The Regulatory Imperative for Blockchain

Do you have blockchain fever? A lot of frenzied activity is underway in the financial services industry (FSI) focused on trialing and concept-testing distributed ledger technologies underlying the digital currency Bitcoin. Traditional financial services firms are not only testing Bitcoin, but also other uses of blockchain for everything from capital markets to payment systems, trade settlement and clearing, commercial paper, derivatives trading and catastrophe reinsurance.

Some of these trials will go nowhere, others will morph and change shape and still others will get to market as the digitization of the industry deepens. Most prognosticators expect several key industry trends to emerge out of the application of blockchain, including:

1. A reduction of post settlement costs as labor is replaced by digital ledger systems
2. An increase in the velocity of capital as transaction-settlement times are dramatically reduced from three days or more to 10 minutes or less
3. Change in the consumer brokerage and back-end financial closing industries
4. A replacement of paper-based records by digital-based trust.

Amidst all the hype about the potential change, disruption and displacement caused by blockchain, most are ignoring a reality about trust and brand: trust in brands is what occurs between people and their experiences with companies, and it is reinforced by behavior, experience and habit. Changing people and their habits from legacy-based systems—including paper-based procedures—is hard and will take time. And so it will be for blockchain. While blockchain may end up displacing and disrupting different parts of the financial services industry, its affects will occur over a longer time frame than many realize – seven to 10 years and more.

Nevertheless, change is in the air, and Blockkchain is the agent of change. What is perhaps not being noticed—and should be—is that blockchain is not one, but multiple ecosystems.

There are at least four ecosystems of blockchain emerging, including:

1. Public blockchains. Bitcoin and related digital currency applications are the first of many other publicly accessible ledgers.
2. Private blockchains. Private company supply chain applications will be used to accelerate the flow of capital, reduce days outstanding and reduce third-party cost and delay in the supply chain.
3. Consortia blockchains. R3 CEV and others are industry-specific applications of digital ledgers that are permissioned versions of public blockchains.
4. Sidechains. These are the linkages for conducting transactions between multiple blockchain ecosystems.

There are a number of obvious regulatory issues bubbling up to the surface as FSI companies trial and test blockchain. Among them are the following:

• Trust. One of the unseen problems being investigated is replacing miners and their Bitcoin incentives for other ecosystems, including private, consortia and sidechain blockchains. In the Bitcoin version of blockchain, it is miners—people and organizations—that are incented to verify the transactions and blocks of the blockchain by being paid in Bitcoin for their trouble, time and expense to do so. The question emerging from these investigations into non-miner systems is, if miners do not act as trusted third parties, what other trust mechanisms are built into the fabric? As such, a key regulatory issue for financial markets with any miner system replacement will be how to eliminate potential for fraud and conflict of interest.
• Conflict of interest and dark pool trading. Another unseen problem being investigated is the varying lengths of time it takes to build out the blocks of the blockchain and its impact on fraud and conflict of interest. Today, Bitcoin is self-regulated to achieve this in about 10 minutes. But other uses of blockchain will have different design intents, from nearly instantaneous real-time to next-day response. One of the key regulatory problems for financial markets with different block-building and validation times is the potential for fraud and conflict of interest where dark pool traders can gain timing advantages and trade against the market.
• KYC and Trust. Is knowing your customer (KYC) left to a market of third-party intermediaries, or are digital ID efforts accelerated for blockchain applications? Do we use a reputational trust model or a third-party trust model for issuance and validation? And what happens in a world where some digital IDs are legally supported and granted in some countries but not recognized or accepted in others? Is there guidance on what is out of bounds versus in bounds for some markets and not others according to regulators?

The activity and rate of change around uses of blockchain in FinTech is blistering. However, for sell-side, buy-side and financial exchanges that make up the FSI, the level of engagement and interaction between the FSI and its regulators appears disjointed and slower than a snails-pace. Fortunately, some regulators are beginning to investigate what blockchain means in the U.S., Europe and the U.K.

In the midst of all this, financial regulators have an opportunity. They can regulate with enhanced transparency and with access to auditable data baked into the emerging and still-to-come blockchain ecosystems. Today, the many different regulatory bodies involved seem frozen in place, unable to respond to requests from the regulated or coordinate policy across states and international borders.

Policy-setting and studies will take regulators only so far. The technology around blockchain is moving too fast for policy studies and papers. Perhaps the regulatory imperative is for regulators to have some skin in the game: to get their hands and minds dirty with what is possible for  the regulated to do with blockchain. Perhaps it is time for the world’s financial regulatory bodies to fund and test a RegTech with its own squad, labs and apps. This would enable regulators to intelligently direct and respond to the emergence of blockchain and insist on regulated use of the technology as it impacts finance and before it spills over into the many industries finance touches.