Sometimes regulation is the necessary impetus to unleash the growth of groundbreaking innovations. It took an Act of Parliament to authorise the build of a train line from Liverpool to Manchester, the first modern railway. It is said that the build of such a railway not only served to connect two great industrial towns for the movement of goods but also heralded the beginning of passenger rail travel.
You could argue, however, that the Internet evolved in absence of government intervention, it was (it appears) a collaborative project and benefited, in fact, foremost from deregulation. The Internet Society, an instrumental guide in the development of an ‘open’ internet, advocated that the internet was for everyone. With an organisation now spanning across many countries with 80k members that voice surely had a sway in how the technology evolved. Regarding deregulation, in financial services, this saw the 2009 meltdown, but in telecoms and the internet, deregulation fostered the growth of both sectors (Skype has been, infact, a large beneficiary of telecoms deregulation). For the Internet movement, one pivotal moment was the hand over of the DNS system, invented by P. Mockapetris, from the control of the US government, to a private body called ICANN.
So sometimes innovation requires governments to lead the charge, sometimes it may require them to step back.
Where is distributed ledger heading?
W3 and Linux Foundation are helping with the standardisation of distributed ledger technology but that is just the software. Networks require collaboration to grow. Just as we have seen the Internet grow, a similar form of collaboration is required for the Internet of Value.
And the role of Regulators?
Currently, the view of regulators is to encourage innovation in fintech by restrained supervision, this is the ethos of the ‘Sandbox’. Some countries view a Sandbox as a non-intervention environment until the initiative has scale and other view it as ongoing light monitoring. The stated purpose of the Sandboxes are roughly to encourage competition in the financial services markets and reduce barriers to entry. As such, regulation in financial services may be now turning more towards proportionality as a guiding principle rather than by-the-letter compliance. The FCA started this trend with principle-based regulation and now, with the Sandbox, we will see an even lighter touch model, which could be simply amount to a signed statement of intent by a startup to endeavour to protect consumers.
The volte face of lighter touch regulation is for the regulator to have a closer hand on innovative businesses and understand clearly the barriers they face. In Australia, ASIC’s Innovation Hub saw that the barriers facing fintech businesses were speed to market and meeting “organisational competence” requirements. It is the empirical understanding of the experience of innovators in technology that leads to a more informed, better adapted set of rules for the market.
What happens when consumers are at risk?
The difficulty here is the tendency for knee-jerk policies to address particular incidents, such as the stupendous loss/theft of $60m in the first decentralised organisation run solely by computer code: theDAO. To not react could be seen to be ambivalent, to react may be to usurp the opportunity of the technology to mature.
The stark difference between the Internet as a communication network and the Internet of Value is that ‘value’ is at stake, which means unavoidably that consumers are at risk. Reading some of the posts after theDao fallout, I noted a mention of a French investor who had put in 1/3 of his lifesavings in theDAO. Innovations are fun until someone gets badly hurt.
This is not to say that theDAO was or was not subject to regulation as a potential investment scheme; it conceivably was, but that did not prevent the ‘innovators’ from releasing the code and building the first hedge fund without a manager.
Rolling back a few years, in a similar vein of defiance to authority, centralised cryptocurrency was always head-to-head with regulation until bitcoin decentralised the ownership and maintenance of a digital cash system, that simple necessity to circumvent regulation led to the wondrous creation of the blockchain, the most raved about feature by governments and industry alike.
Where to from here?
Technical standardisation of distributed ledger technology in its various permutations, whether Interledger, Hyperledger or Corda, will be the trajectory for now. Addressing the scalability issues of distributed ledgers are internal challenges that may involve re-inventing the web with, for instance, IPFS – but the intervention of regulators here is largely uncontroversial.
Thereafter, when the software is deployed into networks and financial assets are more widely recorded on distributed ledgers then the regulators will need to be heavily involved in the conversation.
From the letter to the spirit of regulations
The technology is, to a degree, already ready to deploy so some discretion is required from regulators. For that to happen, the requirements of ‘how’ financial instruments should be created and recorded needs to be clarified by domestic regulators. In the US, the CFTC’s Commissioner Giancarlo, was very vocal about moving away from a dogma on how a financial instrument should be embodied to looking more at how the spirit of the regulations can be adhered to otherwise (see here). In France, it required legislative invention to add bonds on a blockchain (see here); in the UK it appears that no legislating is needed (see Heal Bond Alliance).
The ‘look and feel’ of a Bearer Asset
There are some specific questions about creating pure assets on a blockchain for them to live there independently. Bitcoin behaves as a bearer asset but global policy has moved against such assets. It is certainly possible to emulate registered ownership with a blockchain by attributing public keys to individuals, but when the asset moves from one user to another it has the ‘look and feel’ of a bearer asset, as the asset is separate from the record of who is its owner. These issues of categorisation will need to be addressed in time.
Is it a contract or a wallet or both?
With blockchain, shares and bonds can do more than just be legal contracts, they can also, in themselves, receive dividends/coupons. It is as if the blockchain breathes life into assets. A bond was always a legal contract but now a blockchain bond can conceivably be a wallet too. This is another categorisation issue that will require an ongoing discussion.
In all, financial instruments on a blockchain are like something we have never seen before so, without question, it will require regulators to convene to assess how best to categorise them. We have to recognise that regulators are already approving blockchain based financial instruments so the discussion is not a theoretical one nor have regulators taken any particularly adverse position in respect of blockchain based assets. In fact, in the US, the CFTC gave Overstock permission to issue its shares on a blockchain.
Changing Risk Profiles
Looking ahead, when we have ‘singing and dancing’ digital assets that record legal obligations but also act as wallets or as distributed applications, then we need to also consider a slight change in the risk portfolio that digital assets bring. I no longer have a document that says I own x shares in Apple, I have a ‘living and breathing’ asset that I own that also receives money from the Issuer of the instrument.
In addition, all of these digital assets rely to a large extent on public key cryptography where you have a private key to your wallet and, therefore, to your assets. In this world, consumers will need to understand better the security implications of looking after their own private keys. I suggested in a previous post that banks will likely take over this role for the majority of persons or we will see a shift to hardware based security whereby insurers will ensure hardware wallets – the equivalent of safety deposit box insurance but for digital assets.
Low Hanging Fruit
Beyond living and breathing assets and the changed regulatory risk profiles, there certainly are areas where blockchain inspired innovation can happen addressing industry problems but without major regulatory intervention apart from the simple recognition of electronic signatures as valid evidence for signing a contract.
R3’s Corda elegantly picks the low hanging fruit in this area for distributed ledger technology. Corda starts as a distributed notarisation workflow tool that takes away the possibility of version confusion of agreements between relevant stakeholders. This is not about creating new forms of assets it is simply ensuring that the contents/ obligations of assets are comprehensively agreed upon.
Returning to the question of innovation or regulation first, we have to appreciate areas where regulation in financial services has led the charge. MIFID and the recognition of MTFs challenged the share exchange market; now PSD2 is going to open up banking to deeper competition from fintech players. In these two instances, regulation can be characterised as cataclysmic for incumbent industries. At the moment, the EU is not taking a particularly forthright view on crowdfunding and does not intend to be proactive to level the playing field yet, even though that area of fintech is experiencing regulatory fragmentation in the Single Market. It may become ripe for harmonisation at the junction when the fragmentation inhibits the industry from growing. Same is true for distributed ledger in that the EU would prefer to observe through a Taskforce than act pre-emptively – let it grow, let it find its roots first.
Possibly the conclusion here is that regulators help innovation when they act pragmatically in the application of rules (to remove the dogma of compliance), when they observe/ monitor closely the innovators through Sandboxes and, when they have a thorough understanding of the areas through running Sandboxes and therefore being able to act decisively to level the playing field or pass an Act to allow the equivalent of ‘railways’ to be built for blockchain. In the meantime, the Internet of Value will grow just as the Internet did with international, regional coordination at every level. But the Internet of Value does require close monitoring as unsurprisingly ‘value’ is at stake and when consumers lose then it can be hard for regulators to act with restraint; in essence, deregulation in fintech is not the same as deregulation in telecoms or the Internet.