Blockchain is the technological darling of the financial press. Once a niche technology, blockchain has captured the interest and research spend of legislators, regulators, investment banks, financial markets and venture capital funds. There are plenty of “explainers” which describe what blockchain is. The time has now come to move from “what” and “why” to consider the regulation of “how”.
Blockchain relies on the principle that people can share and verify communal knowledge stored in a digital ledger. There is a slightly broader term of distributed ledger technology (DLT) which refers to a system of databases where all nodes in a system connect to cryptographic infrastructure which ensures consensus between them. Although marginally different, the terms are often used interchangeably. However, the crucial piece is that there is a verified record is held in many places at once, digitally and in encrypted form.
As DLT is a new means of managing transaction recording, storage and data sharing, it can be applied to a wide variety of services and activities, such as peer-to-peer lending, proxy voting, medical data, property records and ownership of securities. One of DLT’s most interesting potential uses is increasing financial industry efficiency, especially in post-trade processing, auditing and regulatory reporting.
As we get closer to using DLT for financial market infrastructure, regulatory scrutiny will intensify. How should DLT be regulated? How will regulators address the cross-border issues which will inevitably arise? Are there deeper legal and public policy issues to consider?
Following the lead of industry interest, many regulators have established blockchain taskforces or discussion groups and made public statements on the use of DLT in financial markets. This includes the International Organisation of Securities Commissions (IOSCO), the Financial Stability Board, the US Federal Reserve, the International Monetary Fund, European Securities and Markets Authority, the Japan Financial Services Agency, the UK’s Financial Conduct Authority and the Australian Securities and Investments Commission.
Statements by these regulators and others have generally been engaged and optimistic, though in the words of one, focused on “responsible innovation”. Consideration of international cooperation on DLT is also a theme, with the Bank for International Settlements Committee on Payments and Market Infrastructures noting in its Digital Currencies Report that “a coordinated approach at a global level may be important for regulation to be fully effective”.
So far, regulators have been focused on two aspects of DLT in particular: which approach they should take to regulate the development and use of DLT and what benefits regulators themselves may accrue from DLT.
On the approach, regulators around the world are focused on a balance between fostering innovation and ensuring market stability. While learning quickly about the benefits of and challenges to DLT, regulators are considering the way forward for start-ups and incumbent financial institutions alike.
In the words of Australian Securities and Investments Commission Chairman, Greg Medcraft, “[a]s regulators and policymakers we need to ensure what we do is about harnessing the opportunities and broader economic benefits, not standing in the way of innovation and development”.
This approach was echoed by CFTC Commissioner Giancarlo, who has proposed the view that DLT should be regulated with the same approach as was taken with the development of the internet, noting that “do no harm” was the right approach then as it is now.
A key incentive for regulators to take this approach is the transparency which DLT can provide. Transparency could take a number of forms, but a key benefit would come from the transparency regulators would enjoy, if given access to relevant ledgers and cryptographic keys, to observe transactions in near real-time and determine patterns of money moving between financial institutions.
The transparency advantage could also lower market participants’ compliance costs, as regulators would have access to their own copy of a DLT ledger. The combination of such transparency and the immutability of the record would enable regulators to review and audit transactions as they happen, or during a later investigation. Suspicious transactions could be identified and traced without the time lag that generally hampers regulators.
There is a deeper set of possible regulatory benefits too. If DLT is combined with smart contracts then regulation could move more from an “extrinsic” setting to an “intrinsic” setting, such that compliance becomes hard-wired into the very fabric of the marketplace.
Regulation in DLT goes beyond dealings with regulators. Critical legal issues also form part of its regulatory framework. In addition to quite complex cross-jurisdictional legal issues there are also fundamental issues such as the conflict between the flexibility of the public policy of laws and the immutability of the ledger.
A key strength of DLT in providing transaction certainty could be a weakness if the flexibility to adapt is lost. An example where this issue can be relevant is insolvency, where legal systems replace strict contractual adherence with proportionate liability in the interests of public policy. The breadth of legal flexibility in the “real” world needs to be considered in creating the architecture of a DLT solution.
Blockchain and distributed ledger technology could transform the fabric of the financial marketplace in many ways, or more specifically, as Nasdaq’s CEO Bob Greifeld recently put to a room full of City execs: “If you are in a blockchain-enabled environment […] you have the ability to leapfrog and do things in 10 minutes.”
Regardless, regulation is fundamental to that marketplace. For the transformation to be achieved, the issues of regulation, in all their forms, needs to be identified, analysed and solved.
Andreas Gustafsson, senior vice president and Jimmy Kvarnström, vice president at Nasdaq with Scott Farrell and Andrew Wingfield, partners at King & Wood Mallesons