Financial regulations in the new generation of Blockchain

January 19, 2018

Blockchain technology is a nascent technology that is providing evolving applications in finance every day. Several regulators have already signaled their intention to examine the use of blockchain, also referred to as distributed ledger technology (DLT). While potentially attractive to regulators due to increased transaction security and reduced risk of manipulation, this new technology gives rise to difficult legal challenges that regulators are grappling to understand. This short article analyses the regulators’ approach to blockchain.

Regulatory perspective

It is clear that regulators will pay close attention to the development and use of DLT in the regulated sector. Regulators have generally avoided regulating technology itself and have paid attention to the uses and products that may be promoted or developed across the technology platform.

While the market monitors potential regulatory developments, effective governance is the key to the successful implementation of DLT to protect participants, investors and stakeholders while ensuring that the system is resilient in the face of systemic risk, privacy concerns and cybersecurity threats.

The development of the regulatory approach is still unclear, but it is incumbent on the industry as a whole to monitor applications to which blockchain may be put and avoid products and processes that are abusive or will lead to systemic risk. Otherwise, we can expect heavy- handed regulation that will limit the future development of the technology and the benefits it can provide.

 

Regulating Blockchain Technology Worldwide

Blockchain is the technology of choice for many startups. As per research by Outlier Ventures Research Team in May to June of 2016, 200 new startups were added in six weeks. Businesses and startups popped up around the virtual technology and sprouted with lightning speed. While many countries are supporting the development of the digital currencies, thus encouraging new ways of transacting and new businesses to bud, there are some that have boycotted the new technology, deeming it as an illegal negative disruption that brings financial instability and global economic unrest.

The Trading of Financial Instruments: A Highly Regulated Sector

A financial instrument is a contract that gives rise to a financial asset or equity instrument. According to the EU definition,¹ the category of “financial instruments” includes a large range of products: transferable securities, options, futures, swaps, forward, derivatives and contracts for differences.

Every activity dealing with financial instruments is highly regulated. For example, activities like financial investment advisers and portfolio managers all require preliminary approval by national regulators. This is also true for advertising and marketing of financial products.

The use of blockchain technology in the markets induces a change of paradigm. Since the development of blockchain-based “disintermediation” exchanges, the current regulatory regime appears to be ill-suited to facilitating growth and innovation in the Fintech community.

Exchanges Using Blockchain: New Benefits, New Paradigm and an Ill-suited Legal Framework

The blockchain technology brings new properties to the operation of market platforms. New platform that allows participants to enter financial contracts deployed on a blockchain introduces various innovations and brings major  benefits compared to traditional exchanges. Regulators have taken note of the numerous benefits of using blockchain technology in financial markets.

The main point is that exchanging through an “on-chain” platform eliminates the need for an intermediary to ensure the execution of the transactions.

Other benefits include enhanced resilience and secured transactions. Thanks to the distributed verification of transactions, there is no need for a centralized trusted third party to hold the funds and verify the transactions. The post-trades processes are more efficient: by using the blockchain, the clearing and settlement of any transaction is accelerated since the trade confirmation as well as the allocation and settlement can be combined in a single step. Furthermore, the enforcement of the transaction does not rely on a third party: transactions are automatically executed on a blockchain.

The emerging trust dynamics are not accounted for in existing financial regulationsThe European set of rules for regulated markets are designed in order to achieve two major objectives:

  • protecting investors and safeguarding market integrity by establishing harmonised requirements governing the activities of authorised intermediaries; and
  • promoting fair, transparent, efficient, and integrated financial markets⁵.

The concept of a decentralized platform based on blockchain technology transforms the classic paradigm of financial exchanges. Blockchain can provide trust through its inherent structure, and may remove the necessity for a third-party intermediary. Blockchain disintermediates transactions. Because blockchains are decentralized and immutable, counterparties can transact with each other without the need of a third party for guaranteeing that transactions will be executed, and without requiring financial guarantees from the counterparties.

A Call for a New Regulation

All over the world, governments and regulators have become aware of the potential impacts of blockchain technology on financial markets. They are also aware of the need to renew and redesign the regulatory landscape.

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