Preparing for Blockchain
by Ritt Keerati, CTSP Fellow | Permalink
Policy Considerations and Challenges for Financial Regulators (Part I)
Blockchain―a distributed ledger technology that maintains a continuously-growing list of records―is an emerging technology that has captured the imagination and investment of Silicon Valley and Wall Street. The technology has propelled the invention of virtual currencies such as Bitcoin and now holds promise to revolutionize a variety of industries including, most notably, the financial sector. Accompanying its disruptive potential, blockchain also carries significant implications and raises questions for policymakers. How will blockchain change the ways financial transactions are conducted? What risks will that pose to consumers and the financial system? How should the new technology be regulated? What roles should the government play in promoting and managing the technology?
Blockchain represents a disruptive technology because it enables the creation of a “trustless network.” The technology enables parties lacking pre-existing trust to transact with one another without the need for intermediaries or central authority. It may revolutionize how financial transactions are conducted, eliminate certain roles of existing institutions, improve transaction efficiencies, and reduce costs.
Despite its massive potential, blockchain is still in its early innings in terms of deployment. So far, the adoption of blockchain within the financial industry has been to facilitate business-to-business transactions or to improve record-keeping processes of existing financial institutions. Besides Bitcoin, direct-to-consumer applications remain limited, and such applications still rely on the existing financial infrastructure. For instance, although blockchain has the potential to disintermediate banks and enable customers to transfer money directly between each other, money transfer applications using blockchain are still linked to bank accounts. As a result, financial institutions still serve as gatekeepers, helping ensure regulatory compliance and consumer protection.
With that said, new use-cases of blockchain are emerging rapidly, and accompanying these developments are risks and challenges. From the regulators’ perspectives, below are some of the key risks that financial regulators must consider in dealing with the emergence of blockchain:
- Lack of Clarity on Compliance Requirements: New use-cases of blockchain—such as digital token and decentralized payment system—raise questions about applicability of the existing regulatory requirements. For instance, how should an application created by a community of developers to facilitate transfer of digital currencies be regulated? Who should be regulated, given that the software is created by a group of independent developers? How should state-level regulations be applied, especially if the states cannot identify the actual users given blockchain anonymity? Such lack of clarity could lead to the failure to comply and/or higher costs of compliance.
- Difficulty in Adjusting Regulations to Handle Industry Changes: The lack of effective engagement by the regulators could prevent them from acquiring sufficient knowledge about the technology to be able to issue proper rules and responses or to assist Congress in devising appropriate legislation. For instance, there remains a disagreement on how digital tokens should be treated: as currencies, commodities, or securities?
- Risks from Industry Front-running Policymakers: The lack of clarity on the existing regulatory framework, coupled with possible emergence of new regulations, could incentivize some industry players to “front-run” the regulators by rolling out their products before new guidelines emerge in hope of forcing the regulators to yield to industry demand. The most evident comparison is Uber, in which the application continues in violation of labor laws.
- Challenges arising from New Business Models: Blockchain will propel several new business models, some of which could pose regulatory challenges and unknown consequences. For instance, the emergence of a decentralized transaction system raises questions about how such a system should be regulated, how to confirm the identities of relevant parties, how to prevent fraud and money laundering, who to be responsible in the case of fraud and errors, and more.
- Potential Technical Issues: Blockchain is a new technology—it has been in existence for less than a decade. Therefore, the robustness of the technology has not yet been proven. In fact, there remain several issues to be resolved even with Bitcoin―the most recognized blockchain application―such as scalability, lag time, and other technical glitches. Moreover, features such as identity verification, privacy, and security also have not been fully integrated. Finally, the use of blockchain to upgrade the technical infrastructure also raises questions about interoperability, technology transition, and system robustness.
- Potential New Systemic Risks: Blockchain has the potential to transform the nature of the transaction network from a centralized to a decentralized system. In addition, it enhances the speed of transaction settlement and clearing and improves transaction visibility. Questions remain whether these features will increase or undermine the stability of the financial system. For instance, given the transaction expediency enabled by blockchain, will the regulators be able to analyze transactional data in real-time, and will they be able to respond quickly to prevent a potential disaster?
- Risks from Bad Actors: Any financial system is exposed to risks from bad actors; unfortunately, frauds, pyramid schemes, and scams are bound to happen. Because blockchain and digital currencies are new, such risks are potentially heightened as consumers, companies, and regulators are less familiar with the technology. The fact that blockchain changes the way people do business also raises questions about who should be responsible in the case of frauds, whether the damaged parties should be protected and compensated, and who should bear the responsibility of preventing such events and safeguarding consumers.
- Other Potential Challenges and Opportunities: Blockchain’s revolutionary potential could unveil other policy and societal challenges, not only in the financial industry but also to the society at large. For instance, blockchain could alter the roles of some financial intermediaries, such as banks and brokers, leading to job shrinkage and displacement. At the same time, it could provide other opportunities that would benefit society.
Because blockchain has the potential to transform several industries and because the technology is evolving rapidly, unified and consistent engagement by financial regulators is crucial. However, based on the current dynamics, there is a lack of unified and effective engagement by regulators and legislators in the development and deployment of blockchain technology. The regulators, therefore, must find better ways to interact with the financial and technology industries, balancing between (1) regulating too loosely and thereby introducing risks into the financial system, and (2) regulating too tightly and thereby stifling innovation. Such engagement should aim to help the government monitor activities within industry, learn about the technology and its use-cases, collaborate with industry players, and lead the industry to produce public benefits. Policy alternatives that would facilitate such engagement should aim to achieve the following three objectives:
- Engage Policymakers in Discussions on Blockchain in Unified and Effective Manners: The policy should promote collaboration between the regulators and industry participants as well as coordination across regulatory agencies. It should create a platform that allows the regulators to (1) convey clear and consistent messages to industry participants, (2) learn from such interaction and use the lessons learned to adjust their rules and responses, (3) provide appropriate recommendations to legislators to help them adjust the policy frameworks, if necessary.
- Allow Policymakers to Ensure Regulatory Compliance and Maintain Stability of the Financial System: Second, the policy should enable the regulators to ensure industry compliance. More importantly, it should preserve the stability of the financial system. This means that the policy should allow the regulators to anticipate and respond quickly to potential risks that may be introduced by the technology into the financial system.
- Promote Technological Innovation in Blockchain / distributed ledger technology: Finally, while the policy should aim to enhance the regulators’ understanding of the technology, it should refrain from undermining the industry’s incentives to innovate and utilize the technology. While regulatory compliance and consumer protection are crucial, they should not come at the price of innovation.
Part II of this series will discuss potential alternatives that policymakers may utilize to enhance collaboration among various regulatory agencies and to improve interactions with industry participants.
Policy Alternatives for Financial Regulators and Policymakers (Part II)
In Part I, we discussed potential regulatory concerns arising from the emergence of blockchain technology. Such issues include lack of clarity on compliance requirements, challenges in regulating new business models, potential technical glitches, potential new systemic risks, and challenges in controlling bad actors.
To mitigate these issues, effective interaction between regulators and industry participants is crucial. Currently, there is a lack of unified and effective engagement by regulators and policymakers in the development and deployment of blockchain. Soundly addressing these matters will require better collaboration among regulators and more frequent interactions with industry participants. Rather than maintaining status quo, policymakers may choose among these alternatives to enhance collaboration between the regulators and industry participants:
- Adjustment of Existing Regulatory Framework: Under this approach, the regulators either modify the existing laws or issue new laws to facilitate the emergence of the new technology. Examples of this approach include (1) the plan by the Office of the Comptroller of the Currency (OCC) to issue fintech charter to technology companies offering financial services and (2) the enactment of BitLicense regulation by the State of New York. Essentially, this policy alternative allows financial regulators to create a “derivative framework” based on existing regulations.
- Issuance of Regulatory Guideline: Because some regulations are ambiguous when applied to blockchain-based businesses, regulatory agencies may choose to provide preliminary perspectives on how they plan to regulate the new technology. This may come in the form of a statement specifying how the regulators plan to manage blockchain applications, how active or passive the regulators will engage with industry players, how strict or flexible the rules will be, what the key priorities are, and how the regulators plan to use the technology themselves. Such a guideline will provide industry participants with added clarity, while offering them flexibility and autonomy for self-regulation.
- Creation of Multi-Party Working Group: A multi-party working group represents an effort by regulatory agencies and industry participants to collaborate and arrive at a standard framework or shared best practices for technology development and regulation. Under this approach, various regulatory agencies would work together to formulate and issue a single policy framework for the industry. They may also collaborate with industry participants to learn from their experiences and take their feedbacks to adjust their policies accordingly.
- Establishment of Regulatory Sandbox: Several foreign regulators—such as the United Kingdom, Singapore, Australia, Hong Kong, France, and Canada—have established regulatory sandboxes to manage the emergence of blockchain. A sandbox essentially provides a well-defined space in which companies can experiment with new technology and business models in a relaxed regulatory environment and in some cases with support of the regulators for a period of time. This leads to several potential benefits, including: reduced time-to-market of new technology, reduced cost, better access to financing for companies, and more innovative products reaching the market.
Each of the aforementioned policy alternatives has different advantages and disadvantages. For instance, while status quo is clearly the easiest to implement, it fails to solve many policy problems arising from the existing regulatory framework. On the other hand, although a regulatory sandbox will be the most effective in promoting innovation while protecting consumers, it will also be the most difficult to implement and the costliest to scale. Given the trade-offs between these alternatives and the fact that these alternatives are not mutually exclusive, the best solution will likely be a combination of some or all of the above approaches. Specifically, this report recommends a three-prong approach, including:
- Issuance of Regulatory Guideline: Financial regulators should provide a general guideline of how they plan to regulate blockchain-based applications. Such guideline should include details such as: key priorities from the regulators’ perspectives (such as consumer protection and overall financial stability), the nature of engagement between the regulators and industry players (such as how active the regulators plan to monitor companies’ activities and how much leeway the industry will have for self-regulation), how the regulators plan to address potential issues that may arise (such as those arising from the incompatibility between the new business models and the existing regulations), and how industry players may correspond with the regulators to avoid noncompliance. To the extent that such an indication could come from the President, it would also provide consistency in the framework across agencies.
- Creation of Public-Private Working Group: The regulators should establish a public-private working group that would allow various financial regulatory agencies and industry players to interact, share insights and best practices, and brainstorm ideas to promote innovation and effective regulation. Participants in the working group will include representatives from various financial regulatory agencies as well as industry players. The working group will aim to promote knowledge sharing, while the actual authority will remain with each regulatory agency. It will also serve as a central point of contact when interacting with foreign and international agencies. Note that although similar working groups, such as the Blockchain Alliance, exist currently, they are typically spearheaded by the industry and geared toward promoting industry’s preferences. The regulators should instead create their own platform that would allow them to learn about the technology, discuss emerging risks and potential options, and explore potential policy options in an unbiased fashion.
- Enactment of Suitable Safe Harbor: Although blockchain may expose consumers and the financial system to some risks, regulators may not need to regulate every minute aspect of these new use-cases, particularly if the risks are small. Hence, under certain conditions, the regulators may consider creating safe harbor that would allow industry players to experiment with their ideas without being overly concerned with the regulatory burden while also limiting the risks to consumers and the financial system. For instance, with respect to money transfer applications, FinCEN may consider creating safe harbor for transactions below a certain amount.
This recommendation essentially aims to promote a prudent and flexible market-based solution. The recommendation affords industry players the freedom to operate within the existing regulatory environment, while also giving them greater clarity on the applicability of the regulations and enabling productive interaction with the regulators. It also allows the regulators to protect consumers and the financial system without stifling innovation. Lastly, this solution is viable within the existing political context and despite the complex regulatory regime that exists currently.
For policymakers, the most important near-term goal should be to ensure that regulators are well educated about blockchain and that they understand its trends and implications. With respect to regulatory compliance, policymakers should be attentive to the adoption of the technology by existing financial institutions, particularly in the area of money transfer, clearing and settlement of assets, and trade finance. Longer-term, Congress also ought to find ways to reform the existing financial regulatory framework and to consolidate both regulatory agencies and regulations in order to reduce cross-jurisdictional complexity and promote innovation and efficiency.
The emergence of blockchain and digital ledger technology represents a potential pivot-point in the ongoing global efforts to apply technology to improve the financial system. The United States has the opportunity to strengthen its leadership in the world of global finance by pursuing supportive policies that promote financial technology innovation, while making sure that consumers are protected and the financial system remains sound. This will require a policy framework that balances an open-market approach with a circumspect supervision. The next 5-10 years represents an opportune time for U.S. policymakers to evaluate their approaches toward financial regulation, pursue necessary reform and adjustment efforts, and work together with technology companies and financial institutions to make the United States both a global innovation hub and an international financial center.