Alex Batlin’s Briefing of Crypto 2.0 Musings Regulation

Alex Batlin’s Briefing of Crypto 2.0 Musings Regulation

by April 5, 2016

The importance of understanding and working with, not around regulation, in FinTech cannot be overstated in my opinion. You can develop the best technology in the world, but it will be useless unless it can be applied once it touches regulated environments. Regulation itself is impacted by the wider geo-political context e.g. G20 priorities, so any new technology that can align itself with existing regulation, or better still enable its emerging requirements is likely to be widely adopted.

Author: Alex Batlin

G20 Priorities in Reforms

Let’s consider one of G20’s key priorities that is driving regulation today – financial stability. According t0 FSB, at the St. Petersburg Summit, G20 leaders agreed on the priorities for completing the core elements of reforms:

  • Building resilience of financial institutions
  • Ending too-big-to-fail
  • Transforming shadow banking to transparent and resilient market-based financing
  • Making derivatives markets safer

Blockchain promises

Blockchain promises to address in part all of the above elements.

  • Autonomous and distributed nature of blockchain solutions can significantly reduce operational risk as no single person or organisation is able to circumvent process or alter agreed state, and there is no single point of failure – an example of High Availability and Business Continuity patterns. In the most extreme case, you may not need to reply on banks to keep ledgers of value ownership, that task can be performed by a trusted blockchain network.
  • Regulatory KYC, AML, sanctions and investor suitability checks, as well as mandatory VAT payment processes can be baked into blockchain managed asset classes, replacing expensive detection and cure with prevention, therefore reducing costs and improving reliability.
  • All transactions on blockchain can be made visible to all participants, so you can achieve unparalleled transparency and data availability.  Regulators can become nodes in the network to monitor for systemic risk in near real-time, improving data quality and decision making, whilst reducing reporting costs for the service providers. For the first time it may be possible to track provenance of collateral as it is hypothecated and re-hypothecated to avoid dangerous levels of over-leveraging.

Blockchain technology, by massively lowering the cost of building trusted intermediary businesses, can also go a long way to achieving another of G20’s key goals – financial inclusion. The organisation formed to spearhead this initiative, GPFI, makes the following points:

2.5 billion adults globally – about half the total adult population – have no access to financial services delivered by regulated financial institutions.  … Due to a lack of access, the poor are forced to rely on moneylenders for credit at high rates of interest. … The absence of financial inclusion can also contribute to slower economic growth and persistent income inequality.

This potential of blockchain technology is not lost on governments and regulators – I can personally vouch for this as I have had the amazing opportunity to discuss blockchain related matters with numerous central banks, regulators and government representatives at events hosted by the likes of Bank of England, FCA and 10 Downing Street.

The good news it that the potential appears to be there, and the right people are listening, however now comes the hard part. Just because the technology seems to address current and future regulatory challenges, unless it can be recognised by regulators as an acceptable approach, nothing much will happen.

For the last few months I have been advising pro bono Heal Alliance on the blockchain aspects of the Heal Bond. They are working with a number of partners including FCA, to figure out how to raise money and end HIV by issuing a bond to pay for research into a cure.

The idea behind using blockchain is to drastically reduce the intermediation costs of issuing and servicing bonds to maximize money for research in a regulator inclusive way – a term coined by Hyder Jaffrey. To achieve the cost reductions you cannot simply bypass todays regulated financial markets infrastructure (FMI) utilities and avoid associated intermediation costs, so what can you do?

Blockchain – Short-term and long-term solution in regulation

A short term solution may take advantage of lightly regulated products like mini-bonds, where the use of blockchain may overcome the lack of trust in a startup to manage vast amounts of money, and also decrease servicing costs through automation afforded by blockchain.

The longer term solution in my opinion is not to look for lightly regulated asset classes, or drop regulation, but instead change the process of becoming a regulated entity. Take electronic money institution application process – if you expect your business to not exceed an average of €5m of outstanding e-money, you may apply to register as a small EMI, a quicker and cheaper process compared to full EMI status.

Same principle can be applied to blockchain based businesses. For example, it’s technically possible to create say a bond on blockchain that acts as it’s own security depository, custodian, servicing agent and delivery versus payment escrow agent because it matches through inversion of control all of the conduct requirements that todays FMIs provide.

Ability to meet technically the requirements, does not translate to regulatory compliance – in the worst case scenario each newly issued bond would need to be regulated under such a scenario as it’s own securities depository, custodian, central clearing house etc. – impractical under current regime in terms of time and cost.

However, what if the regulation application process stipulated that if you code a a set of smart contracts that conform to a certain regulator specified interface, register them with approved registry contracts, deploy them to an approved by regulator blockchain network and see them pass automated formal proof checks, see formal verification for solidity contracts blog, then the whole regulation application process can be fully automated and become very cheap and super fast – a bit like submitting a mobile app today for inclusion into an app store.

Imagine if you could represent your asset as a set of complaint smart contracts and if you deploy them in an approved manner, within minutes you create a brand new regulated construct that is able to act as it’s own depository, custodian, escrow, notary etc. and the only intermediary fees you pay are the blockchain transaction fees.

In other words, you don’t remove regulation, you don’t change regulation as such, you change how you apply to become regulated. In some ways this feels very radical, on the other hand you could argue the end result would be far more deterministic as you no longer rely on subjective assessment of a description of promises that a system aims to deliver, and instead rely on cold and hard formal mathematical proofs of conformity and safety of crowds – something we simply could not do before.

(This blog post has been first published on Linkedin Pulse and was republished with the allowance of Alex Batlin and is his personal view)

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See more: Alex Batlin’s Briefing of Bitcoin and Money Creation

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