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Building blocks: developing systems using distributed ledger technology

Within financial services, the potential uses of blockchain appear infinite. But does it help reduce risk or create new issues?

March 2016

The publication of the Government Chief Scientific Adviser's report on distributed ledger technology is a welcome signal that the UK sees potential for blockchain.

As the Bank of England mentioned in its Quarterly Report in September 2014 (see our previous article on virtual currencies), there seems to be significant 'next mover' advantage with blockchain as it moves beyond the world of virtual currencies. As it asks fundamental questions about the shape of settlement operations, the Bank of England is planning to make use of and gain from its next mover position, as seen in the "New Heart for a Changing Payments System" speech by Minouche Shafik. Quite an endorsement, so we anticipate other regulators, such as the UK's Payments Systems Regulator, will spark debate about the use of blockchain technology in their field.

Blockchain's method for recording data to form a digital ledger (of transactions, agreements, contracts or anything that needs to be independently recorded and verified as having happened) has a number of useful features:

  • it is very transparent – as it is in the 'cloud', everyone in the network can have access to an up to date version of the ledger;
  • it is hard to doctor the information – making it less susceptible to fraud;
  • the ledger does not need to reveal underlying transaction data – so it is appealing from a data and information security perspective.

When jumping on this trend, as developer, to insource or to form a consortium, there will be slightly dull but important housekeeping issues to take care of – and they are easier dealt with up front than when haunting you at a later date. We'll discuss a just few of these.

  • Disruptive development pushes at the edge of the regulatory perimeter – it may be worth taking time to work with regulators (e.g. through the FCA's Sandbox proposals) or to anticipate the direction of regulation so that it does not quickly make your model obsolete. To ensure technology leads – and regulators follow closely - encourage trials and develop interest with government, central bank and regulatory support.
  • Any system that clearly reduces money laundering and tax evasion and makes economic activities more transparent is likely to meet with regulatory approval in line with their objectives. Take time to demonstrate how your system helps this.
  • Ensure it is clear to you – and to any regulators - how your blockchain proposals work alongside or interface with traditional systems, if required.
  • Blockchain has been picked up faster than predicted – regulators, users and investors will want to know whether your system will be robust and how easily and quickly it can upscale or contract. Blockchain is inherently nimble, efficient and cost-effective. Stakeholders want to be able to see this as an advantage not a deficiency.
  • Blockchain could eliminate the need for ledger reconciliation and clearing, offering potential for decentralisation and cutting out the middle man, thereby removing the need for a trusted third party, bringing speed and cost savings. Would the regulator still be relevant? How do politicians, regulators and central bankers feel about this? It wipes out aspects of the premise on which MiFID II, EMIR or even PSD2 have been brought forward. Perhaps as the concept of Organised Trading Facility has been scoped for MiFID II, further iterations of legislation, MiFID III or EMIR 2, will capture blockchain.
  • Blockchain's cloud approach appears to reduce hardware needs in certain areas. Merchants, utilities providers and employers (as key users of the systems needed to swill cash around the real economy) should be incentivised to fully embrace this sort of modernisation. A pull factor is that blockchain allows for greater certainty of payments receipt, less fraud, fewer mistakes, better cash flow management, and less credit risk. The revised Payment Services Directive (PSD2) should go some way to help with this. There is certainly an intention to ensure that additional participants can use digital payment services to compete alongside banks and other traditional providers. Hopefully, PSD2 is agile enough to encompass blockchain based payments methodologies so that the legislation is not outmoded before it is even implemented. No one fancies PSD 3 yet.
  • There has been much coverage of IT infrastructure issues within the banking system both on a firm level and at the Bank of England (Real Time Gross Settlement system). Technology investment is as big an issue for firms as is regulatory reporting. Blockchain will facilitate moving the debate forward. Access to an open transparent ledger of transactions would be useful for regulators and would really help advance regtech.
  • A question is how to approach your ledger network – should it be open or with permissions i.e. by invitation? How will you enforce a decision across a diversified architecture of equals? How do you deal with malicious actors? How would you protect the integrity of the system?
  • The regulatory regime is said to be technology neutral, in the UK at least. However, it is not easy to see how blockchain fits in to the current structure. In the UK, clearing, investment exchanges and settlement are dealt with differently to activities such as operating a multilateral trading facility or operating a P2P lending platform.

    Part of building confidence and longevity is anticipating how the operators of the infrastructure or the blockchain system itself, as opposed to the actual regulation of the ledger, may be treated under the regulatory structure and within that it really depends what the blockchain is being used for. When it is nearing a critical mass of influence, one thing's for sure, it will be wedged into the regulatory perimeter somehow although it really doesn't obviously fit into the existing structure.

    Many of the concepts in regulation are clearly desirable for an emerging system – conviction about the stability (capital or liquidity) of the provider (as part of financial services infrastructure) could be significant – do you bring blockchain into prudential supervision by the Bank of England (as clearing houses), or the PRA (like banks) or the FCA (as investment exchanges)? Or perhaps this is better handled within the General Prohibition and regulated activities regime (e.g. something akin to the article 36H permissions required for operating an electronic system in relation to lending)?

    Whichever is preferred, we'd suggest a lightweight regime, making maximum use of concepts like the FCA's Sandbox or the PRA's new bank start up unit and lighter touch regimes (e.g., small firm concepts in AIFMD, PSD, e-money etc).

  • How big is your imagination? Potential areas of deployment seem fairly inexhaustible across niche wholesale or volume retail product and services: 'services accessibility passports', cross border payments, foreign exchange, managing product or authenticity warranties, Big Data. Is its impact being considered as part of your existing projects and commercial predictions and planned capital investment?
  • Is blockchain a new Fintech buzzword or will this be the technology that survives? What is the digital technology of the future? Take lessons from the BBC Doomsday project (1984-86) which used laserdiscs as storage – about 30 years later, now almost no tech is available to play these. Build in a planned process of data preservation to deal with technological updates – always bearing in mind IT is not infallible.

Detractors say that blockchain could cause its own set of financial stability risks and weaken monetary policy making, if significant usage occurs. Some might suspect that stakeholders may even work to prevent widespread adoption to avoid issues caused by price volatility, low liquidity, longer term higher transaction costs or a finite amount of links in the chain. Naturally, any system needs to have an air of permanence, simplicity, an understandable regulatory regimen and a comprehendible approach to ascertaining price and value.

The final piece of the jigsaw is that current thinking on blockchain appears to have found the fragment missing from a lot of fintech innovation: how to add real value. For now, official moves appearing to embrace blockchain, however prudently (e.g. virtual currencies), are refreshing.

Unquestionably, regulators, firms and potential users should strive to ensure this technology is harnessed to create a viable system, with users conducting their business or personal financial services activities with confidence and security. This is not overly ambitious and, without a doubt someone will utilise blockchain within a leading-edge, intelligent and involved mass market setting (with genuine prospects of longevity) within five years. It is too soon to forecast the passing of traditional systems; but smartphones changed telecoms within a very short time span. Blockchain has great potential.

If you have any questions on this article please contact us.

Issues to consider when developing systems using blockchain
Jonathan Rogers

Jonathan Rogers

Jonathan looks at regulatory issues for blockchain systems developers, particularly for financial services.

"Without a doubt someone will utilise blockchain within a leading-edge, intelligent and involved setting... within five years."