Beauty and the blockchain: regulators are watching the story closely

Blockchain is not something new to the financial sector.  In fact, it’s been around for years.  It will be, however, a slow process to integrate it into systems already in place and, as with any disruptive technology, for regulators to assess and mitigate its risks by regulating appropriately.

Although the technology isn’t novel, regulators now seem to be shifting their gaze to it and have begun investigating the benefits and issues, observing before introducing any required regulation.  Like any technological evolution, there are ugly issues to iron out, but also plenty of opportunities that the industry seems raring to embrace.

This article will explore the latest approaches to blockchain.  It will describe how it can be used positively in financial services, look at the challenges and comment on how regulators are currently approaching the technology.

The blockchain fairy tale

Blockchain is a type of distributed ledger technology (DLT), a trustless system that is decentralised and immutable.  Banks are looking to this technology with the aim of reducing operational cost and effort by liberating financial operations from their legacy systems.  It is beginning to be embraced by several industries, such as health and pharmaceuticals, and it is easy to see how its advantages translate across to the finance sector.

There are many use cases in which blockchain technology could create efficiencies:

  • In AMLD and KYC, the advantages of reduced cost, errors and duplication of effort indicate it is time that the industry adopted DLT, for the long-term advantages outweigh the initial costs, as we discussed at our recent conference and outlined in a previous article.
  • Payments is another area in which blockchain could revolutionise banking, from the speed of transactions – thanks to its near-real-time capabilities – to the lack of need for intermediaries and its immutability, it is a sphere that is ripe for the advantages of DLT.
  • Capital markets is another place where blockchain can reduce errors and disagreements whilst speeding-up settlement time, for example in the form of smart contracts which will be able to automatically verify and execute the terms of a contract, and also in reference data management, as well as several other areas.

There are many ways that it has been thought blockchain could assist with banking and there are likely to be many more envisaged in the future.  DLT’s application is seen as more of a ‘when’ than an ‘if’, with several major banks and regulators running research and trials and the creation of numerous Fintech start-ups in the technology.  It seems important, with these disjointed approaches to DLT, that a banks and Fintech companies come together to work on technology compliance solutions, in a forum for open, collaborative dialogue.

Not all sunshine and rainbows

There are certainly many challenges, currently, to the widespread application of blockchain technology.  Cost – both in terms of money and time – is one of the largest hurdles for the sector at this stage.

Though the technology is not completely new, it is still in its infancy and there are many issues that need to be dealt with before the industry will be entirely willing to take the plunge.  The security risks, privacy concerns and liability issues are, perhaps, some of the most worrying issues that require clear and practical solutions before sensitive information can be entrusted to the new technology.

Several vulnerabilities of DLT would need to be addressed, including distributed denial of service attacks, privacy in the decentralised system and risks of consensus hijacking which could tamper with the validation process.  That being said, its emerging use in medicine and pharmaceuticals should be a signal that these can be overcome, and many firms have responded to these various challenges.

And the regulators?

The European Commission is observing blockchain developments and this shows in the number of events, papers and taskforces they are releasing on the topic.  However, so far, DLT remains largely unregulated, as these bodies, like the EC, seem to be taking a ‘wait and see approach’ whilst doing their own research.

This approach seems to be intended to match the infancy of the technology, but firms could also cite the lack of regulation as a reason to avoid its adoption and may also view the technology as a vulnerability to market safety if blockchain is adopted before it can be regulated.  The need to not stifle innovation is clear, and globally regulators seem to be keeping a close eye on DLT’s developments and progress, both wary and welcoming to the industry evolution it might bring.

RegTech and DLT

The automation of blockchain can ease the burden of regulatory compliance and is one of the key drivers of the research into, and adoption of, DLT so it is important to be ready for its arrival.  As the financial sector is tackling the ever-growing barrage of regulation with which they must comply, blockchain is a disruptive technology that could provide some updated and more efficient reinforcements in a variety of areas.  Blockchain could be important in the RegTech sphere for managing compliance.  The approach may be cautious, but, like the regulators, we must actively watch and prepare for its arrival.

With the bombardment of new financial regulation, technology such as blockchain is the next evolutionary step in dealing with the burden of compliance.  There are challenges in moving forward and implementing the new systems that will require collaboration between regulators, firms and technology firms.  Already firms are using DLT to assist with the centralising and categorising of data, and the technology is also helping with authentication processes.  JWG will be exploring the application of DLT and blockchain in greater detail at our Data and Security SIG (DSS), which will bring together senior managers from the buy-side, sell-side and technology firms under the Chatham House Rule.  If you would like to find out more about this group, please contact dss@jwg-it.eu

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