ECB and BoJ point to major problem in DLT-based payments

The European Central Bank (ECB) and the Bank of Japan (BoJ) have concluded that a confidential distributed-ledger payments network cannot be audited effectively without increasing the network’s operational risk.

“The existence of trustworthy central sources of information in auditing processes would be beneficial for effective auditing,” the central banks said in a research paper.  

A central source would ensure both confidentiality and auditability, but it could also establish a single point of failure for the network, the paper said.

The paper provided an update on Project Stella, the two central banks’ joint project on distributed ledger technology (DLT).

The ECB and BoJ began exploring DLT in 2016. In Project Stella’s first phase, they examined how the technology would handle large-value payments, while the second stage investigated securities payment delivery. The last phase considered how the technology could be used for cross-border payments.

But one of the biggest concerns for central banks globally has been the level of privacy that a DLT network offers participants, given transaction data is visible throughout the network. For the fourth stage of Project Stella, the ECB and BoJ have analysed whether a balance can be found between confidentiality and auditability.

Privacy-enhancing technologies and techniques (PETs) have been developed to limit access to information on DLT networks, particularly for third parties. But this has introduced new challenges around auditing.

To ensure accountability, the level of auditability aimed for in payment and settlement systems, based on distributed ledger technologies, should be similar to that in centralised systems

ECB/BoJ research paper

“To ensure accountability, the level of auditability aimed for in payment and settlement systems, based on distributed ledger technologies, should be similar to that in centralised systems,” the report says. This is applicable regardless of the type of settlement asset.

In a centralised model, the central operator of the network discloses non-confidential transaction information at the request of the auditor.   

The ECB and the BoJ believe a similar level of auditability could be achieved in a DLT model, but only when PETs are not present.

“The auditor would run a DLT node in the network for this purpose, although there may be cases where the auditor accesses the ledger via participants in the network,” the report says.

Privacy tools in use

To discern whether a DLT network with PETs can be audited effectively, the central banks analyse the different types of privacy tools and divide them into three categories.

Those which are classed as “segregating” ensure a participant can only see a subset of transactions. PETs classed as “hiding” introduce cryptographic or encryption technology to inhibit third parties from interpreting the transaction data, while “unlinking” PETs make it difficult for third parties to determine transaction relationships.

“When PETs are used, the auditor cannot view or interpret the transaction information,” the paper says. Additional information for auditing would therefore be needed to be obtained via alternative data sources.

The ECB and BoJ suggest a single trusted source, either an existing DLT component or a credible third party, could provide the necessary information to the auditor. But the introduction of such a model would also increase risks to the network.

“While reliance on … [a single] source of information has obvious benefits for auditing from all three perspectives, it may become a single point of failure in the auditing arrangement,” the authors say.

If there was a single entity storing all transaction information, the central banks conclude, a potential security breach could result in a leak of the transactional details of all participants.

“In cases where the single entity is an essential DLT component, its failure may compromise the functioning of the entire DLT network,” the paper says.

This article first appeared on sister website Central Banking.