Is blockchain the revolutionary technology that will rewrite the rules for the finance industry, identifying authenticity
and verifying payment flows that arise at a business-to-business level or between business and consumers and
peer-to-peer? The consequences of the blockchain evolution would significantly open the field for technology
platforms and reduce operational costs. This would also be a major challenge to the established institutions in
the consumer finance and business finance sectors. In order to be successful, this technology will need to overcome
a number of legal and regulatory issues.
What is blockchain?
Blockchain provides a new approach to holding and
authenticating data. It is a database operating through
distributed ledger technology in which data is recorded on
computers, by way of a peer-to-peer mechanism, based
on pre-agreed consensus algorithms in the applicable
participating network. It is a form of database where data is
stored in the chain in either fixed structures called 'blocks' or algorithm functions called 'hashes'.
Each block includes unique features such as its unique block
reference number, the time the block was created and
a link back to the previous block. Each block is reviewed
by a number of nodes and the block is only added to the
database if the node reaches consensus that the block only
contains valid transactions. Content includes digital assets
and instructions which reflect the transactions and parties to
those transactions. The ability to track back through previous
blocks in the chain makes it possible to identify transactions
back to the first ever transaction completed, enabling parties
to verify and establish the authenticity of the assets in the
latest block. This makes blockchain exceptionally accurate and
secure.
The blockchain is based on specialist users of the system
being able to apply advanced computing software to identify
time stamped blocks, verify the accuracy of the block using
sophisticated algorithms and add the verified block to the
chain. As the number of participants increases, the replication
of the data over a wider base makes it harder for any person
to alter the data in the chain. Any attempted addition or
modification to the information on a block needs to be
approved by all users in the network and verification of any
block can only happen through a 'proof of work' process.
As a result, the data is identified and authenticated in near
real-time, providing a permanent and incorruptible database
sufficiently robust to operate as a store of value (eg in
the case of cryptocurrencies such as Bitcoin) or providing
an indisputable record for example relating to securities
transfer and partnership. If the above description holds true,
blockchain provides a revolutionary technology that could
save the finance industry billions of dollars (for example, in
settlement and reporting costs) but may impact the need for
certain types of trusted third parties.
Important features
One of the most important features about blockchain is that
it is a decentralized system, created and maintained by users
of the network rather than being dependent on any central
or third party intermediary. The blockchain may be public
and open ('permissionless' or 'unpermissioned') or
structured within a private group ('permissioned').
Permissionless blockchains include Bitcoin and Ethereum, in
which anyone can set up a node that validates, observes and
submits transactions. The identities of the participants are not
known (other than the unique and random identities known
as an 'address'). Permissioned ledgers restrict participation
in the network and only the specific participants are given
access and are known within the network. The network is
private, and only organizations that have been authorized can
participate and view transactions. Permissioned technologies
include the Hyperledger Fabric project and the JPMorgan
Juno project.
The development of blockchain technology enables parties to
establish and transfer assets or information securely without
the need for a trusted third party such as a bank or registrar.
Verification is provided within the electronic system rather than
based on, for example, a bank to bank identification number.
Blockchain is best known for its role in establishing electronic
currency such as Bitcoin. As a means of creating and securely
transferring value on a fast and cost-efficient basis, it is viewed
as a disruptive technology that could replace major aspects of
the banking system. Blockchain may be used to improve various
functions such as currency exchange, trade execution,
peer-to-peer transfers and even enhance the application of and
compliance with anti-money laundering rules.
The impact on finance
Numerous financial institutions and entrepreneurs are now
actively engaged in developing or looking at ways to develop
blockchain technology in relation to traditional systems and
service deliveries.
Many banks are individually experimenting with blockchain
technology and a number of consortium activities are already
looking at alternative ways of holding and transferring financial
assets through this new technology.
With the Payment Services Directive II1 (PSD2) broadening
the definition of ‘payment services’ to include ‘payment initiation
services’2 and calling on banks to open up their application
programming interfaces (APIs) to third parties, there are
likely to be more opportunities for FinTech start-ups to challenge
existing bank architecture and data management, with the
possibility of introducing competing technologies and platforms
providing more efficient use and a better customer experience.
The R3 CEV Consortium has brought together 42 leading
financial institutions to develop blockchain technology relating
to banking and financial products. Tests have already been
completed to establish digital assets having characteristics similar
to commercial paper certificates.
The development of finance technologies such as blockchain
provides both threats and opportunities to the banking and
finance sector. Major operational advantages will include
faster completion of financial transactions such as securities
transfer and settlement, cheaper services and reduction in
errors. Examples of potential cost savings include the ability to
automate and verify large scale data pools such as the reporting
requirements brought in by EMIR and similar regulatory
requirements. ISDA is already looking at how the technology
might ease the burden on the industry of certain aspects of
the regulatory regime. This will make dealing with reporting
requirements more efficient and less cumbersome but also
more effective from a regulatory perspective.
Legal and regulatory issues
As with any major new technology, and particularly given
its possible impact on a heavily regulated sector such as the
finance industry, blockchain raises a number of legal and
regulatory issues that would need to be addressed. The UK
Government has published an extensive report, Distributed
Ledger Technology: beyond block chain, as prepared by its
Chief Scientific Advisor on Distributed Ledger Technology,
which outlines some of the challenges that blockchain creates
and faces.
- Jurisdictional application of the law
The basis of legal analysis with regard to the implementation
of blockchain which will be based in principles of contract and
title. These principles differ across jurisdictions and therefore
identifying the appropriate governing law is key to both
contract and property rights. In a decentralised environment,
such as a global computer network, it may be difficult to
identify the appropriate set of rules to apply. Similarly, in
relation to assets which typically apply the jurisdiction of
where the register is held, having no register and not being
able to identify a single place on which the data is held
presents some difficult legal questions, even at the level of
which law to apply.
Due to its decentralized nature, pinpointing which
jurisdiction would apply in the occasion of a breach or
fraud within the blockchain could be challenging. This will
require analysis of specific enacted legislation as well as
relying on treaty agreements and principles of public and
international law. The recent vote of the UK to leave the
European Union will further complicate these issues.
- Decentralized Autonomous Organizations (DAOs)
DAOs are essentially online, digital entities that operate
through the implementation of pre-coded rules. These
entities often need minimal to zero input into their
operation and they are used to execute smart contracts,
recording activity on the blockchain. DAOs can be
particularly challenging to regulate due to their undefined
legal status, which may be open to interpretation
depending on their software engine, the nature of
transactions they are completing or other unique features.
Questions of ownership and responsibility for DAOs can
also be brought to question if any technical issues arise
with their operation.
- Smart contract enforceability
Since smart contracts are prewritten computer codes,
their use may present enforceability questions if
attempting to analyze them within the traditional ‘contract’
definition. It remains unclear whether the elements
of capacity, including the ability to rely on apparent or
ostensible authority would apply. In dynamics contracts
involving third party issues such as offer and acceptance,
certainty and consideration would need to be considered.
- Transparency, data protection and privacy
A significant feature of open or permissionless blockchain
is that of anonymity – users on specific distributed ledger
platforms can enter the network and perform transactions
by using a pseudonym. As such, transparency and in
particular compliance with anti-money laundering rules
as well as taxation regulation can be particularly difficult
issues for regulators as well as enforcement authorities.
It is likely that whilst matching users on the network with
individuals could be complicated, this may be a minimum
requirement for regulated activities.
At the other end of the spectrum, where data on
individuals is required or made available, the parties
will have to provide comfort that data protection and
individuals’ privacy rights are not being breached. It is
likely that technology itself will not be able to secure
certain financial information, and contractual waivers and
consents are likely to go some way to providing data to be
processed within a blockchain architecture.
Response of the regulator
The report Distributed Ledger Technology: beyond block
chain examines the challenges posed by blockchain to
different industries such as government management (or
the conversion to 'smart government'), information and
telecommunications, financial markets and other uses
are examined. The Government Office for Science sees
blockchain as a catalyst for innovation and growth and has
initiated collaborative projects with private institutions for
exploring the opportunities.
Within Europe, the European Parliament appears to be
supportive of avoiding pre-emptive regulation around
blockchain, as published in the ECON committee’s report3.
In the report, Members of the European Parliament
expressed the view that imposing regulation on blockchain
would hinder its development, as its uses and potential
benefits are still being discovered. MEPs are, however,
conscious of treating blockchain with the usual level of
suspicion that surrounds new technology – particularly in the
financial markets – and this willingness to give the technology
some time to develop is a welcome angle to allow for its
development.
Speaking at the Experts Panel hosted by the London office
of DLA Piper on 13 May 2016, ‘Blockchain and the practical
implications of revolutionary technology for financial markets’,
MEP Dr. Kay Swinburne commented that the EU is currently
fostering a constructive debate on the developments around
blockchain and it remains high on the financial services
agenda, as set by the European Parliament and Commission
presidents.
Despite blockchain’s negative association with
cryptocurrencies such as Bitcoin in certain respects, this
distributed ledger technology is believed to have the ability
to develop into a mainstream product which could have
widespread implications, even as far as being a means to solve
developing countries’ problems, which Brussels is particularly
fascinated by. By eliminating the need for middlemen,
blockchain empowers the movement of funds directly from
the sender to the receiver, ensuring that cross-border foreign
aid is distributed in a more targeted and efficient manner,
reaching its intended beneficiaries directly.
In dealing with financial assets authorization for certain
types of activity will be required from the regulator and
passporting or multi-jurisdictional authorizations may be given
but identifying which entity is responsible for which function
becomes increasingly complex.
The ability to establish an authenticated indisputable
record in close to real time will also have the potential
to revolutionize the methods we have of reflecting
ownership of physical assets, ranging from the land registry
to car registrations, intellectual property rights, or shared
ownership amongst other things.
Conclusion
It is likely that blockchain will have a significant impact on
the finance sector, providing it resolves the current legal
and regulatory concerns. The most powerful implications
of blockchain will however, not simply be in providing the
technological basis for faster payment systems and the
development of electronic currencies such as Bitcoin, but
as a means of delivering secure information and instruction
which when combined with the development and adaption
of a range of technologies including artificial intelligence,
robocontracts and other technologies will see powerful
advances in interactions between individuals, businesses and
governing authorities.
We are trialing our own blockchain solutions for paperless
closings on transactions against other uses. If you would be
interested in taking part, please contact Martin Bartlam.
Ethereum |
Ethereum is an example of blockchain that supports smart contracts. In the Ethereum network users can create arbitrary contracts which can be used in a permissionless or permissioned group of users. Through the Ethereum Virtual Machine users can execute smart contracts that may also have ‘Ether’ digital currency attached to their execution.
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DAO |
Decentralized Autonomous Organizations are pre-coded entities that complete transactions within a network through the implementation of pre-written rules. They may require minimal to zero human input for their operation.
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Hyperledger 'Fusion' Project |
This is a project by Linux Foundation and it consists of code contributions from a number of companies such as IBM, JP Morgan and Digital Asset Holdings. As part of that project IBM has released Open Blockchain which is an open source permissioned ledger that also supports smart contracts.
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1 Directive (EU) 2015/2366 of the European Parliament and of the Council of 25 November 2015 on payment services in the internal market, amending Directives 2002/65/EC, 2009/110/EC and 2013/36/
EU and Regulation (EU) No 1093/2010, and repealing Directive 2007/64/EC
2 As referred to in point (3) of Article 4 of PSD2
3 Report on Virtual Currencies by the Committee on Economic and Monetary Affairs of the European Parliament, 3 May 2016
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