Why should blockchain be regulated?

Baozou Commentary : Blockchain technology, or distributed ledger technology, is fundamentally a record-keeping system. The technology has great potential to replace the current financial system by updating records in real time through a smarter and more secure distributed database. The significant decentralized nature of blockchain has had a certain impact on regulators, but the technology will not become a threat to current financial regulators. On the contrary, its ability to reduce costs and increase revenue will stabilize their position in the regulatory system. It is unclear what actions regulators should take in the development of blockchain, but they must ensure that blockchain serves the interests of investors and the market.

Translation: Flora

This month, the Fed joined a chorus of governments around the world in expressing its views on blockchain, the distributed ledger technology that underpins the controversial bitcoin and is essentially a record-keeping system that uses a smarter distributed database that updates records in real time, replacing the central, regularly updated databases used by most financial systems today.

Blockchain advocates praise the technology’s ability to transform and upend the existing financial system by making expensive back-office functions redundant and replacing them with more efficient and secure distributed ledger designs.

In the face of the continuous development of blockchain, regulators have tried to strike a suitable posture. On the one hand, due to the lack of well-known commercial financial blockchain applications, regulation is out of the question. On the other hand, it is still unclear why and how regulation will change during the development of blockchain.

Disruption or technological development?

Blockchain as currently envisioned by financial institutions appears to represent a useful technological advancement, but it is unlikely to be disruptive. Real disruption comes from new players leveraging entirely new business models. In new models, players can cater to consumer needs with low-end products, which incumbents following traditional business models cannot do. Disruptors create new markets. One of the best examples is low-cost airlines, which have pioneered the market for budget travelers.

The open-source and open-access blockchain currency Bitcoin is still disruptive, and could allow the unbanked in developing countries to participate in the global financial system. But the closed, permissioned financial blockchain envisioned by the incumbents of the financial industry is not disruptive. Rather, it represents the continued evolution of database technology. The key difference is that blockchain will not be a threat to the incumbent financial leaders. Instead, the technology will stabilize their position by reducing costs and increasing revenue.

How will regulators oversee blockchain?

The main job of regulators is to ensure that blockchain financial systems cannot exploit loopholes in the existing regulatory system. Regulation is usually isolated from technology, so in the implementation of blockchain systems, the parts that look or act like common counterparties (CCPs) are not actually called this. In addition, there is a risk of repeating the shadow banking of the early 2000s.

The Fed report shows that there are many legal considerations in the process of determining the legal basis for some specific parts of the financial blockchain. In a distributed, decentralized system based on blockchain, intermediaries become redundant, and legal procedures for dealing with securities settlement systems, common counterparties, or central securities depositories will need to be updated. The elimination of common counterparties would also seem to raise systemic risk considerations.

Much of this remains unclear, especially whether regulators should or can take immediate action, since their actions are dependent on the specific implementation of the blockchain.

The maturing peer-to-peer (P2P) lending sector may offer insights into future regulatory issues. The P2P lending sector also promised disruption at the outset, but has gradually developed to the point where the lines between large P2P companies and heavily regulated traditional banks and collective investment schemes are blurring. Regulators are increasingly wary of regulatory arbitrage in the sector.

How does blockchain serve investors?

Financial blockchain business models may follow suit, but the interest regulators have shown in blockchain over the past 18 months suggests they are now ready.

As the investment professional standard with the responsibility of protecting investors, market fairness and market integrity, the Chartered Financial Analyst Institute (CFA Institute) believes that these goals should not be compromised in order to promote the advancement of a particular technology. Many features of blockchain, such as real-time settlement, are not unique to its design and can be achieved using other methods.

Therefore, blockchain may be more like a catalyst. It brings together disparate financial entities to create a new financial system in the 21st century. But the technology will not solve the ethical problem of what regulation means for financial markets, which has lasted for more than a hundred years. Regulators have no choice but to ensure that blockchain serves the interests of investors and markets.