BIS Paper on Embedded Supervision of Blockchain-Based Financial Market

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