Introduction

Earlier this year Data 61 issued its landmark report on distributed ledgers and the scenarios for the Australian economy over the coming decades. Perceptively, the government funded report noted that we are now living “in an era of rapid technology-fuelled change, which is creating complex strategy and policy choices for governments and companies.” The report added that an “explosion in device connectivity, data volumes, digital communication, e-commerce, computing power and overall internet use is reinventing the landscape for governments, companies, societies and individuals.” But the report also mentioned that it is not only the digital technology that matters but also the socio-economic drivers that create the demand for the technology which may be equally or more important. As the report stated, “digital business models that work best have understood people first and digital technology second.”

Since the publication of the Data 61 report it has been mentioned in the Australian press that several new blockchains have appeared in the financial markets to streamline processes and monitor asset provenance. Sydney-based Othera has built blockchain software now trading alternative assets. Othera’s Blockchain Lending Platform and Digital Asset Token Exchange uses JP Morgan’s private blockchain, called Quorum, and was recently joined by Credit Crowd, a commercial peer to peer lender.

The regulatory aspect of DLT

Distributed ledger technology (DLT) is a good example of rapidly developing technology which offers exciting potential to support the needs of consumers and the market. But DLT also presents new challenges and potential risks including how firms allocate responsibilities for systems shared among them. For the regulators, getting any new requirements in place will be a delicate balancing act between these two issues.

Recently the Australian Securities & Investments Commission (ASIC) issued a new information sheet (INFO 219) for both existing licensees and start-ups that are considering operating market infrastructure, or providing financial or consumer credit services, using DLT or blockchain. The information sheet explains that, broadly speaking, ASIC’s framework already requires entities to have adequate technological resources and risk management arrangements, as well as the necessary human resources and organisational competence. ASIC’s historical approach has been ‘technology neutral’, i.e. not to regulate specific technology types, only the activities they facilitate and the firms carrying out these activities. Whilst believing that its existing regulatory framework is able to accommodate the DLT use cases it has seen the regulator is using the information sheet as a starting point to consider what additional regulatory considerations may arise as DLT matures.

The UK perspective

In April the UK’s regulator, the Financial Conduct Authority (FCA), published a discussion paper on DLT. The purpose of the discussion paper was similar to the ASIC’s information sheet in that the regulator wanted to start a dialogue on DLT and its regulatory ramifications as the technology matures. Interestingly, the FCA organised the potential benefits and risks of DLT into the following categories:

1. Governance and technology resilience: firms will have to pay careful attention to allocating responsibilities given the absence of a central point of authority. There are also implications for firms regarding their third party service providers. For example, if a firm using a DLT platform relies on third parties to add, validate, safeguard ad preserve transactions, it will need to have sufficient oversight of these activities to fulfil its regulatory obligations. The firm’s overall IT and cyber arrangements will also have to be proportionate to the nature, scale and complexity of its business.
2. DLT and distributed data: DLT’s data sharing capabilities are particularly relevant in the reinsurance market where multiple reinsurers need to underwrite each reinsurance treaty. Common standards may be necessary for the insurance market to realise the benefits of DLT. Clear DLT standards for the management of contracts and risk data could significantly improve market functioning.
3. Regulatory reporting: it is expected that implementing a DLT solution to perform regulatory reporting would carry similar challenges and risks as implementing any other solution.  For example, managing the interface between a ‘front-office’ system which accepts orders and a DLT regulatory reporting system. In certain situations, this use case for DLT might enable a report to be generated at the same time as an order is placed. This might help firms to mitigate the potential operational risk of multiple legacy systems interacting with each other. However, it remains an open question whether firms would be willing to commit the significant capital which would be necessary to implement such a solution.
4. Record keeping and auditability: DLT offers the ability to aggregate and verify data from multiple sources and offer a shared view of the same record. It, therefore, has the potential to reduce discrepancies and costs substantially. DLT also has the ability to assign a record to a customer’s identity at a very granular level of detail and keep this detail throughout that record’s lifecycle.
5. Smart contracts: DLT can facilitate greater levels of automation through so-called ‘smart contracts’, a phrase which pre-dates the Bitcoin network by over a decade and relates chiefly to executing terms of legal contracts digitally.
6. The use of digital currencies to deliver financial services: buying and selling digital currencies themselves are activities outside the FCA’s regulatory perimeter as the digital currency in itself is not a regulated financial product. Derivative instruments that reference digital currencies though may be regulated financial products. The FCA reports that it has seen a risk of some consumers still perceiving digital currencies to be regulated financial investments. It has therefore posted warnings on its website. Where institutions engage in using digital currencies to deliver regulated financial services, while the digital currency trading element is not regulated, the FCA maintains an interest in the firm’s governance of the systems it uses, whether digital currency-based or not.

Initial coin offerings

Recently, it was reported in the press that ASIC’s chairman, Greg Medcraft, was monitoring closely so-called initial coin offerings (ICOs). Medcraft felt that if the ASIC followed the same definitions and guidance it has previously used when approaching cryptocurrencies then ICOs, as they are typically structured, would probably not fall under the regulator’s purview. However, if the position changed ASIC’s approach to regulating the offering would follow the same guidelines that it applies to any other financial instrument. He said: “If ICOs do come within our mandate, we would essentially take a technology neutral approach and say, ‘Alright, how can we get comfortable about the disclosure of the party issuing the coins? Have the risks been properly disclosed that are related to it? Are there particular conflicts of interests by the issuer?”

The global dimension

Given the cross border implications of DLT regulators across the globe are closely tracking developments. More recently the global standard setting body, the Financial Stability Board, issued a paper that identified 10 issues in the fintech space that merited authorities’ attention. Three of these issues were seen as priorities for international collaboration: (i) managing operational risk from third-party service providers; (ii) mitigating cyber risks; and (iii) monitoring macro-financial risks that could emerge as fintech activities increase. Interestingly, Annex E to the report contains a case study on DLT-based wholesale payment systems noting that, among other things, the Bank of Canada is undertaking a project to build a proof of concept of a wholesale interbank payment system using a distributed ledger and the Monetary Authority of Singapore has embarked on a collaborative project with industry to explore the use of DLT for the clearing and settlement of payments and securities.

As the Data 61 report said, technology is reinventing the landscape for governments, companies, societies and individuals. However, once technology develops further it may also reinvent the landscape for the regulators.