BIS Paper on Embedded Supervision of Blockchain-Based Financial Market
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 Article
Bank of Italy Updates Circular on Collection of Granular Credit DataRelated Articles
BIS and Central Banks Experiment with GenAI to Assess Climate Risks
A recent report from the Bank for International Settlements (BIS) Innovation Hub details Project Gaia, a collaboration between the BIS Innovation Hub Eurosystem Center and certain central banks in Europe
Nearly 25% G-SIBs Commit to Adopting TNFD Nature-Related Disclosures
Nature-related risks are increasing in severity and frequency, affecting businesses, capital providers, financial systems, and economies.
Singapore to Mandate Climate Disclosures from FY2025
Singapore recently took a significant step toward turning climate ambition into action, with the introduction of mandatory climate-related disclosures for listed and large non-listed companies
SEC Finalizes Climate-Related Disclosures Rule
The U.S. Securities and Exchange Commission (SEC) has finalized the long-awaited rule that mandates climate-related disclosures for domestic and foreign publicly listed companies in the U.S.
EBA Proposes Standards Related to Standardized Credit Risk Approach
The European Banking Authority (EBA) has been taking significant steps toward implementing the Basel III framework and strengthening the regulatory framework for credit institutions in the EU
US Regulators Release Stress Test Scenarios for Banks
The U.S. regulators recently released baseline and severely adverse scenarios, along with other details, for stress testing the banks in 2024. The relevant U.S. banking regulators are the Federal Reserve Bank (FED), the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC).
Asian Governments Aim for Interoperability in AI Governance Frameworks
The regulatory landscape for artificial intelligence (AI), including the generative kind, is evolving rapidly, with governments and regulators aiming to address the challenges and opportunities presented by this transformative technology.
EBA Proposes Operational Risk Standards Under Final Basel III Package
The European Union (EU) has been working on the final elements of Basel III standards, with endorsement of the Banking Package and the publication of the European Banking Authority (EBA) roadmap on Basel III implementation in December 2023.
EFRAG Proposes XBRL Taxonomy and Standard for Listed SMEs Under ESRS
The European Financial Reporting Advisory Group (EFRAG), which plays a crucial role in shaping corporate reporting standards in European Union (EU), is seeking comments, until May 21, 2024, on the Exposure Draft ESRS for listed SMEs.
ECB to Expand Climate Change Work in 2024-2025
Banking regulators worldwide are increasingly focusing on addressing, monitoring, and supervising the institutions' exposure to climate and environmental risks.
