The future of DLT regulation

Vince Lucey, Managing Director, Innovation & Change

Blog / 12 Jun 2019

As distributed ledger technology becomes more widespread, regulators are scrutinising its impact. Rather than creating problems for regulators, this technology could enable them to achieve their goals

Nothing is certain except death and taxes, goes the famous quotation. In the finance industry, practitioners might add a third certainty: regulation.

The funds business is one of the most heavily regulated in the world. Since the onset of the global financial crisis a decade ago, the volume of rules that fund companies must follow has grown at a dizzying pace.

On the positive side, regulation protects customers, encourages constructive behaviour and contributes to greater market stability. Unfortunately, regulation also incurs costs and can reduce the investment being spent on innovation.

Distributed ledger technology (DLT), one of the most exciting innovations in financial markets, has already captured regulators’ attention. Companies working in this sector are hoping that regulatory bodies will support and not hinder their growth plans. Are they right to expect a positive outcome?

Open minds

The good news is that regulators in many parts of the world already recognise the potential of DLT. In February, lawmakers in Luxembourg voted to pass a bill that would facilitate greater use of DLT in the country’s financial services industry. Irish Funds, the association that represents Ireland’s funds businesses, has carried out a proof-of-concept that employs DLT to streamline regulatory reporting.

Elsewhere, regulatory bodies in jurisdictions such as Singapore and Hong Kong have signalled support for the innovative technology, which they hope will give their domestic industries an edge in an increasingly competitive, globalised world.

The approach of the Financial Conduct Authority (FCA) in the UK is perhaps typical of regulatory attitudes towards DLT. The authority has created a regulatory sandbox in which novel financial technologies can be trialled and has publicly recognised the potential of DLT to improve efficiency and reduce costs in financial markets.

The authority calls its approach “technology-neutral”. In common with other bodies of its kind, the FCA holds that its mission is not to regulate technology itself but to regulate the business models and client outcomes that arise when that technology is deployed. The technical details of DLT are not the authority’s focus. It is the implementations of DLT that will be scrutinised and deemed to be compliant or not.

As the result of a feedback-driven review, the FCA concluded that its existing rules were flexible enough to accommodate the use of DLT by regulated firms. The authority included permission-less networks in this guidance, providing operational risks were properly identified and mitigated. By implication, permission-based networks were viewed as much more likely to comply with its rules.

The authority’s message, which is broadly echoed by regulators elsewhere in the world, is that firms are welcome to test, develop and deploy systems based on DLT so long as these systems comply with existing regulation.

Tons of data

An open-minded approach by regulators is valuable because there are many potential use cases for DLT. Perhaps some of the most interesting deployments exist at the intersection between commercial and regulatory motives. There is a huge opportunity here because DLT is uniquely suited to achieving greater transparency. As such, it could even be a tool for regulators to use themselves to achieve greater investor protections.

One example concerns regulatory reporting. Regulators receive large quantities of data, often from multiple sources, which they can struggle to process effectively because of its volume and complexity. DLT could facilitate a central database that would allow the regulator to monitor the health of the industry in real time instead of receiving unmanageable quantities of data afterwards.

Another opportunity concerns the second version of the Markets in Financial Instruments Directive (MiFID II), which puts responsibilities on fund companies to prevent mis-selling and ensure all costs are disclosed to the end investor. By improving transparency in the value chain, DLT-based systems could help fund firms to meet their regulatory requirements in an efficient, cost-effective manner.

Then there is the question of AML and fraud. Regulators and private firms spend billions trying to prevent money laundering and other financial crimes. DLT-based systems could enable regulators to achieve their goals more efficiently. A central record of activity in the marketplace, facilitated by DLT, could make these investigations faster and more efficient, removing the need for the costly operations that are today required for transaction monitoring.

Smooth transition

These examples show that, far from being in tension with regulatory motives, DLT could actually help regulators and industry players achieve common goals. But this technology’s usefulness is not a guarantee that it will be regulated effectively.

Perhaps the greatest risk is too much regulation. As digital currencies such as Bitcoin surged in popularity, there appeared a genuine threat that regulators would act to control the burgeoning cryptocurrency industry in a way that would have spill-over implications for other DLT-based services, and perhaps even limit the potential of much safer implementations such as permission-based networks. Thankfully, the cryptocurrency craze has not yet resulted in punitive regulation of DLT services in general.

Nevertheless, to achieve a smooth transition to a world of effective DLT, financial technology firms may consider engaging in dialogue with regulators to ensure their needs are heard. By their own admission, regulators are still coming to grips with the new technology and generally welcome feedback from market participants. Indeed, many incumbent financial companies are themselves struggling to understand how DLT will affect their businesses. However there is a genuine desire to engage with DLT and other novel technologies. Sometimes the main hindrance is simply a lack of resources within firms.

Participating in regulatory sandboxes, partnering with regulators, and submitting feedback when it is requested can all help firms ensure that their industry is regulated in way that aids and does not constrain business growth.

Future trends

If the regulators and market participants can achieve a satisfactory balance between enabling innovation and protecting market stability, there are many exciting possibilities for investors in the implementation of DLT. In the future, systems based on DLT could enable new services such as micro-investing by dramatically reducing the cost of buying units in investment products. In the funds business, DLT also has the potential to revolutionise product development by streamlining back-office processes, thereby making it quicker and cheaper to improve client service and support the creation of new product types.

Calastone is playing an important role in the development of DLT within funds. In May 2019, the entire Calastone network of more than 1,800 financial organisations was migrated to a DLT-based system called the Distributed Market Infrastructure, which will realise significant efficiency gains while opening up new opportunities for users of the network.

The opportunities are numerous. The Distributed Market Infrastructure creates an accurate and reliable source of clean data about the funds market that could be invaluable to asset managers and asset servicing firms and may give rise to new business models and further innovation in the funds market. Given its “technology neutral” stance, the FCA has already signalled its openness to innovation based on DLT. That means businesses are free to explore the potential of the Distributed Market Infrastructure, providing their business models are compliant with existing regulation.

In some respects, the development of DLT can be compared to the innovations that followed the introduction of the iPhone in 2007. Technologists went on to develop use cases that had not been thought of when the iPhone was first demonstrated. Similarly, we expect the development of new use cases in DLT to come quickly.

All the things that come with DLT – efficiency, greater investor experience, transparency – are aligned to what regulators want and should continue to encourage them to perceive it positively.

 


Vince Lucey, Managing Director, Innovation & Change

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