## EXECUTIVE SUMMARY

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### Introduction and scope
- Focus: cross-border payments with emphasis on distributed ledger technology (DLT) as a technology with potential to offer important service improvements and cost savings.
- Paper divided into five sections: overview of emerging fintech technologies; a general analytical framework; overarching implications for financial regulation; analysis of how fintech may change cross-border payments; conclusions.

### Emerging fintech innovations
- Drivers and enabling technologies:
  - Artificial intelligence (AI) and big data: parsing vast databases and automating decisions (credit approvals, regulatory compliance, fraud detection, automated trading).
  - Distributed computing and distributed ledgers (DLT): network-maintained ledgers that could transform payments, securities settlement, and back-office functions; can support non-financial databases (land registries, medical records).
  - Cryptography: enables smart contracts and supports sensing/biometric security systems.
  - Mobile access and the internet: decentralize access via mobile devices and APIs; enable P2P transactions, crowdfunding, greater financial inclusion.
- DLT variants and limitations:
  - Permissionless DLTs: anyone can read, transact, and participate in validation (open schemes underlying Bitcoin).
  - Permissioned DLTs: validation controlled by a pre-selected group (“consortium”) or one organization (“fully-private”).
  - Current technological hurdles: scalability for high transaction volumes, interoperability, privacy protection, operating costs, speed, and transparency.
- Investment trends:
  - Total global investment in fintech companies increased from US$9 billion in 2010 to over US$25 billion in 2016.
  - Venture capital investment rose from US$0.8 billion in 2010 to US$13.6 billion in 2016.
  - Market valuations of public fintech firms have quadrupled since the global financial crisis.

### Organization of financial services — framework and service functions
- Five broad functions of the financial sector:
  1. Make and receive payments, including across borders.
  2. Save to consume or invest later.
  3. Borrow to consume or invest now.
  4. Manage risks to income, savings, and transactions.
  5. Receive advice on the above.
- Technology affects service attributes (speed, security, transparency, privacy, usability) and market structure (organization of providers); shortcomings in attributes create incentives for innovation.

### Key findings
- Boundaries are blurring among intermediaries, markets, and new service providers.
- Barriers to entry are changing: lowered in some cases, increased in others—especially if large closed networks emerge that reduce competition.
- Trust remains essential even as reliance on traditional intermediaries declines.
- Technologies may improve cross-border payments by offering better and cheaper services and lowering the cost of compliance with AML/CFT regulation.
- Uncertainty whether change will be evolutionary or revolutionary; policy responses should be nimble, experimental, and cooperative.

### Policy implications and recommendations
- Regulatory balance: regulators should balance efficiency and stability tradeoffs amid rapid technological change, ensuring risks—cyberattacks, money-laundering, terrorism financing—can be managed without stifling innovation.
- Regulatory approach and priorities:
  - Complement entity-focused regulation with increased attention to activities.
  - Strengthen governance: develop rules and standards to ensure integrity of data, algorithms, and platforms.
  - Consider policy options to support open networks; central banks may need to assess costs and benefits of increasing access to settlement systems or offering digital national currencies.
  - Modernize legal principles to clarify rights and obligations within the evolving global financial landscape.
- International dimension:
  - Fintech is international due to blurring boundaries among entities, activities, and jurisdictions.
  - International cooperation and common standards will be essential; the IMF is positioned to play a significant role.

### How technology may reshape market structure of intermediaries
- Core questions:
  - Will technologies (i) reduce the need for financial intermediaries; (ii) push intermediaries to change internal structures; or (iii) induce entry of new intermediaries while displacing older ones?
- Mechanisms altering intermediaries:
  - Reduce asymmetric information, facilitate matching, reduce transaction costs, alter incentives for integration, change barriers to entry.
- Market-structure drivers summarized (Box 2):
  - Market imperfections: information asymmetries, matching asymmetries, transaction costs.
  - Forms of integration: horizontal (economies of scope) and vertical (control upstream activity).
  - Determinants of contestability: regulation, economies of scale, sunk costs, network externalities.
  - Technology effects: lower asymmetric information, reduce transaction and fixed costs, affect economies of scope, and commoditize functions such as compliance verification.

### Financial stability risks from emerging technologies
- Potential new risks:
  - Services developing outside supervisory frameworks may create risks.
  - Faster, higher-volume automated transactions could increase volatility and asset price correlations.
  - Wider adoption of common algorithms increases cyberattack vulnerability.
  - Increased concentration risk on key nodes and migration toward specialized firms may reduce data-processing and risk-management controls.

### Regulatory responses and supervisory focus
- Shift from entity-based to activity-based regulation:
  - Licensing regimes need redesign to bring new providers within the regulatory perimeter where appropriate.
  - Unbundling of services and migration to networks require greater focus on activities.
- Examples and issues:
  - AML/CFT enforcement on virtual currencies: FATF guidance calls on countries to impose CDD obligations and other AML/CFT measures on virtual currency service providers (primarily exchanges) by clarifying they are “financial institutions” under the FATF standard.
  - Oversight of algorithms: regulators may need to ensure algorithm design/operation does not expose consumers or the financial system to undue risk; verification akin to Basel model would require significant public resources and expertise.
  - Privacy vs transparency: existing legal frameworks impose obligations on intermediaries holding data; open networks lacking a “data controller” complicate application. Ledger immutability may conflict with rights to rectify or erase personal data.
  - DLT design implications: permissionless networks are generally “pseudo-anonymous”; permissioned networks may reveal varying degrees of transaction-party information. Advances (zero-knowledge protocols, selective disclosures) can mitigate privacy/supervisory tensions.
  - Legal questions from tokenisation: legal status of digital tokens and whether ledger transfer conveys legal ownership remain unclear; settlement finality in probabilistic DLTs may require legislative change or contractual remedies.

### Regulatory sandboxes and Regtech
- Sandboxes:
  - Allow firms to test technologies/business models in controlled environments; provide insights but do not replace permanent regulatory frameworks.
- Regtech opportunities and risks:
  - Technologies can automate compliance (AI), aggregate/share data (cloud, DLT), enhance security (cryptography), identify suspicious transactions (biometrics, big data), facilitate regulator-bank interactions (APIs).
  - Concentration risk: reliance on a single Regtech provider or single regulator data-aggregator could create system-wide vulnerabilities.

### Cross-border regulation and cooperation
- International cooperation essential as technologies operate across borders; current approaches show little consistency, risking regulatory arbitrage.
- International standard setters monitoring fintech include IOSCO, Basel Committee, CPMI, FSB, and FATF.

### Scale and distinct nature of cross-border payments — key statistics
- Cross-border payments accounted for 40 percent of global payments revenues, generating US$300 billion in global revenues in 2015.
- Business-to-business payments totaled US$240 billion in revenue on US$135 trillion in flows.
- Average transaction value: US$15,000 to US$20,000; typical fee: about US$30 to US$40 per transaction.
- Remittance sending costs average 7.5 percent of the amount sent (13 percent by bank wire-transfer).
- Almost one-third of remittance transactions take two or more days to be processed.
- Settlement times for cross-border payments can take up to five days for the most common currency pairings.
- Cost breakdown of an average cross-border transaction: compliance (13 percent), trapped liquidity (34 percent), foreign exchange risk management (15 percent), and claims, treasury and other operations (38 percent).
- SWIFT usage: 11,000 institutions in 200 countries, sending more than 25 million messages per day.

### Payment system types, value chain, and shortcomings
- Value-chain segments: capturing (user interface), messaging (payment instructions), settlement (domestic and cross-border), disbursing (recipient interface).
- Account-based vs token-based systems:
  - Account-based: transfer a claim on a payments object recorded in an account; require identity verification and supporting infrastructure.
  - Token-based: transfer of a payments object (e.g., cash); can function without counterparty knowledge but entail high costs and risks.
  - DLT-based transactions favor token- over account-based systems.
- Shortcomings of current cross-border services: costly, cumbersome, opaque pricing, slow; drivers include high fixed compliance costs, bilateral correspondent relationships requiring idle liquidity, manual back-office operations, and market power of correspondent banks and capturing firms.

### Possible DLT-centered evolution scenarios (in increasing order of disruption)
- (i) Back-end processes:
  - Use DLT to improve speed, transparency, end-to-end tracking, and invoice reconciliation (e.g., SWIFT global payments innovation).
  - Expected effects: efficiency gains with little market-structure impact; lower back-office fixed costs could diminish economies of scale but other entry barriers remain.
- (ii) Compliance:
  - DLT combined with digital identity, biometrics, and AI could lower AML/CFT and sanctions-control costs via KYC utilities and standardized registries.
  - Market effects: easier entry in capturing and disbursing segments; digital identities could enable switching and reduce economies of scope from proprietary data (contingent on data sharing or regulation).
  - Risks: privacy and security of personal information; security of digital identities; regulatory constraints on outsourcing customer due diligence may limit adoption.
- (iii) Means of payment:
  - Virtual currencies and token-based payments over permissionless or permissioned DLT could shorten the payments chain and reduce reliance on correspondent banks.
  - Hub-and-spoke private virtual-currency networks:
    - Users convert fiat to tokens via spokes; tokens transferred over a hub to payees; tokens exchanged back to fiat via spokes.
    - Market-structure implications: messaging and settlement by central banks or correspondent banks may be bypassed; exchanges and wallet providers compete in capture/disburse; need to build trust implies sunk costs remain.
    - Examples explored: Circle, Ripple, Visa “B2B Connect” (in partnership with Chain); commercial banks exploring issuance of virtual currencies to facilitate bank-to-bank transactions.
    - Technical caveat: fiat transfer into/out of exchange accounts still settled through central bank.
  - Attributes and caveats for end users:
    - Potential benefits: faster, more traceable, easier to use, cheaper, more secure payments.
    - Caveat 1 — Valuation and FX risk: erratic valuation of virtual currencies introduces FX risk—two conversions (acquire and sell) create volatility exposure; hedging may raise costs.
    - Caveat 2 — Trust and regulation: legal certainty, issuer stability, security of exchanges/wallets, and AML/CFT protection required.
    - Caveat 3 — Interoperability and market power: lack of interoperability could preserve high prices via network externalities; regulation may be needed to address anti-competitive concerns.
  - Central bank digital currencies (CBDCs):
    - CBDC: a widely available DLT-based representation of fiat money, exchanged at par with central bank liabilities; not interest bearing at least initially.
    - Motivations: resolve coordination problems, spur innovation, retain monetary policy effectiveness, offer a DLT-based platform potentially more secure/resilient, facilitate small value payments and inclusion.
    - Costs/risks: platform management and integrity, scalability, privacy concerns, FX risk and potential “dollarization” pressures in less liquid currencies.
    - Comparative implication: government sponsorship increases trust and stabilizes issuance/exchange rates; private networks would become more interoperable if they migrate to using a CBDC.

### Card-based payments, remittances, and correspondent banking
- Card providers distribute cards via local banks; they aggregate and net payment information but rely on correspondent banks to clear and settle cross-border transactions.
- Remittances often involve capturing agents, MTOs, disbursing agents, and domestic bank transfers settled in central bank money; the heart of the chain remains the correspondent banking relationship.
- Franchised/integrated MTO networks may not involve immediate fund flows; netting and eventual correspondent transfers are required because remittances are often one-way flows.

### Central bank digital currencies — design and distribution (Appendix III highlights)
- Why issue a CBDC:
  - Efficiency gains in payments infrastructure, potential cost savings on notes and coins, financial inclusion, countering private monopoly and coordination failures, preserving monetary policy transmission.
  - Institutional challenge: central banks must weigh roles as overseer, regulator, catalyst, or operator; private sector may lead on technology.
- Design elements:
  - Issued in same unit of account; liability of central bank and exchanged at par with other non-equity liabilities.
  - Electronic-only, no physical existence; commercial bank reserves qualify as a form of CBDC by these criteria.
  - Differentiating choices: access scope, fees, minimum/maximum balances, interest, holder identification.
- Distribution models:
  - Two-tier via commercial banks: central bank supplies digital currency to banks, which retail to end-users; central bank limits direct operational involvement.
  - Direct access for selected non-banks: central bank makes digital currency available to selected banks and non-banks with transfers on the central bank’s balance sheet.
- Technology and operational choices:
  - RTGS could be extended for CBDC transfers among holders, but scalability and suitability for many small-value transfers are unclear.
  - Key questions: privacy vs anonymity, security vs speed, cost allocation of operating/maintaining/developing CBDC.
  - Recommendation: gradual approach if CBDCs are introduced, building on experience.

### Sandboxes and Regtech (Appendices IV and V highlights)
- Sandboxes:
  - Controlled environments for pilot trials; can relax certain regulatory/licensing requirements on a case-by-case basis (some rules like AML/CFT and fit and proper cannot be waived).
  - Eligibility: genuine innovation, potential consumer/industry benefit, resources, test-ready product/service, intent to deploy.
  - Safeguards: limits on customers/duration/value, compensation/dispute mechanisms, disclosure/consent, cyber defenses, monitoring/reporting.
- Regtech solutions:
  - Data analytics and AI enable continuous risk monitoring, identify wallets linked to “bad actors,” and reduce manual analysis time.
  - APIs enable automated data exchange and reporting.
  - Cloud applications provide low-cost data storage and standardization; can host KYC repositories.
  - Identity verification (biometrics) improves sender confirmation.
  - Permissioned DLTs could give regulators direct, instant access to financial institution information, potentially replacing traditional regulatory reporting.

*International Monetary Fund — excerpt from Fintech and Financial Services (sdn1705).*

### EXECUTIVE SUMMARY ___________________________________________________________________________ 5

### EXECUTIVE SUMMARY

### Introduction
- A new wave of technological innovations, often called “fintech,” is accelerating change in the financial sector by leveraging big data, advances in artificial intelligence, computing power, cryptography, and the reach of the internet.
- The paper focuses on cross-border payments given the IMF’s mandate to promote the stability of the international monetary system, with emphasis on distributed ledger technology (DLT) as a technology with potential to offer important service improvements and cost savings.
- The paper is divided into five sections: an overview of emerging fintech technologies; a general analytical framework; overarching implications for financial regulation; an analysis of how fintech may change cross-border payments; and conclusions.

### Emerging fintech innovations
- Fintech draws on complementarities among technologies (AI, distributed computing, cryptography, mobile/internet access) and has produced new applications across payments, financing, asset management, insurance, and advice.
- Key technology descriptions and roles:
  - Artificial intelligence (AI) and big data: parsing vast databases and automating decisions (e.g., credit approvals, regulatory compliance, fraud detection, automated trading).
  - Distributed computing and distributed ledgers (DLT): enabling network-maintained ledgers that could transform payments, securities settlement, and back-office functions by cutting costs and enabling direct B2B transactions; DLT can also support non-financial databases (land registries, medical records).
  - Cryptography: enables smart contracts and supports sensing/biometric security systems.
  - Mobile access and the internet: decentralize access to financial services via mobile devices and APIs, enabling P2P transactions, crowdfunding, and greater financial inclusion for “unbanked” consumers in low income countries.
- DLT variants and limitations:
  - Permissionless DLTs: anyone can read, transact, and participate in validation (open schemes underlying Bitcoin).
  - Permissioned DLTs: validation controlled by a pre-selected group (“consortium”) or one organization (“fully-private”), acting more as a common communications platform.
  - Current technological hurdles: scalability for high transaction volumes, interoperability, privacy protection, operating costs, speed, and transparency.

- Fintech investment and market interest:
  - Total global investment in fintech companies reportedly increased from US$9 billion in 2010 to over US$25 billion in 2016.
  - Venture capital investment rose from US$0.8 billion in 2010 to US$13.6 billion in 2016.
  - Market valuations of public fintech firms have quadrupled since the global financial crisis, outperforming other sectors; public interest has grown significantly.

### The organization of financial services — a general framework
- The financial sector performs five broad functions:
  1. Make and receive payments, including across borders.
  2. Save to consume or invest later.
  3. Borrow to consume or invest now.
  4. Manage risks to income, savings, and transactions.
  5. Receive advice on the above.
- Technology affects both service attributes (speed, security, transparency, privacy, usability) and market structure (organization of service providers). Effects on attributes and market structure can be discussed separately though they interact.
- Shortcomings (unmet user needs) create incentives for firms to develop new services; the magnitude of shortcomings affects the speed of adoption. Sources of persistent shortcomings include:
  - Technology limits (e.g., bandwidth constraining speed).
  - Regulation constraints (e.g., inter-state banking laws limiting convenience).
  - Market structure (e.g., monopolists providing lower quality/higher cost services).
- Box summary (Box 1): different users prioritize different service attributes; improving attributes when shortcomings exist can induce jumps in demand.

### Key findings (from the Executive Summary)
- Boundaries are blurring among intermediaries, markets, and new service providers.
- Barriers to entry are changing: lowered in some cases, but increased in others—especially if large closed networks emerge that reduce competition.
- Trust remains essential even as reliance on traditional financial intermediaries declines and reliance on networks and new types of service providers rises.
- Technologies may improve cross-border payments by offering better and cheaper services and lowering the cost of compliance with anti-money laundering and combating the financing of terrorism (AML/CFT) regulation.
- The financial services sector is poised for change, but it is uncertain whether the change will be evolutionary or revolutionary; policy responses should be nimble, experimental, and cooperative.

### Policy implications and recommendations
- Regulators should balance efficiency and stability tradeoffs amid rapid technological change, ensuring risks to stability and integrity—including cyberattacks, money-laundering, and terrorism financing—can be effectively managed without stifling innovation.
- Specific regulatory approaches and priorities:
  - Complement entity-focused regulation with increased attention to activities, reflecting that financial services will be provided by a diverse group of firms and market platforms.
  - Strengthen governance: develop rules and standards to ensure the integrity of data, algorithms, and platforms.
  - Consider policy options to support open networks; central banks may need to assess costs and benefits of increasing access to their settlement systems or offering digital national currencies.
  - Modernize legal principles: develop new legal rules to clarify rights and obligations within the evolving global financial landscape.
- International dimension:
  - Fintech is an international issue due to blurring boundaries among entities, activities, and jurisdictions.
  - Policymakers need to consider implications for common standards and legal principles, aligned with national priorities.
  - International cooperation will be essential; the IMF is positioned to play a significant role.

### Conclusion
- Fintech offers substantial opportunities to improve financial services, including cross-border payments, yet poses challenges to competition, trust, monetary policy transmission, and financial stability.
- Policymaking must be adaptive, cooperative, and focused on maintaining trust, integrity, and stability while enabling beneficial innovation.

*International Monetary Fund — FINTECH AND FINANCIAL SERVICES, Executive Summary*

### 17.      Technology can also affect the market structure of service providers. Will new

### sdn1705 - 17.      Technology can also affect the market structure of service providers. Will new

### How technology may reshape market structure of intermediaries
- Core questions raised:
  - Will new technologies merely increase profits and efficiency of established players, or have deeper repercussions?
  - Specifically, will they (i) reduce the need for financial intermediaries (specialized financial firms, banks and non-banks alike, that facilitate transactions between two or more parties); (ii) push intermediaries to change their internal structures (possibly leading to partnerships and acquisitions); or (iii) induce the entry of new intermediaries while displacing older ones?
- Mechanisms through which technology can affect intermediaries:
  - Reduce asymmetric information (limited knowledge of one’s counterparties to a transaction).
  - Facilitate matching of parties to a transaction.
  - Reduce transaction costs.
  - Alter incentives for horizontal or vertical integration (offer multiple services to end-users or acquire upstream suppliers).
  - Change barriers to entry for new intermediaries to compete against incumbents.

### Box 2 — Technology and Market Structure (summary of drivers)
- Market imperfections that justify intermediaries:
  - Information asymmetries: intermediaries provide information on counterparties, monitoring, enforcement, and share costs over many users; trust is essential.
  - Matching asymmetries: pooling of savings addresses indivisible investment opportunities and enables liquidity and shorter-term investments for savers.
  - Transaction costs: complexity and specialized operational, technological, and legal knowledge.
- Forms of integration:
  - Horizontal integration: economies of scope—leverage fixed resources or intangible assets (e.g., user payment-pattern information) to provide multiple services.
  - Vertical integration: strategic control of upstream activity rather than monitoring it.
- Determinants of contestability (barriers to entry):
  - External constraints such as regulation.
  - Economic barriers from:
    - Economies of scale: average costs decline with output; fixed costs of producing, distributing services, and complying with regulation.
    - Sunk costs: marketing expenses to build brand value and trust.
    - Network externalities: value of exclusive networks increases with users, especially in payment systems.
- How technology can alter these determinants:
  - Undermine need for intermediaries by lowering asymmetric information (automated credit scoring), transaction costs (online payments), or improving matching (peer-to-peer lending, crowd-sourcing).
  - Lower fixed costs of operation (back-office automation) and reduce network externalities (inter-network operability).
  - Affect economies of scope (social media platforms cross-selling financial services) and incentives to control upstream production (commoditizing functions such as compliance verification).

### Technology, regulation, and financial stability — objectives and evolving needs
- Why regulate the financial sector:
  - Address vulnerabilities and imperfections that weaken financial stability, undermine market efficiency, and expose consumers to risks.
  - Regulation should: (i) provide incentives to account for systemic risk; (ii) protect consumers where information is hard or costly to obtain; and (iii) support competition and prevent oligopolistic behavior.
  - Regulation should be proportional to entities’ and activities’ contribution to systemic risk and maintain flexible boundaries to monitor and adjust regulatory arbitrage between the unregulated and regulated perimeter.
- Regulation’s role in supporting trust (Box 3 summary):
  - Trust defined as “a meaningful expectation as to the future conduct of a person, an organization or as to the functionality of a system” (de Larosière 2009).
  - Legal certainty, predictable legal frameworks (public and private law), private information (long-term relationships), and public track records (well-functioning infrastructure) help establish trust.
  - Regulation signals resilience by ensuring sound financial position, accurate representation, prudential standards, and governance meeting regulatory requirements.

### Financial stability risks from emerging technologies
- Potential new risks:
  - Development of financial services outside supervisory and regulatory framework may lead to new risks.
  - Acceleration in speed and volume of transactions could either promote efficient price discovery or increase volatility and instability.
  - Greater reliance on automated transactions could increase market volatility via higher asset price correlations.
  - Wider adoption of common algorithms and technological solutions could increase cyberattack vulnerability.
  - Increased concentration risk on key nodes as market structures adjust and network interconnections strengthen.
  - Migration toward specialized firms along the payments chain may reduce controls for data processing and risk management.

### Regulatory responses and supervisory focus
- Shift from entity-based to activity-based regulation:
  - Licensing regimes will need redesign to bring new service providers within the regulatory perimeter where appropriate.
  - The “unbundling” and migration of services from intermediaries to networks may require reliance less on entity-based regulation and more on activity-based regulation.
- Examples of evolving regulation:
  - AML/CFT enforcement on virtual currencies: FATF guidance calls on countries to impose CDD obligations and other AML/CFT preventive measures on new types of virtual currency service providers—primarily virtual currency exchanges—by clarifying they are “financial institutions” under the FATF standard.
  - Note: focus on exchanges may need revisiting if virtual currencies become so widely used that conversion to fiat is no longer necessary.
- Oversight of algorithms:
  - Regulators may need to ensure algorithms are designed and operate without exposing consumers or the financial system to undue risk.
  - Self-governance and network-enforced standards can help where governance is transparent, but inherent limitations exist and oversight/regulation may be necessary.
  - Effective verification of underlying technologies (e.g., analogous to the Basel approach for banks’ internal risk models) would require significant public resources and expertise; feasibility is unclear.
  - Lessons may be drawn from algorithmic trading regulation (e.g., MiFID II; U.S. NASD and Financial Industry Regulatory Authority, Inc. rules).
- Privacy versus transparency in distributed information technologies:
  - Users need privacy protection; regulators need transparency for supervision and to reduce transaction costs.
  - Existing legal frameworks impose obligations on intermediaries holding data; these approaches are difficult when data is held within an open network lacking a “data controller.”
  - Ledger immutability in some DLTs may conflict with rights to rectify or erase personal data.
- DLT design implications:
  - Permissionless networks: generally “pseudo-anonymous”—identity not revealed but transaction details are known.
  - Permissioned networks: transaction-party information and transaction details may or may not be revealed to participants.
  - Advances (e.g., zero-knowledge protocols) can allow identity verification and transaction processing without revealing information; other technologies enable “selective disclosures” by users to trusted parties (such as supervisors).
- Legal and contractual questions from tokenisation and settlement:
  - Legal status of digital tokens (intrinsic tokens like Bitcoin or asset-based tokens representing interests in other assets) and legal effect of their transfer are unclear.
  - Question example: does transfer of an asset-backed token on a ledger transfer legal ownership of the security, or is registration outside the ledger still required?
  - DLT in payment systems raises settlement finality issues: existing legislative rules that prohibit reversal of payments may not fit distributed networks based on probabilistic finality; problems may require legislative change or, as second best, contractual and general legal principles.
  - Example: in Bitcoin blockchain, a new block is added approximately every 10 minutes; probabilistic finality builds progressively as more blocks are added.

### Regulatory sandboxes and Regtech
- Regulatory sandboxes:
  - Sandboxes allow firms to test new technologies and business models in a controlled environment and enable regulators to address potential risks without stifling innovation.
  - Sandboxes provide valuable insights to policymakers but are not a substitute for effective, permanent regulatory frameworks.
- Regtech opportunities and risks:
  - Emerging technologies could facilitate regulatory compliance by automating manual processes (artificial intelligence), aggregating/sharing/storing data (cloud-computing, DLT), enhancing security (cryptography), identifying suspicious transactions (biometrics, big data), and facilitating regulator-bank interactions (APIs).
  - Excessive or indiscriminate reliance on Regtech could create new problems and potential system-wide disruptions:
    - If multiple financial institutions rely on a single firm providing solutions or on a single regulator to aggregate data, that entity could be vulnerable to cyberattack or malfunction.
  - Further analysis and assessment may be needed before widespread Regtech adoption for compliance.

*International Monetary Fund — excerpt from Fintech and Financial Services (sdn1705).*

### 32.      As new technologies operate seamlessly across borders, international cooperation is

### As new technologies operate seamlessly across borders, international cooperation is

### Cross-border regulation and cooperation
- International cooperation is essential as new technologies operate seamlessly across borders; current regulatory approaches show little consistency across jurisdictions, risking regulatory arbitrage.
- Bilateral and multilateral efforts underway:
  - Bilateral cooperative arrangements exist to promote innovation and share information about innovative financial services.
  - International standard setters monitoring and studying implications of technological change include:
    - International Organization of Securities Commissions (IOSCO)
    - Basel Committee on Banking Supervision
    - Committee on Payments and Market Infrastructures (CPMI)
    - Financial Stability Board (FSB)
    - Financial Action Task Force (FATF) has issued guidance.

### The scale and distinct nature of cross-border payments
- Key statistics and characteristics:
  - Cross-border payments accounted for 40 percent of global payments revenues, generating US$300 billion in global revenues in 2015.
  - Business-to-business payments totaled US$240 billion in revenue on US$135 trillion in flows.
  - Average transaction value was of US$15,000 to US$20,000, and the typical fee about US$30 to US$40 per transaction.
  - Remittance sending costs average 7.5 percent of the amount sent (13 percent by bank wire-transfer).
  - Almost one-third of remittance transactions take two or more days to be processed.
  - Settlement times for cross-border payments can take up to five days for the most common currency pairings.
  - Costs of an average cross-border transaction can be broken down into: compliance (13 percent), trapped liquidity (34 percent), foreign exchange risk management (15 percent), and claims, treasury and other operations (38 percent).
  - SWIFT is used by 11,000 institutions in 200 countries, sending more than 25 million messages per day.
- Cross-border payments are inherently different from domestic payments:
  - Domestic payments typically settled by domestic banks and the central bank.
  - Cross-border payments require ad-hoc arrangements, often between commercial (correspondent) banks.

### Demand, supply, and payment system types
- Users and their needs:
  - Users include households, SMEs, and large corporates seeking remittances, payments while abroad, and payment for foreign goods and services.
  - Transactions range from infrequent, small-value (households) to frequent, large-value (corporates).
  - Key user attributes: low-cost, security, convenience, predictability, and transparency (including confidentiality of information).
- Payments chain segments and functions:
  - Capturing: interfacing directly with users (banks, MTOs, telecoms, digital companies).
  - Messaging: handling payment instructions, often independent of actual transactions.
  - Settlement: domestic settlement (transfer within jurisdiction, reserves at central bank) and cross-border settlement (commonly by correspondent banks holding accounts with one another).
  - Disbursing: interfacing with recipients.
- Account-based vs token-based systems:
  - Account-based systems transfer a claim on a payments object recorded in an account (require identity verification, regulation, standards, infrastructure).
  - Token-based systems involve transfer of a payments object (e.g., cash); can function without knowledge of counterparties but typically entail high transaction costs and risks related to moving cash.
  - DLT-based transactions favor token- as opposed to account-based systems.

### Shortcomings and market structure drivers
- Shortcomings of current cross-border payment services:
  - Costly, cumbersome, opaque pricing, and slow.
  - Payments routed through many banks, causing delays and fees.
- Drivers of shortcomings:
  - High fixed costs of compliance.
  - Bilateral relationships requiring banks to hold idle liquidity and incur FX exposures.
  - Manual and personalized back-office operations for claims and disputes.
  - Market power of correspondent banks and capturing firms allowing extraction of revenue via direct fees, FX spreads, and float.
- Market concentration and entry barriers:
  - Intermediaries are required due to technology and information asymmetries; they verify identities and fund availability.
  - High barriers to entry arise from fixed and sunk costs to interface with users, comply with regulation, build trust, and operate large back-offices.
  - Network externalities in messaging and settlement increase concentration.
  - Horizontal integration is systematic among correspondent banks; vertical integration exists where capturing agents undertake compliance verification.
- Boxed market-structure specifics:
  - Capturing segment: concentration from fixed and sunk costs; MTOs dominate retail space.
  - Messaging segment: concentration from network effects; SWIFT central.
  - Domestic settlement: central banks play key role; high sunk and fixed costs; offer minimal credit risk, payment finality, liquidity provision.
  - Cross-border settlement: highly concentrated among few large correspondent banks due to size, compliance/back-office fixed costs, and network externalities.

### Possible evolution under fintech (DLT-centered scenarios)
- Three scenarios of DLT-based application adoption (in increasing order of potential disruption):
  - (i) Back-end processes
  - (ii) Compliance
  - (iii) Means of payment
- Back-end processes (DLT applied to processes):
  - Initiatives (e.g., SWIFT global payments innovation) aim to use DLT to improve speed, transparency, end-to-end tracking, and invoice reconciliation.
  - Correspondent banks could use shared permissioned DLT platforms to automate tracking and optimize liquidity and risk management.
  - Regulatory implication: regulators will need to be satisfied that technologies are sufficiently robust so as not to increase operational risk.
  - Expected effects:
    - Efficiency gains most evident, with little impact on market structure.
    - Lower fixed back-office costs could diminish economies of scale and spur new entry, but many other entry barriers would remain.
    - End-users may benefit from greater transparency and reduced invoice reconciliation costs; impact on speed and end-user costs is unclear if correspondent banks remain oligopolistic and do not pass on savings.
- Compliance (DLT combined with other technologies):
  - Potential to significantly lower compliance costs via KYC utilities and digital identity, facilitating information sharing and reducing AML/CFT and sanctions-control costs.
  - DLT could create and maintain registries of standardized customer information and digital identities; complemented by biometrics and artificial intelligence.
  - Regulatory limits: extent to which regulation allows outsourcing of customer due diligence may constrain adoption.
  - Market effects:
    - New DLT-based compliance entrants might collaborate with incumbents in capturing, disbursing, and settlement segments.
    - Entry easier in capturing and disbursing segments; digital identities could allow end-users to switch providers more easily, reducing economies of scope from proprietary customer data—contingent on incumbents’ willingness to share or regulatory requirements to do so.
    - Cross-border settlement through correspondent banks would keep size as a barrier to entry.
  - End-user effects and risks:
    - Services likely cheaper and more inclusive.
    - Privacy and security concerns over personal information on the ledger unless participation is limited to trusted counterparties or restrictive disclosure and data-limiting technologies are used.
    - Security of digital identities is a key issue (e.g., risk if a digital identity is stolen and misused).
    - Authorities must ensure regulatory compliance is not hampered by reliance on third parties.
- Means of payment (DLT underpinning new payment types):
  - Emergence of virtual currencies: tokens exchanged electronically over permissionless (open) or permissioned DLT-based networks, shifting payments from account-based to token-based systems.
  - Example note: Bitcoin is a well-known virtual currency; many others exist, each with specific underlying technologies.

*International Monetary Fund (excerpt from SDN1705).*

### 56.      Two applications of DLT as a means of payment are relevant for cross-border

### Two applications of DLT as a means of payment (excerpt)

### Hub-and-spoke private virtual-currency networks
- Structure and flow:
  - Users exchange fiat money into a virtual currency (DLT-based tokens) held in digital wallets through ATM machines, point of sales terminals, online interfaces, or other means (the spokes).
  - Tokens are transferred, possibly across borders, over the virtual currency’s secure network (the hub) to the payee’s digital wallet (Figure 6).
  - Tokens are exchanged into foreign fiat money, as desired, through the same means as above (spokes again).
- Market structure implications:
  - Pressure to shorten the traditional payments chain; messaging and settlement either in central bank money or through correspondent banks would no longer be needed.
  - Virtual currency exchanges and wallet providers would compete for customers in capturing and distributing segments, potentially taking significant business from other players.
  - Specialized firms such as MTOs could feel the greatest pressure; banks might retain customers via saving, borrowing, risk management, and advice services.
  - The need to build trust—and thus sunk costs—would remain.
- Examples being explored:
  - Circle, Ripple, and Visa through their “B2B Connect,” in partnership with Chain.
  - Commercial banks exploring issuance of virtual currencies to facilitate transactions between banks, possibly in different jurisdictions.
- Technical caveat:
  - The transfer of fiat currency from a user’s account to the virtual currency exchange’s account, upon purchase of the token, would still be settled through the central bank.

### Attributes for end users and three caveats
- Potential user benefits:
  - Cross-border payments could become significantly faster, more traceable, easier to use, cheaper, and more secure.
- Caveat 1 — Valuation and FX risk:
  - Potentially erratic valuation of virtual currencies introduces risks and could limit adoption for large value payments.
  - Two “foreign exchange rate” conversions are needed: when the token is acquired, and when it is sold; volatility undermines hub-and-spoke networks even if tokens are held for very short periods.
  - FX risk could potentially be hedged, although costs could then rival those of correspondent bank transfers.
  - He and others (2016) argue virtual currencies are not likely to be adequate stores of value given volatility in exchange rates to fiat money.
- Caveat 2 — Trust and regulation:
  - Trust is needed in: legal certainty regarding transfer of ownership of the virtual currency; the stability and security of the underlying technology and issuance rule (or backing); and the security of virtual currency exchanges and wallet providers (data security and wallet access).
  - Regulators may need to consider regulatory approaches to virtual currency exchanges and wallet providers that sufficiently protect consumers and address AML/CFT concerns.
- Caveat 3 — Interoperability and market power:
  - Lack of interoperability among networks could keep prices of hub-and-spoke payments high due to strong network externalities and potential market power of providers.
  - Regulation aimed at addressing anti-competitive concerns could help alleviate this outcome.

### Central bank digital currencies (CBDCs)
- Concept and defining features:
  - A CBDC would be a widely available DLT-based representation of fiat money, not a parallel currency; it would introduce a new means of payment and store of value but not a new unit of account.
  - The CBDC would presumably be exchanged at par with the central bank’s other liabilities (cash and reserves), through banks or directly at the central bank.
  - The CBDC would not be interest bearing, at least as a starting point.
- Potential motivations for central banks:
  - Resolve coordination problems over new virtual currencies and spur technological innovation.
  - Retain control of monetary policy effectiveness if privately-issued virtual currencies gained significant ground (though this is unlikely per He and others 2016).
  - Offer a DLT-based platform potentially more secure and resilient than current settlement systems exposed to single point of failure risk.
  - Facilitate small value payments and boost adoption and efficiency of the decentralized service economy.
- Costs and risks:
  - Managing the platform and its integrity, resolving scalability, and dealing with issues of privacy.
  - FX risk with other currencies would remain, as foreign payees would seek to transfer the CBDC into their local currency; in less liquid currency countries this could induce a certain degree of “dollarization”—namely the adoption of the payer’s more liquid currency as a common unit of account.
- Comparative implications vs. private hub-and-spoke networks:
  - Many implications for services and market structure are similar, but government sponsorship should increase trust in the technology and issuance rule and help stabilize issuance and exchange rates.
  - Privately-sponsored networks for payment services would become more interoperable, and thus more competitive, as they migrate to using the CBDC.

### Other sources of change and competitive entrants
- New players could emerge from social media companies, online retailers, and popular tech companies, leveraging trust, ease of use, and user-tailored services rather than purely technological advantage.
- Fintech firms attenuate market imperfections and transform cost structures by providing products that respond to user needs for trust, speed, low cost, security, usability, and transparency.

### Policy and regulatory implications
- Regulators and central banks face both challenges and opportunities:
  - Fintech could substantially change the stability versus efficiency trade-offs regulators manage.
  - Regulators will increasingly need to look to specifics of the technology itself and manage trust and privacy challenges.
  - Fintech may offer solutions for regulatory challenges including know your customer and AML/CFT issues.
  - International cooperation will be essential to develop effective regulatory frameworks for fintech.

*Source: IMF staff.*

### Appendix I. A Framework of Analysis

### sdn1705 - Appendix I. A Framework of Analysis

### Framework overview: demand, supply, and service shortcomings
- Goal: provide details of how to apply the framework to gauge the impact of new technologies on service attributes and market structure.
- Focus: service attributes — describing demand and supply and identifying shortcomings of services (Figure I.1).

- Step 1: restrict analysis to one basic function of finance. From end-user standpoint these are:
  - (i) make and receive payments
  - (ii) borrow
  - (iii) save
  - (iv) manage risks
  - (v) receive financial advice

- Step 2: categorize end-users and highlight attributes most valued by each group.
  - Most valued attributes capture users’ preferences or main purchasing criteria (examples in financial services): speed, security, transparency, ease of use, trust.
  - Attributes can change over time as habits and expectations evolve.
  - Usage goals: description of users’ ultimate intent (example for cross-border payments: sending/receiving remittances, paying for foreign goods and services).
  - Buying patterns: research behavior, frequency and ease of switching providers.

- Common user groups (illustrative): households, small and medium businesses, large corporates, financial firms (other typologies possible).

- Step 3: describe supply of services through three intermediate steps:
  - Decompose supply into a value chain (sequential functional steps satisfying usage goals); generic chain composed of “steps 1, 2 and 3.” (Appendix II illustrates the value chain for cross-border payments.)
  - List service providers active in each value-chain segment and group into markets. A market: set of firms catering to the same user groups. Markets can span value-chain segments via vertical integration; a single firm can span multiple markets if it serves multiple user groups.
  - Evaluate the attributes of available services in each market (are services fast, secure, easy to use, transparent, trustworthy?).

- Identifying shortcomings:
  - Shortcomings are derived by assessing user satisfaction with the attributes they most value.
  - If different attributes (or combinations) would cause users to pay significantly more or consume significantly more at unchanged prices, the existing service exhibits shortcomings (approach in spirit of Fung and Halaburda (2016); Berger, Hancock, and Marquardt (1996)).

### Market structure and vertical integration
- Purpose: provide additional detail on determinants of vertical integration / firm boundary.
- Vertical integration: strategic decision to act in more than one value-chain segment (references: Lafontaine and Slade, JEL 2007; Whinston 2003; Gibbons 2005).
- Theoretical motivations:
  - Coase (1937) and Williamson (1971, 1975, 1979, 1985): integration responds to potential hold-up problems from relationship-specific investments.
  - Grossman and Hart (1986); Antras (2003): integration ensures sufficient investment in relationship-specific innovation.
  - Lafontaine and Slade (2001) following Holmstrom and Roberts (1998): moral hazard/agency-monitoring reasons for integration.
  - Cost savings: core capabilities may serve multiple value-chain segments, inducing integration.

*Italic source attribution: IMF staff (sdn1705 - Appendix I. A Framework of Analysis and Appendix II. Cross-Border Payments and Correspondent Banking).*

### 15.      Payments using credit or debit cards. Card providers distribute cards to end-users through

### 15. Payments using credit or debit cards. Card providers distribute cards to end-users through local banks.

### Card-based payments and correspondent banking
- Card providers distribute cards to end-users through local banks.
- Card providers aggregate and net out payment information, but continue to rely on correspondent banks to clear and settle cross-border transactions.

### Remittances: multiple players and netting
- Remittance flows often involve additional links but retain the core correspondent banking relationship:
  - Individual A may deposit money with a “capturing agent,” which then operates through a money transfer operator (MTO) with links to the domestic banking system.
  - Individual B may receive funds from a local “disbursing agent” affiliated with a local MTO, possibly different from that in the euro area.
  - These arrangements add transfers between domestic banks, settled in central bank money, on either end of the chain.
  - The heart of the chain remains characterized by a correspondent banking relationship.

### Remittances via franchised or integrated MTO networks
- Remittances can be intermediated by a single MTO or by specialized agents operating proprietary communications networks.
- In many such cases, remittances will not involve an actual flow of funds immediately:
  - As individual A deposits money in the euro area branch of an MTO, a message is sent to the Philippine branch to disburse funds to individual B.
  - This mechanism can continue only while the Philippine branch has peso liquidity.
  - Because remittances tend to involve one-way flows, eventually the euro area branch must transfer funds to the Philippine branch, involving a correspondent banking relationship.

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### Appendix III. Central Bank Digital Currencies: Why and How?

### Purpose and scope of the appendix
- Considers two questions:
  - Why would a central bank want to issue a digital currency?
  - What form could such a currency take and how would it be distributed?
- Implications for monetary policy setting/transmission and for financial stability are left for future discussions.

### Why issue a CBDC? (efficiency and policy rationales)
- Efficiency considerations:
  - Introducing a CBDC may allow the central bank to perform its role in insuring an effective payments infrastructure, including issuance of currency and provision of a lender of last resort function, more efficiently.
  - Central bank must show introducing a CBDC provides greater efficiency gains than regulating the payments industry and/or entering into public-private partnerships.
  - Examples exist of improved payments efficiency without CBDCs (e.g., Africa; Denmark close to a cashless society without a CBDC).
- Cost and inclusion considerations:
  - Gradually replacing notes and coins with a central bank electronic currency entails savings on costs of maintaining and replacing notes and coins for the state.
  - May significantly reduce transaction costs for individuals and small enterprises with limited or costly access to banking services; may facilitate financial inclusion.
- Countering private monopoly and coordination failures:
  - CBDCs could counter monopoly power from network externalities of private virtual currencies or operators.
  - Could address inability to ensure full stability and safety of privately coded currencies and overcome coordination failure in agreeing on technological standards.
- Monetary policy considerations:
  - Proliferation of private virtual currencies might erode demand for central bank money and the transmission mechanism of monetary policy; a CBDC may forestall or relegate private virtual currencies to secondary roles.
  - Current threats are not imminent given existing private virtual currencies’ transaction domain and limitations.
- Institutional challenge:
  - Central banks must weigh roles as overseer, regulator, catalyst, or operator of new technologies, recognizing they will often lag private sector technological know-how.

### What kind of CBDC? (design elements)
- Impact depends on:
  - (i) CBDC’s basic design;
  - (ii) its other characteristics;
  - (iii) how it is distributed;
  - (iv) the technology used.
- Basic design requirements:
  - Issued in same unit of account as fiat money.
  - Liability of the central bank and exchanged at par with its other non-equity liabilities—mainly cash and commercial bank reserves.
  - Other components of base money would continue to be issued, at least initially, to ensure a smooth transition.
  - CBDC would be exchanged electronically and have no physical existence (entry in one or several ledgers).
  - By these criteria, commercial bank reserves are a form of CBDC.
- Differentiating characteristics:
  - Access need not be confined to commercial banks.
  - Fees on CBDC transfers may differ by transaction category and holder.
  - There might be minimum or maximum balances or transfer sizes.
  - Interest may or may not be paid on the CBDC.
  - Identifying holders of CBDC could be challenging.
  - Design features may be complements or substitutes (e.g., paying interest affects substitution between CBDC, cash, and bank deposits).

### Distribution models (two simplified models)
- First model (two-tier via commercial banks):
  - Central bank exchanges its non-equity liabilities at par against digital currency to commercial banks.
  - Digital currency is “retailed” through these banks to other banks and non-banks (individuals, corporations, wallet providers, payment system operators).
  - Advantages: avoids central bank dealing with end-user usability and platform compatibility.
  - Central bank retains role to monitor and regulate the market, service providers, and technology; encourage innovation and competition among wallet providers.
  - Central bank is part operator and part catalyst; limits involvement to standards, functionality, and distribution to banks.
- Second model (direct access for selected non-banks):
  - Central bank makes digital currency available to reserve banks and select other banks and non-banks.
  - Transfers of CBDC among authorized holders, including non-banks, take place directly on the central bank’s balance sheet.
  - Proportion of CBDC on the central bank’s balance sheet depends on preferences of banks and non-banks.
  - Involves central bank more closely in operating the system; may raise privacy concerns, especially if transactions validated by multiple participants (noting development of “zero-knowledge verification” systems).

### Technology choices and operational considerations
- Possible to extend RTGS technology to transfers of CBDC among holders.
  - Existing settlement systems are exposed to single point of failure risk; a CBDC could be more secure if ledger exists in multiple copies.
  - RTGS is designed for large-value transactions among a well-defined set of permissioned banks; it could be used in the first distribution model.
  - Unclear whether RTGS could/should be extended to a much larger set of holders and for relatively small amounts.
- Technological and organizational choices raise questions:
  - Can the chosen technology guarantee privacy if not anonymity?
  - Can it be made secure while maintaining speed?
  - Who bears the costs of operating, maintaining, and developing the digital currency—the central bank or private sector participants?
- Recommendation on approach:
  - Many questions are deeply political and complex; warrants a gradual approach to introducing CBDCs, if at all, building on experience and evolving fintech technologies.

---

### Appendix IV. The Sandbox Approach: Selected Jurisdictions

### Purpose and common features
- Sandboxes provide a controlled environment for firms to conduct pilot trials of innovative financial services and products before larger-scale launch.
- Aim to strike balance between promoting innovation and preserving financial stability and consumer protection by lowering barriers to testing while ensuring safeguards.
- Some sandboxes provide greater clarity on regulatory expectations where products/services do not fit existing frameworks.

### Regulatory flexibilities and safeguards
- Regulations: Certain regulatory or licensing requirements can be relaxed, adapted, or waived on a case-by-case basis—often limited to the regulatory agency’s purview.
  - Some regulations cannot be waived (e.g., AML/CFT, fit and proper requirements, tax legislation).
- Eligibility criteria:
  - Product/service must involve genuine innovation (new or emerging technologies or novel use of existing tech).
  - Must have potential to address a problem or bring benefits to consumers or industry.
  - Other criteria: necessary resources, thorough business plan, test-ready product/service, intent to deploy in jurisdiction.
- Safeguards in sample sandboxes:
  - Restrictions on scope of live tests: limits on number/type of customers, duration, total value, and specific products/services.
  - Additional customer protection measures: compensation arrangements, dispute resolution and redress mechanisms, disclosure and consent requirements.
  - Risk management controls: defenses against cyberattacks and system disruptions.
  - Monitoring and reporting requirements.

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### Appendix V. Examples of Regtech Solutions to Facilitate Regulatory Compliance

### Data analytics and AI for compliance
- Data analytics tools enable continuous risk monitoring and analysis to enhance compliance:
  - Can identify virtual currency wallets associated with “bad actors” via technical information or transaction patterns, enabling authorities to identify transactions involving illicit activities.
  - Reduce time, labor, and human error involved in analyzing large datasets.
- Cognitive computing and artificial intelligence:
  - Machine learning enables self-improving methods for data analysis, modeling, and forecasting (e.g., stress testing).
  - AI can treat regulatory content as data, permitting programmatic management; may eventually track and interpret regulatory changes.

### Interoperability, cloud, and identity technologies
- APIs:
  - Allow software programs to connect; could be used for automated exchange and reporting of data, including information exchange with regulators.
- Cloud applications:
  - Provide relatively low-cost, flexible solutions for data storage, standardization, and sharing.
  - Central data repositories on the cloud could serve subsidiaries within an institution or allow access across the industry (e.g., KYC repository).
- Identity verification (including biometrics):
  - Effective and secure methods to confirm sender identity (e.g., facial recognition comparing national ID photo to user’s face).
  - Identity confirmation can use pattern analysis against proprietary transaction records and publicly-available digital ledger transaction records.

### Distributed ledger technologies for regulatory access
- Blockchain and other distributed ledgers:
  - Could give regulators direct, instant access to information of financial institutions.
  - Could replace regulatory reporting by having regulators participate in the ledger, using appropriately secured permissioned-based systems.

*Source: sdn1705 - 15.      Payments using credit or debit cards. Card providers distribute cards to end-users through*

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_Source: https://www.imf.org/-/media/files/publications/sdn/2017/sdn1705.pdf_