Bank for International Settlements Proposes “Embedded Regulation” for Blockchain Markets

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    The Bank for International Settlements (BIS), an international financial institution owned by the world’s central banks, has published a working paper, called Embedded Supervision: How To Build Regulation Into Blockchain Finance, which supports the idea of constructing blockchain-based regulation into markets, by making the case for a regulatory framework that can open up new ways of supervising financial risks and provides compliance in tokenised markets to be automatically monitored by reading the market’s ledger, thus reducing the need for firms to actively collect, verify and deliver data. 

    A decentralised market is modelled that replaces today’s 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 market’s economic consensus would be strong enough to guarantee that transactions are economically final so that supervisors can trust the distributed ledger’s 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.

    The paper’s author, Raphael Auer, Principal Economist at the BIS, calls it “embedded supervision”.

    The paper sketches out the basic design for embedded supervision. It then models a distributed ledger-based financial market and shows under what conditions supervisors can trust the data from a distributed ledger.

    DLT makes possible the decentralised trading of asset-backed tokens, as well as decentralised financial engineering based on these tokens via self-executing contracts.

    As data credibility in such markets is assured by economic incentives, supervisors need to ensure that the market’s economic consensus is strong enough to guarantee the finality of transactions and resultant ownership positions. Only in this case can supervisors trust the quality of the data in the distributed ledger.

    To this end, the paper outlines a distributed and permissioned market in which “blocks” of financial contracts are verified by third parties. These verifiers stand to lose a set amount of verification capital should the blockchain ever be reversed, thus voiding existing transactions.

    …The paper’s main theoretical result is to show how much capital verifiers would have to stake so that no market participant would ever find it profitable to bribe them into reversing the transaction history. As transactions would then be economically final, supervisors could then trust the distributed ledger’s data.

    The full paper is available here.

    Regulating cryptocurrencies: assessing market reactions, Auer on Cryptocurrencies in 2018

    Hat tip to  Simon Zenios & Co LLC  for the lead on the article.