How should blockchain be regulated?
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This month, the Federal Reserve joined a long list of government institutions across the world in releasing its views on blockchain. This distributed ledger technology, which underpins the well-known and controversial bitcoin cryptocurrency, is essentially a recordkeeping system that can replace a periodically-updated central database—a design that underlies most financial systems used today—with a clever distributed database that updates in near real time.

Proponents of blockchain technology laud its ability to revolutionize and disrupt existing financial systems, making swaths of costly back-office functions redundant and replacing them with a more efficient and secure distributed ledger design.

Yet regulators have struggled to strike a suitable posture in response to blockchain developments. On one hand, there is nothing yet to regulate, with no known commercial-scale financial blockchain applications. On the other hand, it is still unclear why or how regulation should change in anticipation of technological development.

Disruption or technological development?

Blockchain, as currently envisioned by financial institutions, seems to represent a useful technological advance but is not likely to be disruptive. True disruption results from a new entrant taking advantage of a new business model that enables them to cater to consumers with low-end products that incumbents cannot offer due to legacy business models. Disruptors create a new market. A good example of market creation are low cost airlines, which have opened up a market for budget travelers.

Bitcoin, the open-source and open-access blockchain currency, still holds some disruptive promise because it may yet enable the unbanked in the developing world to participate in the global financial system. But the closed-access permissioned financial blockchains envisioned by incumbents in the industry are not disruptive. Rather, they represent the ongoing march of database technology. The key distinction here is that blockchain does not necessarily pose a threat to financial incumbents. Instead, it may help sustain them by reducing costs and possibly improving profitability.

How will regulators oversee blockchain?

A large part of regulators’ work around blockchain will be to ensure that blockchain-based financial systems are not able to find loopholes around existing regulation. While regulation is typically technology-agnostic, it’s possible that the way in which blockchain systems are implemented will mean that components that, for example, look and act like a central counterparty (CCP) are not in fact called central counterparties. There is a risk here for a rerun of the growth of shadow banking in the late 2000s.

As the Federal Reserve report notes, there are numerous legal considerations involved in determining the legal basis of specific parts of a financial blockchain. For example, the legal procedures that deal with securities settlement systems, central counterparties, or central securities depositories may need to be updated if these intermediaries are made redundant by a distributed and decentralised system based on blockchain. Replacing CCPs also would appear to affect systemic risk considerations.

It remains largely unclear what, specifically, regulators can or should do right now because so much will depend on the specific way in which a blockchain is implemented.

Some insights into future regulatory issues may be provided by the more mature peer-to-peer (P2P) lending sector. P2P lending was also originally promised to be disruptive, but the sector has since evolved to a point where large P2P firms are increasingly indistinguishable from more highly-regulated traditional banks or collective investment schemes. Regulators are casting an increasingly wary eye on the potential for regulatory arbitrage in this area.

How will blockchain serve investors?

The evolution of financial blockchain business models will likely follow suit, but the interest shown by regulators in blockchain over the past 18 months suggests that this time they may be more prepared.

As the investment profession’s standard bearer for investor protection, market fairness and market integrity, the CFA Institute believes that these goals should not take a backseat in the interests of promoting a specific technological advance. Many features of blockchain, such as real-time settlement, are not unique to its design and could be achieved using other methods.

As a result, the lasting legacy of blockchain may turn out to be that of a catalyst, enabling many disparate financial actors to come together and cooperate on the design of 21st century financial plumbing, whatever that ultimately looks like. But it will not solve the ethical issues that have driven regulation in financial markets for more than a hundred years. Regulators need to ensure that blockchain is serving the interests of investors and the market, not the other way around.

Sviatoslav Rosov, PhD, CFA, is an analyst in the capital markets policy group at the CFA Institute, a global association of investment professionals.


The views of Contributors are their own and are not the views of The Hill.