Distributed Ledgers & 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, enabling innovative extensions to Bitcoin. This enables the creation of applications built upon the core Bitcoin protocols that allow for the development of decentralized, 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 regulatoy 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 of particular interest to those involved in the regulatory space:
- Proof of existence
- Proof of process & 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 particularly useful, for example, where two parties entered into a contract with specific financial parameters. The blockchain technology allows the agreement to be rapidly andpermanently recorded without resorting to a third party to record 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 & 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 irrefutably demonstrates compliance with those processes, again without the need for a third party middleman.
This concept could be extended to include proof of audit/control, where each new version of a document can be shown 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 the 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 counter-parties.
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 to think 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 neck-deep in meeting existing regulatory deadlines should care about the future impact of blockchain technology: the reality is, the technology in its current form is still immature and not quite fully or widely understood enough to form the basis of regulatory reform, although this is changing.
However, if the sustainability of current regulatory initiatives ever comes into question – both in terms of regulator’s ability to effeciently govern them, and bank’s ability to profitably comply with them – then blockchain technologies may provide a timely and useful solution at acceptable cost and risk to all parties.
“Innovations in payment technologies and the emergence of digital currencies”, Bank of England Quarterly Bulletin, Q3 2014.