VISA’s recent announcement that it will test run blockchain-based settlement of claims between its participants is the latest sign that distributed ledger technology, often called blockchain technology, has made its way from the slightly geeky Bitcoin environment (ie, play money units that derive their real-world exchange value from the pure fact that its users agree to attribute this value to them) into mainstream finance. Blockchain technology can settle basically anything that could be represented by a bit of data. Whereas it might be used in the real economy for sending around, for instance, healthcare entitlements or royalties, the financial world is exploring its use for moving around cash (in the sense of central bank-issued fiat money), securities (equities and debt), and derivative contracts.
The long-term potential of blockchain-based settlement of financial assets is still unclear. At the moment, technological issues are at the centre of the discussion. Long-term, however, the absence of a clear legal and regulatory framework might create a glass ceiling, preventing the rise of this technology beyond a certain point. So far regulators have mainly been concerned with preventing illegal activities associated with the use of virtual currencies; however, legal and regulatory questions are much broader, especially on an international scale.
The importance of questions of commercial law and financial regulation will become apparent once supervised institutions such as banks, pension funds or CCPs go beyond the test stage and actually consider moving around significant amounts on the basis of blockchain-based platforms. They, as well as their supervisors, are unlikely to feel comfortable with this idea unless risks are clearly attributed from a legal perspective, particularly in the event of insolvency of the institution’s counterparty or collateral provider. While insolvency might still pose manageable risks within a given jurisdiction, outcomes are unclear once participation in a blockchain platform is spread around the globe. The reason is that the entitlements represented do not easily fit with traditional legal analysis and, accordingly, jurisdictions might take different approaches to the question of who ‘owns’ a given asset in the event of insolvency of a platform participant. While this legal risk is already difficult to manage in the context of traditional, custodian-based holdings of securities, blockchain-based settlement is completely uncharted territory in legal terms.
Similarly, regulation and supervision of blockchain based settlement of financial assets amounts to nothing less than terra incognita. As there is no need to hold blockchain-based financial assets through a financial market infrastructure, these assets are traded ‘over the counter’, to adopt an expression well known from the derivatives world. For purposes of micro- and macro-prudential supervision, there is consequently a need to make holdings and streams visible to supervisors. Lastly, but most importantly, supervisors have to take an interest in the internal functioning of a blockchain platform and scrutinise the soundness of their internal rules: it is on the basis of these rules that assets are acquired and disposed of with legal effect.
Two of my recent pieces, which are available here and here, explore these questions in greater detail, particularly in relation to the settlement of securities. The main findings are expressed in six ‘principles’, which are designed to form the basis for further discussion. Further, both papers contemplate the need for international co-operation on this matter and propose an international soft-power mechanism to allow for speedy progress. In the EU, thinking is slightly more advanced as comparable issues have been addressed in the Financial Collateral, Settlement Finality and Banks Winding-up Directives. However, as blockchain-based assets pose problems different from those caused by traditional securities, a new instrument would be needed. The issue is highly Brexit-sensitive, as London is currently at the forefront of these technological developments but might find itself outside a common legal and regulatory EU framework.
Philipp Paech is Assistant Professor of Financial Law and Financial Regulation at the London School of Economics and Political Science.