Central Banks Propose Atomic Swaps for Securities Settlement
A joint report recently published by the European Central Bank (ECB) and Bank of Japan (BoJ) proposed new blockchain-based methods of securities settlement, including cross-chain atomic swaps and a mechanism called ‘delivery versus payment’ (DvP). The research is part of a joint project known as Project Stella, which was launched in December of 2016. The central banks hope to create more secure, usable, and flexible systems for securities settlement that will improve on existing systems using blockchain.
The settlement mechanism proposed by the ECB and BoJ is known as delivery versus payment (DvP) and works by executing logic to ensure that transfer of one asset occurs if and only if transfer of the corresponding asset occurs. This is a consensus system similar to the way smart contracts work. Regarding DvP, the report states:
“DvP could be conceptually and technically designed in a DLT environment with cash and securities on the same ledger (single-ledger DvP) or on separate ones (cross-ledger DvP).”
Cross-ledger transactions refer to securities settlement between multiple distinct blockchains. These settlements are made possible with the use of cross-chain atomic swaps, a technology popularized by Bitcoin, Litecoin, and the Lightning Network. Cross-chain atomic swaps essentially connect different blockchains so that users can transact directly with each other without the use of a third party, such as an exchange. They leverage a technology called hash time-locked contracts (HTLCs), which work by requiring each party to acknowledge and verify the amount of the transaction cryptographically within a certain time frame. One shortcoming of this technology is the fact that the two blockchains interacting must utilize the same hashing algorithm, such as SHA-256 in the case of Bitcoin and Litecoin.
Project Stella has developed prototypes for their DvP systems on multiple permissioned blockchains at this point, including Corda, Elements, and Hyperledger Fabric. They have determined from their research that DvP settlements are possible between entities on a single ledger, or between entities on multiple ledgers. At this point, they have not accomplished cross-chain communication between multiple ledgers without actually linking the individual ledgers via added protocol on each side of the transactions.
The report points out that use of DvP and atomic swaps for securities settlement comes with some challenges. First, implementing DvP settlement across multiple ledgers requires multiple transactions between each party so that the settlement can be properly verified. This architecture can also slow down transaction speeds and subsequently reduce network liquidity. Although a given user is protected from losing funds in this system in the case where the corresponding party does not verify the transaction, that user is still stuck with an incomplete transaction. In other words, the system may not be fully reliable in its early stages, until contingency plans are developed to account for this scenario.