The FCA has opened for consultation its discussion paper on distributed ledger technology (DLT), often referred to as blockchain technology, and is accepting responses until 17 July 2017. Ian Stevens and Alan Nelson, partners at CMS, take a closer look at the issues and possible consequences
The Financial Conduct Authority (FCA) has issued a discussion paper on the potential for future development of DLT in the markets it regulates.
The FCA acknowledges that DLT is a rapidly developing technology with exciting potential, but is conscious that it may also present new challenges and potential risks. The FCA is keen to engage in discussion with users and providers of DLT solutions in order to explore where the balance of risk and opportunity lies.
The publication of the discussion paper follows the introduction of several schemes by the FCA in an effort to encourage innovation, such as the Innovation Hub and the Regulatory Sandbox.
What is DLT?
The FCA describes DLT as technology that “combines various existing tools such as shared databases, cryptography and peer-to-peer networking to offer firms the ability to share data efficiently and securely.”
To expand on this further, DLT is essentially an asset database that is stored identically on multiple computer systems – known as ‘nodes’ – which are controlled by different entities which all form part of a network. Any update to the ledger that takes place is reflected in all nodes – in many DLT solutions this update takes place almost instantaneously.
The security and accuracy of the assets stored in the ledger are maintained through cryptographic techniques. A network can also set rules regarding who can record entries, allowing either one, several or all participants to update the ledger.
DLT is seen as having huge potential in the financial industry – for example, to record transactions or trace ownership of assets such as shares or even vehicles. Many of the world’s leading banks are actively investing in DLT, and the World Economic Forum predicts that it will become the “beating heart” of finance.
According to a UK Government report, the global finance industry pays around $65-90bn annually on post-trade costs – a figure that could be reduced, according to Santander, by $20bn per year through the use of DLT.
Currently, each firm needs to maintain its own ledgers to record its agreements and positions with its customers and counterparts. Its counterparts must also do the same.
This duplication can lead to inconsistencies, requiring costly and time-consuming reconciliation and error-correction activities. The existence of multiple technology platforms, legacy systems and manual workarounds introduces further complexity and operational risk.
DLT could facilitate a solution: the sharing between firms of a single, secure, authoritative record of financial events and the agreements between them.
There is a common belief that deployment of a common DLT architecture could achieve significant savings by delivering higher-quality data, fewer discrepancies and faster agreement of details between firms. Even within an individual organisation, DLT has the potential to generate significant efficiencies – stripping out multiple systems and replacing them with one single source of truth.
One of the benefits DLT could bring to the automotive industry is providing certainty and security to the supply chain – the foundation of an industry involving the manufacturing of products with hundreds, if not thousands, of different parts.
With widespread adoption of autonomous cars on the horizon, the likelihood of counterfeit parts becoming prevalent is high. DLT could facilitate a system that tracks the creation and ownership of parts. For instance, each part would receive a unique identifier as part of the supply chain which is then recorded on the secure shared ledger. Those with access to the ledger would know what parts have been created and by whom, as well as other key data.
The FCA anticipates several DLT solutions will move “from proof of concept to real-world deployments” in the second half of 2017 into 2018.
A variety of DLT solutions are already being deployed in regulated financial services through the various mechanisms of the FCA’s Innovate initiative – including the Regulatory Sandbox and Direct Support.
With the brisk pace at which DLT is developing, the FCA is mindful of the need to engage in dialogue with stakeholders to ensure the current regulatory framework is appropriate. The FCA acknowledges that consideration of how specific regulatory requirements apply to DLT may be required. The overarching issues on which the FCA is inviting discussion are:
- What risks and opportunities does DLT present to the FCA’s statutory objectives of market integrity, consumer protection and competition, and how any risk can be mitigated by regulated firms?
- Can DLT support more effective competition, financial systems integrity and deliver better consumer outcomes?
- Do any characteristics of DLT make it challenging to fit DLT solutions into the regulatory framework, despite the FCA’s approach of ‘technology neutrality’?
The FCA has traditionally taken a technology-neutral approach to regulating financial services. However, the discussion paper notes that the FCA needs to consider whether that approach may prevent or restrict sensible development of DLT, and whether it therefore requires adjustment.
Once the FCA has received responses to the discussion paper, the replies will be reviewed and the FCA will then consider its next steps. This might take the form of a Summary of Responses or a Consultation Paper. The FCA is also planning a series of events, roundtables and bilateral discussions on DLT. <