Regulators Raise Red Flags

Now the wave of white-noise that broke over Blockchain has washed up on the rocks of reality, a review of the more considered comments provided by the world’s leading financial services securities industry regulators may be appropriate.

These regulators started raising red warning flags over the applicability of this technology to the securities trading in the wholesale financial services sector about 6 months ago, starting with the European Central Bank at the SIBOS conference, Geneva September 2016.

Here, Yves Mersch, a member of the ECB Executive Board, in a keynote address stated:

there are substantial operational, governance and legal aspects which need to be carefully looked at…the Eurosystem cannot, at this stage consider using DLT in the market infrastructure”

Many of these points, particularly the difficulties around system governance had been raised repeatedly in the preceding months. Oliver Wyman[1]commented in February 2016:

As the mechanisms currently stand, records are irrevocable once entered…… this has implications for judicial interventions in the event of disputes. Regulators will not accept a mechanism that prevents their lawful intervention

This was supported by Hogan Lovells a few months later where they stated[2] :

Regulators will want to ensure that any DLT system has an effective governance arrangement and there will need to be clarity as to which entity or entities take regulatory responsibility for the orderly operation of this

The ECB’s primary concern however appears to be market fragmentation however with Mersch commenting:

A multitude of different DLT approaches and models could jeopardise financial market integration by increasing fragmentation

Near identical concerns were then raised by the DTCC in Q2-17, when Larry Thompson[3] said:

The industry’s embrace of an assortment of Blockchains and software solutions relying on a multitude of standards would further complicate the existing market structure

A cynic might regard this as a somewhat self-serving comment, with the DTCC attempting to position itself as the “distributed ledger provider of choice” for securities trading – but the point has validity, as evidenced by comments from Shigehiro Kuwabana, Executive Director at the Bank of Japan[4]:

No doubt DLT is an innovative technology …. however it cannot be said to have yet reached the superiority required to replace the centralised system

This reflects the position reached by the Bank of International Settlements, Committee on Payments and Market Infrastructure. In a 23 page report[5] released a month before Kuwabana’s comments the committee concluded:

The risks associated with payment, clearing and settlement activities are the same irrespective of whether this activity occurs on a single or central ledger, or on a sychronised distributed ledger”

The BIS went on to conclude that the DLT approach suffered from the further demerit of introducing additional risks including:

  • Uncertainty about operational and security issues
  • Lack of interoperability with legacy platforms
  • Ambiguity relating to settlement finality
  • Soundness of the legal underpinnings
  • Absence of a robust governance framework
  • Issues relating to data integrity
  • Concerns about data immutability
  • Issues surrounding data sharing and privacy

Although R3 Corda is seeking to address a number of these[6], most have yet to be addressed by any the current DLT proposals[7] despite these issues having been extant for over 12 months.

This is evidenced by the 2016 European Securities and Markets Authority list of the challenges facing the applicability of the technology to the securities markets:

  • Lack of interoperability across ledgers and with legacy platforms
  • Lack of data privacy
  • Uncertainty of legality and enforceability of contracts and records
  • Unspecified governance processes

Adding:

  • Unproven ability to scale
  • Lack of a recourse mechanism
  • Inability to net derivatives
  • Impossibility of short selling
  • Difficulties in managing margins
  • Lack of anonymity

In September 2016, the Politecnicodi Milano published its review the applicability of DLT to the securities markets[8].

In a particularly damning paragraph the Politecnicodi Milano comments that the bitcoin consensus approach, having being rejected by all proposed DLT solutions results in the worst possible scenario:

a single authoritative ledger massively duplicated among network nodes (introduces) the risk of combining together the worst of two scenarios: the single authoritive ledger could be hacked, with any appeal to an alternative independent data source being invalid

Following this with:

the only widely accepted opinion is that any form of ‘decentralised consensus’ must provide a recourse mechanism to some form of centralised higher authority, an oxymoron which does not yet exist

Even if the technical issues relating to scalability, inoperability, ambiguity of settlement and so on can be addressed, any DLT solution still needs to overcome the hurdle or regulatory acceptance. Currently this appears to be insurmountable.

By definition any DLT solution needs to be able to operate across national boundaries. Although the international regulatory agenda is increasingly co-ordinated, an overarching international framework simply doesn’t exist – and even if it did, a single DLT solution that such a framework could consider has yet to be implemented.

This is without considering the benefits of the existing centralised approach. The existing centralised arrangements offer significantly more than simply clearing. These facilities offer counterparty netting, transfer payments, increased exposure transparency with the resulting reductions on balance sheet demands.

Additionally centralised securities depositories in Europe are mandatory[9] meaning that should a DLT solution seek to disintermediate this function, this would only be possible if significant legislative change is introduced. The chances of this are minuscule.

There is also a bigger issue to address. Whilst simultaneous execution and settlement may contain counterparty risk, DLT does not eliminate this risk. Each contracting party will still be required to fund its positions and perform its contractual obligations. Proposing to the securities industry regulators, on a global basis, that the existing regulatory infrastructure needs to be completely overhauled to facilitate the introduction of DLT – a technology that introduces additional layers of risk not currently extant in the existing arrangements – on the basis that there is a counterbalancing benefit of a containment of settlement risk, is a proposition that has little chance of success.

Given this it is little wonder the DTCC Vice Chairman Larry Thompson concluded in his Frankfurt address:

Understanding how the technology fits into existing regulatory frameworks will be critical. We do not expect that the regulatory framework which has been created over the past 70 years will change significantly…to make way for an embrace of DLT”.

 

 

 

 

 

[1] See “Blockchain in Capital Market” February 2016

[2] Blockchain DLT and the Capital Market Journey published in conjunction with EY October 2016

[3] DTCC Vice Chairman speaking in Frankfurt April 2017

[4] March 2017

[5] Distributed Ledger Technology in Payment Clearing and Settlements

[6] Specifically soundness of legal underpinning and privacy of data

[7] There are differences separating a Blockchain implementation from a Distributed Ledger Technology. Whilst it is the case that all Blockchains are distributed ledgers, not all Distributed Ledger Technologies are Blockchains. Detailing these differences is out of scope for this paper

[8] Response to ESMA / 2016 / 773 Distributed Ledger Technology Applied to Securities Markets

[9] Central Securities Depositories Regulation

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