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BIS Working Papers No 811 Embedded supervision: how to build regulation into blockchain finance by Raphael Auer Monetary and Economic Department September 2019 JEL classification: D40, D20, E42, E51, F31, G12, G18, G28, G32, G38, K22, K24, L10, L50, M40 Keywords: tokenisation, asset-backed tokens, cryptoassets, cryptocurrencies, regtech, suptech, regulation, supervision, Basel III, proportionality, blockchain, distributed ledger technology, central bank digital currencies, proof-of-work, proof-of-stake, permissioned DLT, economic consensus, economic finality, fintech, compliance, auditing, accounting, privacy, digitalisation, finance, banking BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS. This publication is available on the BIS website (bis). Bank for International Settlements 2019. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated. ISSN 1020-0959 (print) ISSN 1682-7678 (online) WP811 Embedded supervision: how to build regulation into blockchain finance i Embedded supervision: how to build regulation into blockchain finance 1Raphael Auer 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 markets 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 todays 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 markets economic consensus would be strong enough to guarantee that transactions are economically final, so that supervisors can trust the distributed ledgers 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 classification: D40, D20, E42, E51, F31, G12, G18, G28, G32, G38, K22, K24, L10, L50, M40. Keywords: tokenisation, asset-backed tokens, cryptoassets, cryptocurrencies, regtech, suptech, regulation, supervision, Basel III, proportionality, blockchain, distributed ledger technology, central bank digital currencies, proof-of-work, proof-of-stake, permissioned DLT, economic consensus, economic finality, fintech, compliance, auditing, accounting, privacy, digitalisation, finance, banking. 1Email: Raphael.auerbis. I thank David Archer, Ryan Banerjee, Morten Bech, Rainer Bhme, Dirk Broeders, Stijn Claessens, Johannes Ehrentraud, Marc Farag, Jon Frost, Leonardo Gambacorta, Marius Jurgilas, Thomas Leach, Henry Holden, Krista Hughes, Sbastien Kraenzlin, Joey Patel, Jermy Prenio, Joseph Noss, Tara Rice, Tarik Roukny, Hyun Song Shin, Philip Wooldridge, and an anonymous referee for the BIS working paper series; members of the Basel Committee for Banking Supervisions Task Force on Financial Technology, of the Financial Stability Boards Financial Innovation Network, and of the Financial Stability Institutes Suptech Network; as well as seminar participants at the Bank for International Settlements, the European Central Bank-University College London 2019 P2P Financial Systems conference, the Swiss Financial Markets Supervisory Authority, and the Swiss National Bank for comments. I further thank Alan Villegas and Giulio Cornelli for outstanding research support. The views expressed in this paper are those of the author and not necessarily those of the Bank for International Settlements. ii WP811 Embedded supervision: how to build regulation into blockchain finance Table of contents Introduction . 1 Embedded supervision of token ecosystems: a primer . 5 The trade-off between costs and data gaps in todays compliance process . 5 Compliance in DLT-based markets . 7 Embedding supervision in markets that achieve economic finality . 11 Economic finality in a permissioned market with decentralised verification . 12 Embedded supervision and economic finality. 17 Operational aspects: harnessing the fintech opportunity . 18 Conclusion . 20 References . 22 Appendix: glossary . 28 WP811 Embedded supervision: how to build regulation into blockchain finance 1 Introduction Authorities around the world today are grappling with the rise of distributed ledger technology (DLT) in finance. The challenge facing them is how best to apply technology-neutral regulation, so that similar risks are subject to the same regulation. 2This paper investigates how the “same risk, same regulation” principle might be applied to the financial supervision of DLT-based markets. It argues that, while regulation should remain technology-neutral, supervision should evolve in parallel with technology. 3Although DLT may not change the underlying risks, it might open up new ways of supervising these risks. 4So, instead of trying to fit cryptoassets into existing regulations, such as securities laws formulated long before the advent of DLT, it is worth asking how new technologies could serve to better monitor risks in financial markets. Based on these characteristics, this paper puts forward the concept of “embedded supervision”. This comprises a regulatory framework that provides for compliance to be automatically monitored by reading the markets ledger. As such, it reduces the need for firms to actively collect, verify and deliver data. DLT makes possible the decentralised trading of asset-backed tokens, as well as decentralised financial engineering based on these tokens via self-executing (“smart”) contracts. If such innovations take root, they will drive the development of financial markets via new forms of transparency and data credibility. The fundamental novelty is that DLT builds such credibility with a decentralised data structure based on economic consensus. Effectively, this harnesses the incentives of individual market participants to replace middleman-based data verification. Compliance monitoring would then be automated, by relying on the trust- creating mechanism of decentralised markets for supervisory purposes.For example, for the case of a bank that holds asset-backed tokens, compliance with the Basel III capital standards could be automatically verified. This would be done by computing the ownership of (borrowing and lending) balances and the associated risk weights in the relevant distributed ownership ledgers. Embedded supervision could ease the conflict between data availability, the cost of data collection and verification, and privacy. Compliance expenditure weighs heavily on financial institutions, and even more so on smaller firms. Supervisors thus face a trade-off between getting the data they need and keeping the costs of compliance within reasonable limits. Embedded supervision could further help 2The rise of so-called cryptocurrencies has also threatened to bypass existing legislation, in particularly with regard to anti-money laundering/know-your-customer (AML/KYC) legislation and facilitating illicit activity (see Mser et al (2013), Foley et al (2018) and Fanusie and Robinson (2018), thus calling for a response to level the playing field (see Carstens (2018a,b,c), Landau and Genais (2018), Auer and Claessens (2018 and 2019), and FATF (2018). 3Whereas “regulation” is the process of writing the rules that apply to the regulated entities, “supervision” is the enforcement of these rules. 4FIMNA (2018) and HM Treasury-Financial Conduct Authority-Bank of England Crypto-assets Taskforce (2018) apply existing regulatory frameworks to new DLT-based financial products according to underlying economic activity. They argue that, in most cases such as the funding of a business via an initial coin offering (ICO) or a traditional initial public offering (IPO) the choice of financial technology (ICO vs IPO) does not change the underlying risks. 2 WP811 Embedded supervision: how to build regulation into blockchain finance maintain the confidentiality of firms and their customers, since cryptographic tools can be used to report an institutions aggregated financial exposures to the supervisor without disclosing the underlying individual transactions. At this point, it should be noted that the concept of embedded supervision goes much further than simply reading a distributed ledger. The key issue is that data are not necessarily valid just because they are stored in multiple places. In todays compliance process, the datas trustworthiness is guaranteed by the legal system, the relevant authorities and the threat of legal penalties. In DLT-based markets, by contrast, data credibility is assured by economic incentives. In this world, the supervisors must primarily examine the conditions under which the markets economic consensus is strong enough to guarantee the quality of the data contained in the distributed ledger. But what principles should govern a regulatory framework designed to use a markets distributed ledger for financial supervision? This paper discusses four principles for the deployment of embedded supervision (see Table 1). Principles of embedded supervision Table 1 Embedded supervision is a regulatory framework that provides for compliance with regulatory standards in DLT- based markets to be automatically monitored by reading the markets ledger. It would reduce the administrative burden for firms, while increasing the quality of data available to the supervisor. Four principles would guide their use: Embedded supervision can only function as part of an overall regulatory framework that is backed up by an effective legal system and supporting institutions. DLT-based exchange can evidence the transfer of ownership of asset-backed tokens from one known entity to another, but the connection between the underlying asset and the digital token must be guaranteed by the legal system. Additional institutions may also be required, for example, to guarantee the accuracy of external reference points that are relevant to payoffs of smart contracts. Embedded supervision can be applied to decentralised markets that achieve economic finality. If there is no central intermediary to guarantee that a transfer of funds or securities has become irrevocable, an economic one must be applied. Following Auer (2019), economic finality means that a transaction can be considered as final once it is certain that, from a specific moment, it will never be profitable to undo. Embedded supervision needs to be designed within the context of economic market consensus, taking into account how the market will react to being automatically supervised. Embedded supervision creates incentives for a regulated firm to cheat the supervisor by altering the transaction history in the blockchain. Supervisors thus need to ensure that the markets economic consensus is so strong that any attempt to deceive the supervisor will be unprofitable. Embedded supervision should promote low-cost compliance and a level playing field for small and large firms. Embedded supervision should be designed to keep the fixed costs of compliance low. The supervisor may need to monitor aspects of decentralised markets such as the verification market and the governance of decentralised systems) to ensure a level playing field for entrants. Source: Authors elaboration. WP811 Embedded supervision: how to build regulation into blockchain finance 3 These applications run on “permissioned” DLT, in which peer-to-peer exchange is facilitated by decentralised economic consensus. At the same time, such systems retain an overarching coordination mechanism tied to the legal system that determines who can participate in the market and that guarantee the quality of the underlying assets. Hence, the first principle of embedded supervision is that it must be part of an adequate entity-based regulatory framework, backed up by an effective legal system and supporting institutions. Foremost, this means that asset “tokenisation” the process by which claims on real assets are digitally represented is validated by the legal system. Although cryptography and distributed ledgers can prove the transfer of asset-backed tokens from one entity to another, the connection between the underlying asset and the digital token must ultimately be guaranteed by the legal system which alone can underpin the ownership of assets such as real estate or shares in a brick-and-mortar business. Summing up, the first principle of embedded supervision calls for a proper understanding of what DLT-based trading can achieve, and what it cannot. Just as in todays system, a decentralised financial system would need to be solidly rooted in both the legal system and supporting institutions such as land registries or rating agencies. What differs from todays system is the operational setup of how these entities trade with each other, how such trading is recorded, and how misbehaviour is deterred. 5The second and third principles which constitute the papers core theoretical results concern the economic incentives at work to guarantee the finality of transactions in decentralised markets. For a supervisor to monitor compliance involving any set of transactions and ownerships, these transactions must be irrevocable and final (see CPMI-IOSCO (2012). If there i
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