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Embedded supervision: how to build regulation into blockchain finance

Summary:
BIS Working Papers  |  No 811  |  16 September 2019 by  Raphael Auer PDF full text (1,011kb)  |  33 pages Focus How might blockchain-based financial markets be regulated and supervised? This paper argues that asset tokenisation and underlying distributed ledger technology (DLT) open up new ways of supervising financial risks. It then puts the case for "embedded supervision", ie a framework that allows compliance with regulatory goals to be automatically monitored by reading the market's ledger, thus reducing the need for firms to actively collect, verify and deliver data. Contribution

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BIS Working Papers  |  No 811  | 
16 September 2019
PDF full text
 (1,011kb)
 |  33 pages

Focus

How might blockchain-based financial markets be regulated and supervised? This paper argues that asset tokenisation and underlying distributed ledger technology (DLT) open up new ways of supervising financial risks. It then puts the case for "embedded supervision", ie a framework that allows compliance with regulatory goals to be automatically monitored by reading the market's ledger, thus reducing the need for firms to actively collect, verify and deliver data.

Contribution

The paper sketches out the basic design for embedded supervision. It then models a distributed ledger-based financial market, and shows under what conditions supervisors can trust the data from a distributed ledger.

DLT makes possible the decentralised trading of asset-backed tokens, as well as decentralised financial engineering based on these tokens via self-executing contracts.

As data credibility in such markets is assured by economic incentives, supervisors need to ensure that the market's economic consensus is strong enough to guarantee the finality of transactions and resultant ownership positions. Only in this case can supervisors trust the quality of the data in the distributed ledger.

To this end, the paper outlines a distributed and permissioned market in which "blocks" of financial contracts are verified by third parties. These verifiers stand to lose a set amount of verification capital should the blockchain ever be reversed, thus voiding existing transactions.

Findings

The paper's main theoretical result is to show how much capital verifiers would have to stake so that no market participant would ever find it profitable to bribe them into reversing the transaction history. As transactions would then be economically final, supervisors could then trust the distributed ledger's data.

The paper also discusses what kind of legislative and other arrangements would be needed to promote low-cost supervision, data privacy, and a level playing field for both small and large firms. It argues that the main challenges would be to embed the concept of economic finality in the legal system and how to design rules for assigning responsibility in decentralised markets.


Abstract

The spread of distributed ledger technology (DLT) in finance could help to improve the efficiency and quality of supervision. This paper makes the case for embedded supervision, ie a regulatory framework that provides for compliance in tokenised markets to be automatically monitored by reading the market's ledger, thus reducing the need for firms to actively collect, verify and deliver data. After sketching out a design for such schemes, the paper explores the conditions under which distributed ledger data might be used to monitor compliance. To this end, a decentralised market is modelled that replaces today's intermediary-based verification of legal data with blockchain-enabled data credibility based on economic consensus. The key results set out the conditions under which the market's economic consensus would be strong enough to guarantee that transactions are economically final, so that supervisors can trust the distributed ledger's data. The paper concludes with a discussion of the legislative and operational requirements that would promote low-cost supervision and a level playing field for small and large firms.

JEL codes: D40, D20, E42, E51, F31, G12, G18, G28, G32, G38, K22, K24, L10, L50, M40

Keywords: tokenisation, asset-backed tokens, stablecoins, cryptoassets, cryptocurrencies, regtech, suptech, regulation, supervision, Basel III, proportionality, blockchain, distributed ledger technology, digital currencies, proof-of-work, proof-of-stake, permissioned DLT, economic consensus, economic finality, fintech, compliance, auditing, accounting, privacy, digitalisation, finance, banking

International Settlement
The Bank for International Settlements (BIS) is an international company limited by shares owned by central banks which "fosters international monetary and financial cooperation and serves as a bank for central banks". The BIS carries out its work through subcommittees, the secretariats it hosts and through an annual general meeting of all member banks. It also provides banking services, but only to central banks and other international organizations. It is based in Basel, Switzerland, with representative offices in Hong Kong and Mexico City.

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