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DLT (blockchain) for a Regulatory Use Case

It is obvious that distributed ledger technology (DLT, originally blockchain) is one of the most intriguing and conspicuous FinTech “invention” of the recent era. Enormous amount of effort and money is spent to research, evolve and try to find out possible use cases, not only technically but also from a “concept” perspective.

The reader of this article is assumed to have a basic knowledge about the blockchain (DLT for the financial use cases), it’s proposed advantages and drawbacks from a technical point, thence deep analysis of DLT will not be given here. But briefly, it is worth to mention that for the financial use cases the definition is given by BIS[1] as “the processes and related technologies that enable nodes in a network (or arrangement) to securely propose, validate and record state changes (or updates) to a synchronized ledger that is distributed across the network’s nodes”. The differences between blockchain and DLT can be summarized in two bold points. While blockchain architecture based on “permissionless (open to anyone, public)” concept, DLT requires much more a permissioned (private) infrastructure because the financial markets and the institutions are under strict regulations. The second one is the proof of work vs proof of concept (or stake) which is used for decrypting or verifying the “hashes”. The original blockchain based on the proof-of-work function, because of the unique nature of financial markets, for verifying purposes a more broader approach, proof-of-concept (or stake) is used.

Both in regulatory environment and research area, at least for the first stages, the possible use cases for financial markets are proposed especially for post trade services, KYC and securities lending. The main research focused on these three areas and some initiatives manage to deploy their solutions such as IBM and Santiago Stock Exchange (securities lending) Hyperledger Technologies Fabric 1.0, R3 Corda.

Though few, one of the use case for financial markets is also mentioned as the regulatory area. Though it has some burdens and discussion points, the unique “single source of truth” functionality of DLTs makes the infrastructure attractive for the regulatory purposes as discussed below.

During the last financial crisis, the most paramount and shocking disability of the financial regulators was the “blindness” to the depth of the problem. This caused a delayed response hence to foresee the consequences of the intervention and the amount that would be to be undertaken by the public cannot be easily assessed. Later on, as a remedy, LEI (Legal Entity Identifier) concept is introduced to financial system under the aegis of Financial Stability Board (mandatory) initiative, to accumulate the information.

To perform regulatory activities and responsibilities, the public should maintain the correct and workable data about the financial transactions and the counterparties to them. Especially in terms of supervisory and monitoring activity. That is the reason why recently the reporting regulations is the most commonly introduced new type of legislation to the financial system. This is also crucial in terms of AML (anti money laundering and terrorist financing) regulations. The financial system is forced to provide full transparency to the regulators both in financial contracts and the financial institutions as well as customers.

Though the possible use cases of DLTs in financial markets are already under discussion, it is for sure that DLT (blockchain) infrastructure provides an immutable, “single source of truth”. That means, all the transactions and beneficial ownership of any asset on the ledger can be traceable backwards, from the very first issuance of this particular security. And, this is the exact information which regulatory authorities are looking for.

The main area of DLT research on financial markets heavily focused on post-trade services and possible use cases for KYC and securities lending. There are only a few lectures that touch the issue from a regulatory use case. However, DLT can be a benchmark for the regulators to monitor and supervise the activities of asset holders and as well as financial institutions with the “single source of truth” functionality. For regulatory purposes, if the constant and reconciled information is the upmost importance then that is what the DLT will offer. Immutable, near to real time and reconciled, ready to use information.

My current personal view is, considering LEIs and ISIN coding, the imaginary world of DLT use case for regulatory purposes will look like as such. In this imaginary world, the LEI will give fingertips for financial counterparties and the ISINs will point out the financial instruments. In terms of beneficial ownership, the coding of LEI, financial counterparty and additional embedded second level information to the crypto which remarks the client gives the opportunity to the regulators to trace all the information for regulatory purposes. This embedded information related to end customer is also usable for KYC purposes or vice versa, the KYC enriched crypto can be used for regulatory purposes. For supervisory and monitoring mandate, the regulators will have nodes to the ledgers. These nodes will only be entitled to accumulate information and have a privileged status to encrypt all the information embedded at the keys, to prevent any anonymity that will hinder the regulatory functions. This privilege will also, in contrary maintain the general anonymity at the ledger as well, because only and only the regulatory authorities will have the opportunity to decrypt all the information and no body else. The regulatory nodes will not be entitled to generate proof of concept (or proof of work) function which means that regulatory intervention will be limited only to monitoring the activity and no conflict of interest will be caused.

Hence the infrastructure still evolving, the use case of DLT for regulatory purposes has its own drawbacks that must be discussed and solved to a certain extend. These are related to the technology and infrastructure as well as governance issues.

The first discussion on the issue will be whether separate DLT for each financial instrument will be maintained or single, one huge DLT, covering all instruments will be established. To my view, one single DLT for all financial instruments can be more practical from a regulatory perspective. Otherwise, if each financial instrument will have its own ledger, the reconciliation problem will remain as it is, but just change the pace. Also, in multiple ledgers environment, the information about holdings of a particular individual can only be reconciled after searching all ledgers, which will most probably be more difficult and costly than the current status.

Another and important hurdle is the governance issue. If DLT will be used for regulatory purposes than, implicitly does it mean that all the regulators will have a node to the ledger? In fact, this is not an issue of DLT in particular, because recently the same problem exists between regulators which emanates due to the global nature of financial markets. The dilemma already tried to be solved with supervisory colleagues, multilateral MoUs, bilateral agreements for sharing information, etc. But the current initiatives are not enough to solve the problem of regulators for information gathering and sharing. Developed countries are willing to collect information but not responding or making it difficult for any request. In this regard, most probably the regulators of emerging and underdeveloped markets will benefit most from the regulatory use case of DLTs. May be one solution to the governance issue is to strengthen IOSCO, ESMA, FSB like supranational authorities and having them these nodes to enter the DLTs. Under the governance structure of these institutions more reasonable and acceptable solution will be easy to be achieved.

Also the convergence of software used for DLT infrastructure is under critics. There are several initiatives focused on DLT and deployment of this infrastructure to financial markets. To name some, Hyperledger Technologies’ Fabric 1.0, R3’s Corda, IBM and Microsoft are most pronounced at research area. But my concern is, it looks like a “gold rush” trying each of them to be the first at available use cases and having no coordination and consensus about the software and applicable logic to ledgers. This is understandable to some extent, but our past experience showed us that, unparalleled initiatives can increase the cost of convergence at a later stage. And unfortunately, the regulators are at an “observer” stage just commenting on some high-level guidelines and principles. It is, for sure, early to set up detailed standards but just the right time for regulators to intervene to the research area and canalizing process to prevent uncoordinated approaches that will cause late costs during deployment of DLTs as a market practice. There are national authorities that express their interest to DLTs in financial markets and even having participation to above mentioned initiatives. But all these effort from the regulatory environment is just at national or individual level. More international approach should be maintained and, without creating any anti-competition between initiatives, coordinate the effort for enhancing the DLT infrastructure.

DLT will not change only the mechanics in financial markets, but also the regulatory function will evolve to a new phase. Enhanced transparency, quick reach to beneficial ownership and strong monitoring will increase the confidence to financial markets. Recent researches are focused on possible use cases of DLTs to financial markets but no matter which will be applicable, the regulatory function will response one way or another. Regulators can wait till the market forces them to change their practices or the regulators can lead this change with a more moderated approach. In both ways, there is limited time for regulators to get pace in researches about the DLT. Also, the market must consider the near or far intervention of regulators in the area, during all these researches and rushing to deploy their own solutions at different possible use cases. It is obvious that the regulators will step to the arena sooner or later. Instead of facing enormous amounts of cost for regulatory compliance to lately designed rules and principles, it may very first time the right way to collaborate with regulators before going deeply to deployment.

[1] Distributed ledger technology in payment, clearing and settlement, Bank for International Settlement, February 2017

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