BIS published a working paper that investigates ways to regulate and supervise blockchain-based financial markets. The paper argues that asset tokenization and underlying distributed ledger technology (DLT) open up new ways of supervising financial risks. It makes the case for "embedded supervision"—that is, a framework that allows compliance with regulatory goals to be automatically monitored by reading the ledger of a market, thus reducing the need for firms to actively collect, verify, and deliver 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.
Embedded supervision is distinct from other forms of suptech or regtech, which aim to use machine learning or artificial intelligence to more efficiently monitor the financial industry. The key principle of embedded supervision is to rely on the trust-creating mechanism of decentralized markets for regulatory purposes too. If DLT-based markets were to develop, this would change the way assets are traded and how they are packaged into complex financial products. In DLT-based markets, data credibility is assured by economic incentives. This paper discusses the following four principles for deployment of embedded supervision:
- 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 decentralized markets that achieve economic finality.
- Embedded supervision needs to be designed in the context of economic market consensus, taking into account how the market will react to being automatically supervised.
- Embedded supervision should promote low-cost compliance and a level playing field for small and large firms.
In most jurisdictions, the legal setup is such that a single and regulated clearing and settlement provider is required to verify that an irreversible transfer of ownership has occurred. DLT, however, achieves such a transfer via the economic incentives of verifiers rather than by the authority of a central institution. Only if the principles of finality underlying the regulation and supervision of financial markets infrastructures are modified to recognize decentralized exchange could DLT ever gain traction in regulated finance. Along with this, regulators and supervisors would also have to design rules regarding the assignment of responsibility in decentralized markets in the case of illegal activity.
To implement embedded supervision, regulators would also be required to acquire substantial technological know-how and the willingness to adjust their operational approach to the technology that is being developed by the financial sector. Many supervisors worldwide are open to this possibility and some are already developing the requisite sandboxes. One example is “LBchain,” a blockchain-based sandbox of the Bank of Lithuania, which seeks to embed regulatory infrastructure in a DLT-based market. The benefits might include lower costs for market participants and supervisors, real-time monitoring, deeper insights into the use of internal models, and improved detection of potential window-dressing and other abuses.
Related Link: Working Paper
Keywords: International, Banking, Securities, Blockchain, Embedded Supervision, Regtech, Suptech, Research, Distributed Ledger Technology, Regulatory Sandbox, BIS
Previous ArticleBIS Hosts Conference to Discuss Issues from Emergence of Stablecoins
BCBS amended the guidelines on sound management of risks related to money laundering and financing of terrorism (ML/FT).
US Agencies (Farm Credit Administration, FDIC, FED, FHFA, and OCC) finalized changes to the swap margin rule to facilitate implementation of prudent risk management strategies at banks and other entities with significant swap activities.
PRA published a letter that builds on the expectations set out in the supervisory statement (SS3/19) on enhancing banks' and insurers' approaches to managing the financial risks from climate change.
EBA finalized the guidelines on treatment of structural foreign-exchange (FX) positions under Article 352(2) of the Capital Requirements Regulation (CRR).
FSB published a statement on the impact of COVID-19 pandemic on global benchmark transition.
IAIS published the list of Internationally Active Insurance Groups (IAIGs) publicly disclosed by group-wide supervisors.
FED has temporarily revised the reporting form on consolidated financial statements for holding companies (FR Y-9C; OMB No. 7100-0128).
EC launched a consultation on the review of the key elements of Solvency II Directive, with the comment period ending on October 21, 2020.
ECB launched a consultation on the guide that sets out supervisory approach to consolidation projects in the banking sector.
IAIS published technical specifications, questionnaires, and templates for 2020 Insurance Capital Standard (ICS) and Aggregation Method data collections.