Foreword

Many in the regulatory community have commented on financial technology’s power to change the way we do business. Christopher Woolard, FCA Director of Strategy and Competition said on 22 February 2016 “there are a lot of regulatory and consumer issues that will need to be discussed as the technology evolves. For example, how individuals gain access to a distributed network [blockchain] and who controls this process … are vital considerations for us as a regulator.” The FCA is moving in the right direction in setting up the Regulatory Sandbox, an environment where businesses can play with customers to test ideas (with supervision) and gain authorisation to operate as a business, but need to be cautioned on not stifling the growing industry by focusing on the technology rather than its use. 

 

What is Blockchain?

In order to dispel any preconceived misconceptions I shall start by highlighting the terminology by comparing it to our current financial system. You may think of bitcoins as Pound coins and blockchain, the underlying digital technology behind bitcoin, as the Bank of England, VISA, Euroclear and HSBC, the underlying bricks and mortar institutions behind the Pound.

Blockchain is a shared database for recording transactions in a way that does not allow the record to be altered at a later date; it is often referred to as a “distributed ledger”. Each participant must approve a set of transactions known as a “block” before it is recorded in a “chain” of computer code. The blockchain is distributed to all parties so that they may try to solve the cryptographic puzzle used to secure the blocks. The fastest one to do so is financially rewarded for their effort with newly created bitcoin and the transactions are digitally recorded for settlement and clearing. Parties that process these transactions are called “Miners”. The blockchain can either be publicly available to everyone such as the bitcoin blockchain or private and permission based, such as most models adopted by investment banks.

Banks are exploring avenues by which they can exploit this new technology for payments and settlements by speeding up inefficient back-office settlement systems in order to free up billions in capital currently tied up, which would support trades on global markets.

 

Why is it of interest?

From a regulatory standpoint, it has been argued that blockchain will pave the way for better market transparency by providing better visibility into the swaps trading portfolios of major institutions. Currently, regulators lack the resources necessary to collect sufficient quality data in order to recreate a real-time ledger of the highly complex, global trading portfolios of all market participants.

Blockchain has the potential to provide regulators with a “golden record” of all trades; although, if a private ledger is used, they will need to be a party member.

 

How will it affect markets?

The manipulation of financial benchmarks since 2008 has been well reported and litigated. The situation extends to foreign exchange, gold, silver, swaps and others; it is international in nature and investigations are on-going in new markets, such as treasuries.

To take LIBOR as an example, the benchmark is set by a slimmed down average of rates reported through participating banks with deeply vested interests in the outcome and formerly was administered by the self-regulatory body, the British Bankers’ Association.

The same is true with the gold market, fixed twice a day by five competing banks during undisclosed discussions. Members of these private talks also held private information on price evolution, and again, the self-regulated body, the London Gold Market Fixing, set the benchmark.

Many of these benchmarks have been highlighted as defunct and taken up by exchanges, such as Intercontinental Exchange and CME Group. Though, serious thought should be given as to how to best detect this activity, and whether blockchain can play a part.

A public distributed ledger, or a privately distributed ledger where the regulator is a party, will increase the transparency of real time trades that take place within the market.

Further still, the increase in transparency is expressly needed to track the financial positions of market participants who ultimately set off against each other, thereby creating an instant way to see the net set-off financial obligations of each counterparty. If another Lehman situation were to occur, years would not be needed to unravel who owes what to whom. This information would be instant leading to a better understanding of each market participant’s financial exposure, in real time. A notable caveat is that banks are not likely to take up blockchain in 100% of their businesses processes and therefore anything traded and settled outside of this system would still need to be unwound.

 

What is the right kind of transparency?

It is integral to note that an important divide lies in which kind of transparency is needed within the marketplace. While the above is critical to track the financial position of market participants, it does nothing to stop manipulation of rates. The opaque, undisclosed discussions and the submission of rates will remain regardless of the transaction data with which the regulator is supplied.

Those interested in the regulation of financial markets should look for this more holistic kind of transparency within the coming months or, more likely, years. That is, transparency in disclosing discussions on fixing benchmarks as well as transparency for trade data. Crucially, one is not a supplement for the other.

 

Regulatory standpoint

Should the regulator be given access to the “golden record,” it should not miss the records true value. Rosa M. Abrantes-Metz of the Global Economics Group has produced empirical evidence that “Treasury auction prices may have been too low for years, and that this effect becomes more pronounced the more primary dealers buy.” Her work shows that procurement method of selling US treasuries to a small number of large participants that obtain a large share of treasuries has led to a Department of Justice investigation into the possibility of bid rigging.

As a solution, Rosa suggests (1) recognising and proactively reforming deficient structures; and (2) screening markets regularly through sophisticated data surveillance and independent oversight. The objectives of these solutions are to (1) minimise the likelihood of abuse and (2) enhance deterrence and detection of illegal behaviour. Blockchain can play a key role in these objectives. Further, due to blockchain’s ”golden record” of real time trade data, the regulator can conduct analysis on price movement and potential manipulation, following the methodology Rosa used to uncover previous manipulation. The regulator should move from the back foot of litigants making noise about market abuse to active investigation of potentially suspicious activity.

 

How to regulate blockchain? 

Separately, the regulation of blockchain needs to be considered. Recently J. Christopher Giancarlo, Commissioner at the US Commodity Futures Trading Commission published an article in the Financial Times concluding regulators should first “do no harm” to blockchain and take the approach adopted in the early days of the internet. Chris represents generally the view held in the US, and approaches the issue as a matter of policy. I come to the same conclusion, but would like to delve deeper into why this is the correct position to take.

Fundamentally, blockchain is a protocol. It is a set of rules within computer code that allows the secure, immutable transfer of digital wealth. In order to solve the regulatory puzzle, we should first look at the existing operations of other protocols. A more familiar entity of a protocol such as this is the Internet; it is a set of rules within computer code that allows digital communication. Indeed, the address you have been assigned to access the internet and subsequently read this article is referred to as your IP address, expanded out as Internet Protocol address. Like the blockchain’s core development team, the internet has its own group of individuals who develop and promote voluntary standards called the Internet Engineering Task Force (IETF). You may interact with the internet every day but this may be the first time you are hearing of the IETF.

There are four critical points to note. (1) The system’s efficiency comes from the set of voluntary standards published by the IETF each time they identify a problem, (2) the adoption of the set of standards is voluntary; (3) anyone can publish a new set of voluntary standards; and (4) there is no central authority imposing a decision on those who interact with this system.

In 1998 the IETF produced Internet Protocol version 6 (IPv6) to replace Internet Protocol version 4 (IPv4) as the number of addresses within IPv4 became limited and incapable of handling the explosion of the internet. Individuals using IPv4 who did not want to take part in the switch from IPv4 to IPv6 were not obligated to. Even now there are many newly proposed standards. IPv9 was introduced further expanding the number of addresses within IPv6; however, this time there is no shortage of addresses within IPv6, and this instead just increases the overhead of an IP packet i.e more data for not as much gain. Jim Fleming's IPv8 has had no traction due to practical issues (and debates as to whether it’s even an improvement upon earlier versions). These new standards could be taken up if they provided a meaningful upgrade. This is the case as well with the Bitcoin protocol, currently going through its own disputed upgrade from Bitcoin Core rules with a 1MB size block to Bitcoin Classic rules with a 2MB size block. Jeff Garzik, one of the most prominent bitcoin core developers commented recently that the protocol “give[s] our customers the choice of a whether you like the Bitcoin Core rules, Bitcoin Classic rules. It defaults to what’s currently on the network, which is the Bitcoin Core rules”. Crucially, individuals are free to choose which they prefer through the consensus mechanism.

All of this is not regulation’s concern; regulation is concerned with the actions of those who engage with the protocol. The FCA need not be troubled by the protocol involved in sending an email, but they do need to concern themselves with the emails content. The practical difference for the regulator is the difference between an email to a friend to grab lunch and a phishing scam.

Many firm actions will be flagged as regulated activity depending on the conduct of each firm.  Holding fiat money on account may trigger regulation as a custodian, though further regulation on E-money, Payment Services Provider or Deposit Taking activities may need to be considered. “Anti-Money Laundering” (AML) and “Know Your Client” (KYC) checks will also be prominent compliance considerations.

The actions of the regulator need to be concerned with the actions of the firms that engage with blockchain, and not by blockchain itself.

 

Who are the players?

There are a number of start-ups, backed by the financial industry, looking to change the way business operates. I shall discuss the most prominent:

Setl is using blockchain technology to allow financial instruments to be traded and verified electronically without a central ledger, including foreign exchange trading and consumer loans. It is able to settle any kind of payment and market transaction in central bank money, which is its distinguishing feature from rival competitors. Setl has turned blockchain into a large-scale workable model by creating a system to process more than a billion payments a day.

R3CEV wants to establish consistent standards and protocols, while linking bank collaboration on research, experimentation and design of prototypes to create a “network” effect. Data will be stored outside the bank’s firewalls, analysed, and matched against other counterparties. R3CEV is the largest of the four companies with the most industry backing, at above 40 leading global institutions. R3’s platform is called Corda and has been used with Barclays to make a Smart Contract Template for ISDA documents.

Digital Asset Holdings, whose CEO, Blythe Masters, has raised more than $50m and completed a deal with ASX, Australia’s main exchanges operator, to upgrade its systems. The initial focus for ASX and Digital Asset will be on clearing and settlement services in the cash equities market. One advantage Australia has over other developed markets is its concentrated nature, where the ASX owns the country’s main clearing house as well as the central depository.

Chain issued shares to a private investor using the US exchange’s new Linq system that is based on blockchain technology in partnership with Nasdaq. The exchange group reported that the transaction had created a digital record of share ownership significantly reducing settlement time and eliminating the need for paper stock certificates. It also allowed the issuer and investor to complete and execute share subscription documents online.

 

What’s next?

Once a blockchain system is up and running, it would have to be grafted on to banks’ existing IT and payment systems, some of which have been in place for decades, and meet the requirements of market watchdogs. There is still a long way for blockchain to go before it lives up to its expectations, but that does not seem to have stopped the hype around its potential. 

The regulator should be congratulated on the Regulatory Sandbox and its open arms attitude to financial innovation. This has led to London being the destination of choice for setting up a FinTech business. The Sandbox will lead to more businesses trying to get authorisation to trade through openly engaging with the regulator rather than shying away. The regulator will need to balance this innovation with the need to treat customers fairly and potentially withhold authorisation. The Sandbox gives great visibility in this respect.

However, the regulator needs to focus its attention on blockchain away from the underlying protocol and those who maintain the code, to those firms that engage with the protocol and whether their activity should be regulated.

Once the technology is up and running, the regulator should engage with trade data analysis to actively investigate suspicious activity such as market manipulation, moving to a more proactive approach and getting out of the shadow of better enforcement from the US.  

It will be interesting to see if regulatory response will adequately meet the challenges ahead or let this slip past on misguided transparency and misguided focus. 

 

Baldeep Namas is a member of the Finance Network steering committee, and was a panelist at their 'Future of Finance Regulation' event in May 2016.