Jusletter IT

As many traditional sectors undergo transformation through new technologies, the financial sector still runs mostly on time-proven frameworks, which seemed resistant to rapid technological innovation. These frameworks are, however, under growing pressure for cutting costs and simplifying their structure. An increasing attention is aimed towards the distributed ledger technology (DLT), which may be the key to making financial transactions, their settlement and many other aspects of financial services faster, safer, less complex and cheaper.

The original protocol, called blockchain, serves since 2009 as the framework for the distributed cryptocurrency Bitcoin.¹ Yet, it was soon recognized that the basic concept has much broader application. The technology represents a digital, cryptographic method of a decentralized, transparent ledger. This structure ensures trust in the records through mathematical means without the need for a third, trust-providing party such as central depository or clearing house. It further includes a high level of data security and allows for potentially almost instant record update and review.² The structural basis of this concept is the chain created by the encrypted data blocks holding the records, which is distributed on a multitude of storage devices within the network and kept up to date. The updates ensure that the chains of blocks within the network contain the same records and also that there was no manipulation of the already distributed records. Every update adding a subsequent block to the chain is verified by the network and accepted only if the preceding blocks correspond with the version distributed within the network.³ The blocks hold records which can range from simple, time-stamped transaction information to smart contracts.⁴ The specific features and structure of DLT projects vary based on their expected application. For the application in the financial industry, the ledgers do not feature free access and full transparency of the records like the original blockchain, but are mostly based on limited access available only to participating institutions, in a structure commonly referred to as permissioned distributed ledger. Furthermore, features like rules for creating the blocks, requirements for their validation by the network and network security are mostly solved differently to cryptocurrencies.⁵

The expectations about the impact of this technology on the financial industry are significant.⁶ In 2016, numerous international bodies⁷ and regulatory authorities⁸ released discussion papers and overview reports concerning DLT and its future role in the fintech⁹ industry. Most banks pursue some form of DLT implementation,¹⁰ either as an in-house project or in collaboration with other entities. The most prominent examples of the cooperative efforts are the Hyperledger project, a multi-industry project by the Linux Foundation,¹¹ R3, leading a consortium partnership with over 50 major financial institutions,¹² and the Post-trade Distributed Ledger Group, a group of nearly 40 financial institutions and market infrastructure players.¹³

There are a great number of fintech DLT projects under development, but more importantly, some projects focusing on issues ranging from global payment network,¹⁴ to insurance,¹⁵ to information sharing,¹⁶ to trade¹⁷ and to post-trade¹⁸ processing are already running a trial phase or have announced to do so in 2017.

Despite this innovative surge, there are still significant obstacles to widespread adoption of DLT. Some technological hurdles relate to characteristic features of this technology, mainly the inherent immutable nature of the entered records. There are, however, signals that such issues are not insurmountable.¹⁹ Problematic is also the functionality aspect of the broad distribution, because the individual ledgers cannot be efficient without available interoperability protocols and standards. Dealing with this issue remains the main objective of the cooperative efforts, with one possible solution being the open source distribution of the core elements, like in the case of the platform R3 Corda.²⁰

The new technological dimension of financial services presented by DLT poses the question of appropriate regulatory response. From a general perspective, the element of newness²¹ for the financial processes presented by this technological solution creates a necessity for regulatory reconnection.²² The variable and relentless innovation of technology in general requires constant adaptation of the regulatory regimes in order to manage their obsolescence;²³ so does the broad adoption of DLT. The lack of a corresponding regulatory framework would inevitably lead to some form of «pacing problem».²⁴

The influence of the regulator on the technological design is more likely to be embraced during the early phase of the adoption.²⁵ Yet, at this stage, the regulating authority is provided only with limited information on the final form of the transformation regarding the regulated environment, which leads to difficulties in terms of forming a suitable regulatory framework.²⁶ The regulatory authority is thereby faced with an uncertainty paradox,²⁷ as reformulation of the regulatory regime is needed, but the changing technological landscape is providing a limited ground for specific rules.

This has been recognized on the European regulatory²⁸ as well as the legislative level. The European Parliament adopted on 26 May 2016 a resolution on virtual currencies,²⁹ which summarized opportunities and risks related to the DLT based innovations, going beyond the scope of virtual currencies and envisioning further potential uses in the area of financial services. In this resolution, the European Parliament formulated basic outlines of the smart regulation of DLT, which should be proportionate, avoiding stifling the innovation, but responsive to challenges created by the widespread use of DLT.

In order to approach the regulation of DLT in accordance with the concept foreseen in the resolution, an overall assessment is needed to determine how the new technology fits into the pre-existing legal and regulatory landscape of the more generally applicable rules.³⁰ The initial assessment of the situation was already included in the resolution. According to this the current European legislation for the financial sector could provide a basic regulatory framework for DLT based platforms, but additional tailor-made legislation might be needed. Beyond that, a more in-depth analysis is necessary and it is therefore suitable that the resolution also forms a basis for the creation of a horizontal Task Force on DLT under the European Commission. This should facilitate expert discussion across sectors, identify standards for best practice, but most importantly, assess the existing European regulation and suggest appropriate updates in response to widespread DLT adoption. Given the essential role of the assessment, which the task force is meant to provide, to the formulation of a smart regulation for DLT, the gradual process of formation of this task force is rather disconcerting. This is due to the increasing urgency of such analysis, bearing in mind that delayed regulatory response may be facing an established technology design, modifications of which may be increasingly difficult to implement.

At the same time, the amendment of the regulation should not be limited to a specific use of the technology. The increasing pace of technological innovation is likely to turn use-specific rules soon obsolete, intensifying the division between applicable rules and reality. There are also other arguments for a more technology and purpose neutral approach,³¹ or, at least, for regulatory framework, which is designed to flexibly adapt to changing technological possibilities. The resolution of the European Parliament mentioned above is primarily focused on the application of DLT to virtual currencies, where its use is currently most advanced. However, as I attempted to present in this contribution, the relevance of this technology is much broader and the alternative applications need to be taken into consideration during the formation of the smart regulation. Otherwise the regulatory framework for DLT could fall short of its target.

For the gap between technological and regulatory dimension to stop widening, a smart approach to smart regulation is needed, one that allows for rules that are applicable beyond the scope of the imminent technological horizon, as many potential forms of this and other new technologies will always remain unobservable from today’s perspective.³²

This contribution was aimed at providing a short overview of the current potential of the distributed ledger technology in the financial sector and a limited discussion of the European smart regulation. Significant attention is being devoted to DLT by major commercial as well as institutional entities, with the first examples of later phase implementations already being introduced. Current measures taken towards smart regulation of DLT in the European Union signal progress in the right direction, yet further steps are needed before long, in order to create a regulatory environment that is reflecting the change about to be brought by this new technology in the financial sector.