This week the Bank of England published a blog post summarizing its analysis of the governance of public blockchains. It asks how one should govern a blockchain that becomes a critical piece of financial infrastructure. The focus was on permissionless blockchains and, for now Ethereum, although it notes that it does not consider the blockchain as critical. Yet.
“In the traditional financial system, critical financial infrastructure is regulated to deliver an appropriate level of responsibility, accountability, and control,” says the blog post. “So, there is a question as to what appropriate regulatory oversight of a blockchain could entail, were it to become a more critical piece of infrastructure in the financial system.”
It pointed to the Ethereum Merge, a highly risky move from Proof of Work to Proof of Stake to secure the network. Frankly, it’s hard to criticize the transition at a technical or process level, and one has to question whether conventional institutions could have handled it better.
However, that’s not what the Bank is concerned about. It wants to know what would have happened if something went wrong. Who would have taken responsibility and would be accountable for the financial loss? We’d hazard an answer on the loss: the token holders.
The Bank also mentioned that the UK is looking to extend responsibilities to critical third parties involved in the financial sector, such as cloud hosting companies.
Many in the crypto world are concerned that the move from Proof of Work to Proof of Stake makes the network more susceptible to oversight.
On the flip side, the Basel Committee for Banking Supervision also has concerns about permissionless blockchains. Digital securities are treated (more or less) in the same way as conventional securities for Basel III risk assessments. These lower risk crypto-assets are classified in ‘Group 1’ compared to cryptocurrencies that fall under the higher risk ‘Group 2’.
Last week the Basel Committee published the final version of the crypto-asset rules. It states, “The Committee will continue to reflect on whether the risks posed by cryptoassets that use permissionless blockchains can be sufficiently mitigated to allow for their inclusion in Group 1 and, if so, what adjustments to the classification conditions would be needed.”
The SWIFT example
Digressing from the Bank’s blog post, we’d like to point to other networks that have been free from oversight. And how there could also be new permissioned blockchain networks that also become powerful and are not directly regulated.
Take the example of SWIFT. It is not a payment system and hence is not covered by conventional payment regulations. You read that correctly. At a technical level, SWIFT simply transmits messages across its network. It doesn’t actually make any payments. As a result, until 1998, it had a free pass from regulators. At that point, the central banks concluded that it was too large and important and hence needed to be overseen by central banks as a ‘critical service provider’.
And that’s how the Bank would view Ethereum if it became critical.
How architecture influences regulatory oversight
As a side observation, the choice of how a blockchain network is structured is critical to its ability to grow unencumbered by regulation.
Take the example of Fnality, the permissioned payment network backed by 17 financial institutions. Its chosen path is to have an omnibus central bank account, where its shareholder banks deposit money which is then tokenized for on-chain payments. This choice is the result of the goal to create a single liquidity pool that a bank can use for several applications and platforms.
However, as a result, Fnality has to get clearance from every central bank in any jurisdiction in which it plans to operate. That’s a slow painful process. It is already designated as a systemic payment provider in the UK, and the Bank of England delayed its planned 2022 launch.
In contrast, Singapore’s Partior, in which JP Morgan is one of four founding shareholders, does not have a central bank account. Instead, it’s the network operator in which banks have nodes. So it’s far more like SWIFT. As a result, Partior is going to be able to expand relatively quickly.
That’s not to say the Partior route is better than the Fnality route. They’re both targeting interbank payments but with different priorities. And in both cases, if something went wrong, the legal liability would be clearer compared to Ethereum.