As regulators address the use of blockchain technology by financial institutions, the three words that should guide their efforts: “do no harm.” That was the message from Commissioner J. Christopher Giancarlo of the Commodity Futures Trading Commission during a speech delivered at the Depository Trust & Clearing Corporation’s 2016 Blockchain Symposium earlier this week.
Blockchain technology is, in simple terms, a peer-to-peer, distributed “open ledger." Rather than a traditional, centralized server or clearing process, blockchain relies upon decentralized, consensus-based authentication protocols. Any item that can be securitized or represented as an item of value can be transferred with an immediate settlement process.
Giancarlo, an outspoken blockchain booster, has described distributed ledger technology (DLT) as having “the potential to revolutionize the modern financial ecosystem” with profound implications for financial markets in payments, banking, securities settlement, title recording, cyber-security, and the process of collateral management. His bold prediction: new “smart” securities and derivatives that can value themselves in real time, automatically calculate and perform margin payments, and even terminate themselves in the event of a counterparty default.
Potential applications of the technology are being explored in ways that will benefit market participants, consumers, and governments alike, he says. Distributed ledgers could allow “for the confirmation and ownership transfer of virtually anything from hockey tickets and magazine subscriptions to auto repair warranties and airline loyalty rewards or apartment leases.” Another potential use of DLT is better and more verifiable voting systems, whether for proxies by corporate shareholders, customer satisfaction surveys, or voting for political candidates.
“It will have profound implications for global financial markets by increasing settlement efficiency and speed, linking recordkeeping networks, reducing transaction costs, and increasing market access,” Giancarlo said.
The excitement, however, could be dampened, and momentum derailed, if regulators exercise too heavy a hand. “Innovators and investors should not have to seek government’s permission, only its forbearance, to develop DLT so they can do the work necessary to address the increased operational complexity and capital consumption of modern financial market regulation,” he said. “We can either follow a regulatory path that burdens the industry with multiple onerous regulatory frameworks, or one where we come together and set forth uniform principles in an effort to encourage DLT investment and innovation.”
Giancarlo made the case that regulators have the potential to help their own cause. “DLT may be able to provide regulators with visibility into the trading portfolios of swaps counterparties that they lacked during the financial crisis and that Dodd-Frank mandated,” he said.
A case in point: the collapse of Lehman Brothers. If an accurate DLT record of all of Lehman’s transactions had been available in 2008, its prudential regulators could have used data mining tools, smart contracts, and other analytical applications to recognize anomalies in trade activity, divergence in counterparty exposure, widening credit spreads, and disruptions in short term funding. Regulators could have reacted sooner to Lehman’s deteriorating creditworthiness.
Even if prompter and better-informed regulatory intervention would not have been enough to prevent a run on Lehman, the records held by trading counterparties, and available to regulators, would have accurately shown its open positions. “Imagine if, instead of requiring countless legal actions spanning eight years, we could have known all of Lehman’s exposures within minutes of a bankruptcy filing,” Giancarlo said. “Accelerated settlement of open positions and accounts would have likely taken weeks, not years.”
DLT “may help market participants manage the enormous operational, transactional and capital complexity brought about by the legion of disparate mandates, regulations and capital requirements promulgated globally in the wake of the 2008 financial crisis,” Giancarlo added, referencing one study that estimates it could eventually allow financial institutions to save as much as $20 billion in infrastructure and operational costs each year.
“Development is moving rapidly, certainly faster than underlying legal and regulatory frameworks,” he said. “Rules regarding DLT are currently unwritten and likely years away, leaving the industry with little clarity. Yet, this investment faces the danger that when regulation does come, it will come from a dozen different directions with different restrictions stifling crucial technological development before it reaches fruition.”
Regulators should look to the 1990s and efforts by government agencies to foster the growth and ubiquity of the Internet, Giancarlo said. The Federal Communications Commission, for example, agreed that Internet services “should exist in a minimal regulatory environment that promotes investment and innovation” and issued a series of orders affirming that Internet service providers would be governed under a comparatively relaxed framework.
“Protracted regulatory uncertainty or an uncoordinated regulatory approach must be avoided, as should rigid application of existing rules designed for a bygone technological era…U.S. and foreign regulators must coordinate to create a principles-based approach for DLT oversight in order to provide the flexibility, certainty and harmonization necessary for this technology to flourish,” Giancarlo said.
Regulators would also be wise to examine existing regulations to ensure that they don’t unintentionally harm blockchain adoption, Giancarlo said. For example, one of the CFTC’s recordkeeping rules requires all books and records to be kept in their original form or native file format. Another rule has requirements that certain records to be stored in either micrographic or electronic storage media. The CFTC should revisit these rules and make them technologically neutral “to accommodate DLT and other innovations that promote efficiency, accuracy and security in recordkeeping.”