On 16 September 2019 the Bank for International Settlements (BIS) published a working paper by its Monetary and Economic Department on Embedded supervision: how to build regulation into blockchain finance. The working paper suggests that asset tokenisation and the use of the underlying distributed ledger technology (DLT) in finance provides new avenues for the supervision of financial risks. The paper is intended to contribute to the ongoing discussion of the supervision of new financial products, such as crypto-assets, and the use of technology for the purposes of supervising the financial markets.
The paper argues that the current regulatory frameworks for the supervision of financial markets are not suitable for risks stemming from tokenised markets. Instead, the author proposes the concept of “embedded supervision”, which makes use of the technology underlying cryptoassets to better monitor risks in financial markets that make use of DLT to trade in asset-backed tokens. The concept of embedded supervision comprises of a regulatory framework that provides for compliance to be automatically monitored by reading the market’s ledger. It thereby reduces the burden imposed on firms to collect, verify and deliver this data. Embedded supervision would be based on four principles:
- Embedded supervision can only function as part of an overall regulatory framework that is backed up by an effective legal system and supporting institutions;
- Embedded supervision can be applied to decentralised markets that achieve economic finality, i.e. a transaction is considered final from that moment that it is considered that reversing this transaction will never be profitable again;
- 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; and
- Embedded supervision should promote low-cost compliance and a level playing field for small and large firms.
The author of the working paper designs a blockchain-based decentralised market in which financial contracts are verified by third parties in order to illustrate a possible practice application of embedded supervision. The model is designed in such a way that these contracts have reached their economic finality and that the third parties could not be bribed to reverse a transaction. Supervisors would have access to the verified data, but only the information required for supervisory purposes. The main legislative challenge in order to make the concept of embedded supervision operational is, according to the author, “to provide for the concept of decentralised economic finality in legislation governing financial market infrastructure, ie to allow for ownership to be transferred without the involvement of a central registry.”
Finally, the paper makes a remark on the trustworthiness of data used in the supervision process: where the validity of data is currently guaranteed by the legal system, relevant authorities and the threat of fines, data credibility in DLT-based markets should be ensured by economic incentives. Supervisors should assess which conditions are needed for making the economic consensus strong enough to guarantee this data quality.