Are We Ready for Code-Based Regulation?

By: Jesse Chenard

Blockchain is one technology where we are seeing nations as potential early adopters. Thanks to the promises of the technology, regulators have taken an active interest in the technology. But they have to do more than wait and watch

Are we ready for code-based regulation? – CIO&Leader
An estimated two billion people have no access to banks and hence rely on cash and inefficient transfer systems to participate in their economies. These people effectively operate outside the financial system, making it impossible for central banks to regulate their economic activity.

Facing such challenges, regulators are at a crossroads. Will they embrace new technologies that could make banking more inclusive, efficient, secure, and transparent, or will they preserve the status quo?

At the forefront of this regulatory debate is the emergence of blockchain technology as a solution to many of the challenges facing the legacy systems and processes of financial marketplaces around the world. Gartner has called blockchain one of the top 10 most important trends in 2017 and financial services firms have estimated that cost savings from implementing blockchain technology will run in the tens of billions of dollars.

In the highly-regulated ecosystem of financial services, one of the biggest challenges is establishing legal and regulatory frameworks for new technologies.

Old ways for new technologies

Many regulators globally have taken a cautious wait-and-see approach to blockchain and smart contract technologies. Countries like China and Russia have been slow to embrace regulations while still demonstrating strong interest in the potential of these new technologies. Fintech companies in these hotbeds have largely been self-regulating, often with disastrous consequences.

Other jurisdictions, however, have already begun to take a more active approach. Some regulators have proceeded by simply creating new regulations similar to those applied to existing systems, such as the approach New York State has taken with Bitlicense. Unfortunately, this has had the effect of limiting innovation and preventing new entrants into the market place.

In Luxembourg, the government has been very favorable to innovation and Fintech in general. Instead of forging new regulations, they apply existing Payment Institution Licenses to these new businesses. Meanwhile, the European Central Bank and European Securities and Markets Authority have taken a “wait and see” approach. Unfortunately, without regulators to clarify the rules and create an ecosystem where innovation can thrive, adoption can be difficult if not impossible.

Others have been far more proactive. In France for example, the financial regulatory bodies have launched initiatives to assist Fintech companies with regulatory issues and the Banque de France has piloted blockchain technology with several French banks. However, none of these approaches fully embraces the technology itself, instead focusing on existing archaic complex regulatory burdens. Indeed, companies looking to solve a simple problem can end up spending more of their time attempting to comply with rules that are only tangentially related instead of focusing on the solutions they provide.

Regulatory Sandboxes – One step closer

Many regulators are taking a proactive approach to exploring new technologies without intruding on innovation. The most promising approaches are regulatory sandbox environments that allow businesses to test disruptive technologies in a pre-production environment under regulatory supervision while ensuring financial stability and protection for consumers.

In the UK, the Financial Conduct Authority was the first regulatory body to introduce a sandbox. Similar measures have been announced in Australia, UAE, Hong Kong, Malaysia, Indonesia, and Thailand.

Code-based regulation

As regulators fully understand specific requirements and document them through new regulations, they can take the further step of implementing these regulations directly into the code used by the blockchain participants.

Financial transactions currently move across a plethora of networks with a variety of databases and multiple points of failure, many of them still manual. But with the power of blockchain and distributed ledger technology, these processes can be automated, saving time and money. For blockchain and smart contract technology to reach its full potential, standards must be agreed upon by those on either side of a transaction engendering a new era of cooperation between financial institutions and regulators.

With smart contracts and blockchain technology, regulators can bake the rules and regulations directly into the code of the transactions. Automatic reporting of certain transactions could occur rather than being routed through an entire compliance department before getting to the regulators. Illegal activity could be prevented before it starts. In addition to having full visibility and transparency into the financial transactions themselves, the governments of these forward-thinking countries would be able to take real-time snapshots of the entire economy and readjust their monetary and fiscal policies dynamically instead of responding to monthly, quarterly, or even yearly reports.

Nations as early-adopters

The implications for entire nations and everything from stock exchanges to insurance companies are clearly far reaching and nobody wants to be left behind. In some cases, these developments may lead to a technological leap, much like the advent of cell phones in Africa enabled leapfrogging traditional telecommunication infrastructures.

Perhaps due in part to a nationwide problem with bad assets or recent attempts to demonetize the economy to curb tax evasion and corruption, Indian regulators have taken an interest in blockchain technologies. A number of local and international banks have taken steps towards establishing such a network and initial results are quite promising.

Other nations around the world are close on India’s heels. Some financial centers, such as Singapore and Dubai are moving to become Fintech hubs and take some of the limelight away from more traditional financial centers like London and New York.

The Onus, the Risk, and the Liability

Although no one expects to see immediate changes in regulations and procedures, when governments and regulators have real-time access to transactional information from the marketplace, a decrease in risk can reasonably be anticipated. For example, most nations require suspicious activity to be reported within 30-60 days. In the US, financial service providers have 30 days to file a Suspicious Activity Report with FinCEN, but what happens if the regulators already have real-time access to that information?

Although the onus and liability will likely remain with financial service providers to comply with existing requirements and the legal responsibility for their actions cannot be borne by the regulators, with blockchain technology, both regulators and market participants can reduce their exposure to risk and loss.

Given that the goal for regulators is to foster a more efficient marketplace, and a less risky marketplace is a more efficient marketplace, it’s no wonder that regulators and financial institutions across the globe are focusing on how to best leverage and implement distributed ledger technology.

(The author is the CEO of Blockchain solutions company, MonetaGo. The company’s technology was used by IDRBT, RBI’s research arm for a blockchain trial earlier this year)