Darragh O’Grady and JWG.
There has been much written lately on the potentially disruptive impact that digital currencies may have. However, the blockchain architecture that underlies them has also been a recent subject of a CFTC meeting to discuss the potentially disruptive impact of this new technology. We asked an architecture expert with a background in banking for his views in this piece.
We conclude that the so-called ‘blockchain’ technology underlying digital currencies, such as Bitcoin, may help the banking system meet new regulatory challenges.
Distributed ledgers and the blockchain
A key concept in any system involving the exchange of value is addressing the ‘double spend’ problem, i.e., preventing the same unit of value from being exchanged in two distinct transactions. Historically, this has been the function of banks or other trusted keepers of value, who maintain a ledger that reliably records all transactions and that all stakeholders recognise. With digital currencies, the blockchain acts as the trusted keeper of records.
The blockchain implements a distributed ledger using cryptography, peer-to-peer networking technology and game theory. The mechanics are beyond the scope of this article, but a recent Bank of England report* describes it very well. The key point is that, once the blockchain has information recorded in it, refuting its presence is not mathematically possible.
The design of the blockchain technology underpinning Bitcoin allows additional attributes to be associated with each transaction, allowing innovative extensions to Bitcoin. This enables the creation of applications to be built upon the core Bitcoin protocols that allow for the development of decentralised, middleman-free businesses (often termed ‘Bitcoin 2.0’ applications). Other digital currencies (such as Ripple or Ethereum) have similar concepts.
What does this mean for financial system regulators?
From a regulatory perspective, there are many perspectives depending on the specific concerns or challenges that the regulator deems to be important. This article focuses on three use cases that may be of particular interest to those involved in the regulatory space:
- Proof of existence
- Proof of process and control
- Smart contracts
Proof of existence
Blockchain technology can conclusively prove that a particular document existed at a specific point in time. This may be especially useful, for example, where two parties entered into a contract with precise financial parameters. The blockchain technology allows the agreement to be rapidly and permanently recorded without resorting to a third party to document it on their behalf.
This may eliminate – or reduce – the need for financial transactions (which do not require collateralisation) to remain executed on an OTC basis, while giving the regulators the transparency they require when they need it.
Proof of process and control
Blockchain technology can conclusively prove that given document went through a number of iterations throughout its life, by irrefutably linking each new version of the document in the blockchain with its previous version.
Many regulatory processes require a document to have gone through certain states before any given state (e.g., in anti-money laundering/KYC processes). Recording these state changes in the blockchain conclusively demonstrates compliance with those processes, again without the need for a middleman.
This concept could be extended to include proof of audit/control, where each new version of a document can be denoted to have changed according a defined set of rules. This has the potential to dramatically reduce the cost of governing regulatory compliance in the future.
Smart contracts are a new concept enabled by blockchain technology that could remove or reduce the need for banks as middlemen and, again, provide transparency to financial regulators. A smart contract encapsulates data-driven rules. When the conditions laid down by these rules are met, the smart contract executes the rules – such as issuing a payment from one party to another.
This technology has the potential to enable smart financial contracts based on neutral, objective market data sources; for example, weather derivatives, mortgage rate changes, etc. Banks do not need to act as middlemen, although they may act as counterparties.
It is fair to say that the concepts presented here only scratch the surface of how blockchain technology could shape the regulatory environment in the future. In particular, some out-of-the box thinking will be needed about how all the various concerns and challenges, faced by regulators and banks, could be solved in a mutually beneficial way with this technology.
It may not be obvious in the short-term why those up to their necks trying to meet existing regulatory deadlines should care about the future impact of blockchain technology. Realistically, the technology in its current form is still immature and not quite fully or widely understood enough to form the basis of regulatory reform. But this is changing.
However, if the sustainability of current regulatory initiatives ever comes into question – both in terms of regulators’ ability to efficiently govern and banks’ ability to profitably comply – then blockchain technologies may provide a timely and useful solution at an acceptable cost and risk to all parties.
* “Innovations in payment technologies and the emergence of digital currencies”, Bank of England Quarterly Bulletin, Q3 2014.
With 20 years’ experience in technology in investment banking, Darragh most recently worked in an architecture role at Deutsche Bank in the major financial hubs of London, New York and Hong Kong. Darragh is particularly interested in how technology innovation can give market participants a strategic advantage in the face of continuous regulatory reform.