This week the Bank for International Settlements (BIS), the organization owned by 60 central banks, published a paper entitled “Embedded supervision: how to build regulation into blockchain finance.” The document authored by principal economist Raphael Auer considers how current financial market infrastructures might evolve to use distributed ledger technology (DLT). And in turn, those distributed ledgers could enable automated supervision.
The document isn’t dealing with the current scenario of cryptocurrencies sidestepping anti-money laundering rules. Instead, it explores the supervision of financial markets if they evolve into DLT-based markets which may not have trusted intermediaries or central counterparties. It also explicitly assumes permissioned blockchains which contractually ensures participant liabilities and on-chain digital assets are tightly linked with the underlying asset. For example, the link between a token and the related real estate.
The principle of “same risk, same regulation” has been raised by regulators many times when it comes to cryptocurrencies and digital assets. However, the paper suggests that although the regulation – the writing of rules – should be technology-neutral, how those regulations are policed should evolve with the underlying technology. In other words, use blockchain as a supervision tool to monitor digital asset transactions. The author coins the phrase “embedded supervision”.
While the document doesn’t go into detail about the markets envisioned one doesn’t need too much imagination. There are already initiatives involving the tokenization of securities, bonds, derivatives, real estate, mortgages, foreign exchange, insurance risks and other assets. In the case of the SIX Digital Exchange (SDX) at least three major banks including Citibank, JP Morgan, and Credit Suisse are participants. Then there’s Fnality, which involves 14 global banks who plan to use the Utility Settlement Coin backed by central bank deposits.
If distributed ledgers have automatic monitoring built-in, there is no need to gather data to submit to regulators for compliance. For example, the report suggests that a bank’s Basel III compliance could similarly be automatically verified.
The BIS even suggests that given distributed ledgers are trustworthy, the data extracted in this way has credibility, and hence there is no need for “middleman-based data verification”. However, it emphasizes that the regulator needs to ensure that the market’s economic consensus, including incentives, is strong enough to guarantee the quality of the data. So oversight is to some extent replaced by financial incentives and game theory.
Ensuring finality or that transactions cannot be reversed is an essential requirement to have trust in the ledgers. Currently, that trust is often enabled by central counterparties. These institutions may be superceded by trustworthy blockchains that offer finality. This, in turn, presents a challenge in that the requirement for counterparties is enshrined in many local regulations. That would need to change.
There’s an ongoing trade-off between supervision and the cost burden of compliance, particularly on smaller firms. Financial services remain “stubbornly expensive”. It’s suggested this may be the result of the high barriers to entry created by current compliance costs. By using DLT-based embedded supervision, the expense involved could decline significantly.
The obvious concern about big brother watching is a lack of privacy. However, cryptography could be used to hide personal information. Plus data can be aggregated, and just the summarized risk exposures shared with the supervisory body.
Two examples are provided. Firstly the Bank of Lithuania’s LBChain is running in a sandbox exploring embedding a regulatory infrastructure in a blockchain-based market. Another is the Federal Reserve Bank of Boston’s supervisory node case study.
The conclusion highlights the difference between embedded compliance and the current “regtech”. In the case of regtech machine learning is used to help to monitor the financial sector. Blockchain or DLT based markets is about replacing the trust mechanism. Instead of purely relying on the legal system and oversight from authorities, a future blockchain-based infrastructure could rely on economic incentives to ensure reliable data.