers business works. An atomic swap is a smart contract that enables exchanging cryptocurrencies between two or more people without involving any centralised exchange institution. Hashed Timeclock Contracts (HTLCs), are smart contracts used in atomic swaps. Smart contracts are a piece of software programming containing a contractual agreement that is self-executable once pre-determined conditions are met.

Today most cross-currency trading is done by using a centralised exchange to first sell the cryptocurrency into fiat currency and then buy another cryptocurrency per your pair. The payment gateway company accepts digital assets from the customer, sends them to the liquidity provider, cash out the cryptocurrency to fiat currency, and then pays out to the merchant. This brings counterparty risk at least for the centralised exchange, for example the payment gateway company.

To solve this problem, HTLCs are used to eliminate counterparty risk and effectively solve the problem of interoperability at the settlement layer. It also helps reduce transaction processing fees and minimise the volatility risk associated with using a base currency for traded currency pairs.

On the other hand, the atomic swap has some challenges as it is used for digital assets and a synchronous operation. Both parties must be online until the HTLC operation cycle is completed. The vulnerability arising here is the probability of owning the asset once collateralised if the other party goes offline for a long duration. In short, atomic swaps offer many benefits from an interoperability point of view, while there are still concerns regarding speed and security aspects to be addressed. I believe atomic swaps may trigger a fundamental shift as a concept in the payment industry once the greater adoption of digital currencies is adopted.

Today the actual move of the money as fiat currency to settle the payment transaction is a separate flow from than transaction flow. Once the fiat currencies are digitised in line with Central Bank Digital Currency (CBDC), the settlement and transaction flow will be merged through the single flow as an HTLC type of smart contract to solve the interoperability issues. As a new technology, we will see more or more improvements with atomic swaps to support CDBC operations. CDBCs may provide for many of the same features offered by cryptocurrencies by a strong foundation of trust which does not exist with cryptocurrencies.

Many central banks, industry groups, and banks have a keen interest in blockchain experiments, which allows them to test prototypes while analysing their potential safety and efficiency implications. Mastercard, Visa, and Paypal have already initiated supporting cryptocurrencies in their payment system. Project mBridge is an excellent example of cooperation between the BIS Innovation Hub Hong Kong Centre, the Hong Kong Monetary Authority; the Bank of Thailand; the Digital Currency Institute of the People’s Bank of China; and the Central Bank of the United Arab Emirates to develop a common interoperable platform using DLT.

In response to G20`s roadmap for interoperability, atomic swap seems a potential technology to overcome the challenges of payment system interoperability. I believe decentralised payment infrastructures may still have centralised components under the management of a central authority or organisation, such as market infrastructures, to provide a wider reach and better trust. To achieve this, the APIs, ISO 20022, DLT, and CDBC are the key technologies to invest in for greater interoperability within the cross-border payment systems.

The views, opinion, or information expressed in this article are solely the author's personal view and does not reflect the view of any organisation.

[1]MSISDN is a number uniquely identifying a subscription in a Global System for Mobile communications or a Universal Mobile Telecommunications System mobile network. It is the mapping of the telephone number to the subscriber identity module in a mobile or cellular phone

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Contributed

This content is contributed or sourced from third parties but has been subject to Finextra editorial review.