In finance, now comes automated, embedded supervision. Maybe.
To that end, the Bank for International Settlements (BIS) said in a paper titled “Embedded supervision: how to build regulation into blockchain finance” that distributed ledger technology (DLT) could be a part of bank infrastructure and could be used to automate supervision.
The key seems to be for those financial markets to be based on blockchain. It’s worth stating here that the BIS is owned by 60 central banks across the globe, and can be likened to a “central bank of central banks.” The new paper might give a hint as to what new technologies and processes are under consideration for streamlining back-end and supervisory functions.
The paper notes that in order to realize the value of blockchain, one must look beyond cryptos such as bitcoin and its brethren and look toward permission versions of blockchain, which allow for the trading of asset-backed tokens. Options and futures clearinghouses, among other markets, could be automated.
The rise of DLT in finance, BIS stated, offers up a challenge of “how best to apply technology-neutral regulation, so that similar risks are subject to the same regulation.”
The paper, as authored by BIS Economist Raphael Auer, states that blockchain has value in using smart contracts and ensuring that regulators have an incentive toward honesty.
As the author notes, “the regulator’s goal is neither a specific market structure nor a specific form of exchange. Rather, it is to create a stable financial system that offers high-quality services to consumers and businesses at the lowest possible cost. In this regard, a key puzzle is that, despite ample technological progress, financial services remain stubbornly expensive.
In terms of a high-level view, “the spread of distributed ledger technology (DLT) in finance could help to improve the efficiency and quality of supervision,” according to the paper. That efficiency, we note, would be a stark contrast to the resource-intensive nature of compliance, where such efforts represent several percentage points of operational expenses.
DLT may not change risk, but it can change the way those risks are supervised. In one example of a bank that holds asset-backed tokens, compliance with the Basel III capital standards could be automatically verified.
Specifically, blockchain opens the door to “embedded supervision” in compliance efforts, which would allow regulators to automatically read the financial markets’ ledger, and this automation would reduce the banks’ manual efforts involved in collecting and verifying data.
Embedded supervision, according to the paper, could ease what is termed “conflict” between data availability, the cost of data collection and verification, and privacy. Compliance expenditure weighs heavily on financial institutions, and even more so on smaller firms. Supervisors thus face a trade-off between getting the data they need and keeping the costs of compliance within reasonable limits.
In terms of mechanics, the market would operate in a “distributed and permissioned” manner, and where “blocks of financial contracts are verified by third parties.”
The verifiers themselves have an economic stake in making sure all is kosher, so to speak. They would lose a set amount of capital if the blockchain was reversed or if transactions were voided.
The supervisors, the research contended, would gain access only to the relevant data, depending on whether they need transaction-level information or a more aggregated view. “In this way, embedded supervision could help to maintain the confidentiality of firms and their customers, since cryptographic tools could be used to limit access only to selected parts of the underlying data or relevant aggregates.”
The end result would be a “level playing field” for firms, whether incumbent or new entrants, according to the paper.