Blockchain, DLT and the regulatory landscape: At a point of convergence?

Blockchain and other forms of distributed ledger technology (DLT) have generated considerable interest within the FinTech community, as FinTech start-ups, market infrastructure providers, global banks and global payment and tech providers evaluate technology and potential use cases. But there remain many unanswered questions as to how DLT solutions will evolve to fit into the current regulatory and legal infrastructure. For the technology to progress towards productivity in 2017, broad industry collaboration and emerging regulatory certainty will be critical. DLT is at a point of convergence where the technology, commercial and legal worlds need to evolve to work together to deliver practical solutions.

Core characteristics of blockchain and other DLT systems

  1. Blockchain in simple terms is a technology that enables a shared ledger to be maintained by multiple parties and updated simultaneously so that each party can be confident that the record it holds matches the record which each other participant holds. It has the potential to create significant efficiencies in capital markets.
  2. New transactions are entered in blocks into the shared ledger once validated in accordance with agreed protocols, known as consensus, and are protected by encryption. These entries generate a timestamped record of history and audit trail, with the possibility of automatic identity verification.
  3. Blockchains can be permissioned, i.e. where only participants who are authorised in accordance with the relevant consensus protocols have access (which is most likely in capital markets use cases) or public blockchains i.e. where it is accessible to anyone who wishes to participate.

In October 2016, Hogan Lovells, Innovate Finance and EY published a white paper, Blockchain, DLT and the Capital Markets Journey: Navigating the regulatory and legal landscape, to help progress the understanding of the key legal and regulatory issues which will need to be addressed if blockchain, or other forms of DLT, are to deliver viable and valuable solutions in the complex and highlyregulated environment of capital markets. Achieving success in this area will either require developing solutions which conform to the regulatory framework or engaging with policymakers to reshape its contours. Although the report focuses on the UK’s regulatory and legal environment (including, where applicable, by reference to EU law) it acts as a stepping-stone to understanding the analysis to be applied in other markets as the issues and concepts identified in it tend to give rise to similar concerns in other jurisdictions. Given the need for international co-operation in responding to a global technology, the analysis should also help progress the thinking on the regulatory and legal issues to be navigated in other jurisdictions. The report identifies key themes to consider in this area and uses them to frame the analysis and recommendations for regulators and policy-makers. Although the report focusses on use cases for Capital Markets, similar issues arise for use cases in other areas of financial services, including payments where Blockchain and DLT technology was first developed. As with any FinTech solution, DLT will need to comply with the regulatory and legal framework which applies to the activity which it supports. This is a particular challenge for a “distributed” technology which, in most financial services use cases (particularly for capital markets and payments), would need to operate across national boundaries to be meaningfully useful. Whilst the regulatory agenda in financial services is increasingly co-ordinated at an international level, there is not yet one framework that serves all jurisdictions nor is there one form of DLT.

Significant elements of the regulatory landscape in the UK are defined by EU law, such as MiFID, EMIR and the Central Securities Depositories Regulation for capital markets and PSD for payments, as well as non-sector specific legislations such as the GDPR, none of which were drafted with DLT in mind. The regulatory framework needs to be re-examined in light of DLT developments. Regulators also need to understand where and how DLT can deliver benefit without introducing additional risk.

Brexit will add another layer of complexity, given its uncertain impact on existing EU and UK regulatory infrastructures. Much will depend on whether the UK mirrors existing EU law and regulation, as is intended initially under the proposed Great Repeal Bill, or diverges to form an independent regulatory perspective. Brexit may even present opportunities to launch DLT solutions in the UK if it enables legislation to be updated to reflect the emergence of DLT solutions and remove legal technicalities that obstruct implementation. It may be possible that this could be achieved even if the ultimate outcome of Brexit is that the UK needs to maintain an “equivalent” legal, regulatory and supervisory framework as that commitment would be based on “equivalence” of outcomes rather than being obliged to mirror the legislation. However, even if the UK government could draft new laws and regulations to support and enable the use of DLT technology the cross-border nature of the use cases for capital markets and payments mean that this alone would not be sufficient. Indeed, if Brexit were to result in a significantly divergent approach to regulating use of DLT in the UK and the EU, it may not be possible to realise potential cross-border efficiencies. More recognition of this technology in other jurisdictions would still be needed but, with regulatory support, the UK could be the fulcrum for its emergence on to a wider stage with its regulatory characteristics better understood.

DLT will have many impacts, at operational and strategic levels. Key themes to be considered when analysing the use of DLT in financial services include:

– Scope for disintermediation of market players.

– Certainty and immutability.

– Flexibility of smart contracts and redress the “code is law” proposition (spoiler alert: code is not law…).

– Regulatory uncertainty and potential compliance benefits.

– How competition law applies to permissioned DLT systems.

– Transparency and data privacy.

– Security and system resilience.

Understanding this complex matrix of legal issues supports the development of recommendations for industry and regulators covering legal, market impact, operational and regulatory matters. More detail of those, as they apply to capital markets, can be found in the report.

2017 looks set to be a pivotal year for DLT in capital markets, payments and wider financial services with the key to unlocking its potential dependent on navigating the regulatory and legal landscape whilst building on industry collaboration to deliver interoperability and robust governance structures.

 

What to do now

– Monitor how developments in blockchain/DLT may impact on your area of financial services, as use cases are emerging across financial services: capital markets, market infrastructure, trade finance, syndicated loans, insurance.

– Understand how proposed blockchain/DLT solutions in your area will fit with the legal and regulatory framework.

– Build engagement with regulators, domestic and international, to ensure that solutions being developed are coherent with policy objectives.

– Identify any areas where the proposed use cases fit with policy objectives but not the technical framework and engage with policy-makers to evolve the legislation.

– Engage with the Brexit process to ensure priorities are heard, eg on maintaining influence on developing common international standards.

– Collaborate on industry-level design decisions, including through relevant industry associations such as Innovate Finance, to help develop interoperable solutions and common standards.

– Ensure that the wider legal context is complied with, eg on competition law and data privacy.

– Develop robust governance structures appropriate to the use case.

 

This article was originally written as part of our 'Expect the Unexpected: The Year Ahead in Financial Institutions' booklet. This can be viewed here.  

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