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FCA releases paper on distributed ledger technology

This recent paper by the UK’s Financial Conduct Authority (FCA) aims to spur a dialogue on the future of distributed ledger technology (DLT) within particular markets. In these markets, the FCA’s role is that of the conduct regulator for 56,000 financial services firms and the prudential regulator for 24,000 of those firms. Beyond this, the FCA aims to initiate innovation and competition in financial services, through support for new technology solutions such as DLT.

The FCA’s Discussion Paper on Distributed Ledger Technology, released in April 2017, considers risks and opportunities for distributed ledger technology within the existing regulatory framework of FCA markets. As a rapidly developing technology, the FCA looks at how DLT fits within its strategic objective of ensuring that markets work well. As part of this objective, the FCA aims to make sure that consumers are protected, financial markets are protected, and that effective competition exists in the interest of consumers. Thus, innovations such as DLT encourage competition and support innovation within the financial ecosystem.

Distributed ledger technology (DLT)

With no formal definition of DLT, it may be described as a technological solution that combines existing tools such as cryptography and peer-to-peer networking to enable firms to share data securely. In this solution space, technology firms and investors in the technology have grown in number, while regulated firms have invested increasing amounts of resources in the technology. The report projects that the second half of 2017 will witness more movement from ‘Proof of Concept’ to real-world applications. Thus, amongst the purposes of the paper is to clarify risks and opportunities concerning the technology and how it impacts regulation.

Risks and Opportunities

To understand the potential applications and benefits of DLT, the discussion paper looks at the following key features of the technology:

  • Governance and technology resilience

For regulators, it is necessary to ensure that IT systems and cyber arrangements are proportionate to the scale and functions of their business, and to ensure the security and reliability of services. DLT is seen as a more resilient system than other currently available options, however there are also risks and considerations that come into play with the technology. As a shared system, DLT does not have a central point of authority, which raises questions about allocating responsibilities, regulatory obligations, and the relationship between firms and third parties. Furthermore, the report does not predict an immediate shift in business models but does emphasise the need to consider the operational and conduct risks of using DLT. Among the risks associated with DLT solutions are the possibility of code-based errors that may affect multiple firms, as well as the need to ensure appropriate encryption to counter cyber threats. Benefits of using DLT include enhanced cyber security through in-built cryptographic encryption for all records, in addition to the ability to pinpoint attacks on particular nodes of records.

  • Distributed data

Unique to DLT is the ability for regulated firms to share information selectively with other parties. Such information may include data in the form of order instructions, client information for anti-money laundering purposes, or investor transparency. Such data sharing removes costs associated with flows of information in areas like the insurance market, enables clearer views on contracts, and offers the ability for DLT to support new forms of risk transformation. Yet it must be said that investors who undertake data sharing in areas such as risk transformation will have to continue monitoring risks and capital markets in the area.

In terms of regulatory reporting, DLT enables compliance with obligations in a more cost-effective manner that enhances both efficiency and effectiveness. For example, DLT can replace paper trails and simplify auditing processes. However, a firm must also consider its ability to commit the necessary capital for such implementations. Moreover, a number of firms would need to adopt the solution for it to be effective and have clarity on using DLT-based solutions over other technologies.

  • Record-keeping and audit-ability

The report also discusses the advantages of record keeping within the financial ecosystem. By replacing manual, paper-based processes with DLT, firms can reduce costly record keeping processes and can minimise the risk associated with data loss. DLT offers the ability to aggregate and verify data from multiple sources and provides a shared view of the same record. It also assigns customer identities to gradual details of transactions, and can offer proof of ownership when customers place orders at fund and consumer levels simultaneously. This enhances transparency from a fund perspective and makes it easier to provide ‘direct to consumer’ services.

  • Smart contracts

The FCA report further assesses the manner in which DLT is able to facilitate greater levels of automation through so-called ‘smart contracts’, which can execute pre-determined commands without human intervention. However, firms need to be careful in considering where full automation is appropriate.

  • Digital currencies

Underpinning technologies such as Bitcoin or Ethereum, public DLT networks can be used to trade digital currencies for services, or to realise returns on capital. Depending on the directive of state laws, operators using digital currency services will need to monitor transactions through their businesses and identity, as buying and selling these currencies are activities that currently remain outside regulatory parameters.

Compatibility within existing regulatory framework

The report further highlights the importance of statutory objectives related to outcome rather than processes, in order to ensure consumer protection, market integrity, and competitive markets. In this regulatory framework, the FCA maintains ‘technology neutrality’ but also suggests that certain changes to the regulatory framework may need to be enacted as new markets and technologies arise. Amongst these examples is the allocation of responsibilities in shared networks, which are considered to be ‘trustless environments.’ To ensure better control, it is possible to interact on the basis of a code (e.g. the DAO). Other examples lie in the trading of digital assets, collateral management, and data protection.

Next Steps

The report emphasises its commitment to consumer protection, competition, and market competition, and does not see an immediate need for changes in regulations. However, as a young technology whose implications are not yet fully understood, firms must assess whether the benefits of DLT solutions outweigh the risks associated with its core features. Amongst these are the ability to share information securely and efficiently. A key question that exists around this technology is how far it is needed when compared to traditional technology; and, while it may offer some benefits, this may not be unique when combined with other available technology. Furthermore, the discussion acknowledges some areas of regulatory challenge regarding DLT adoption, and welcomes discussions and events that offer the opportunity to engage with stakeholders in this area.

To review the full FCA Discussion Paper on Distributed Ledger Technology, click here.

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