In mid-December 2017, the UK’s Financial Conduct Authority (FCA) published a really interesting 32-page paper on distributed ledger technology (DLT). The timing wasn’t great, as most of the City was out getting smashed at Christmas parties, so I thought it best to put it aside until the New Year hangovers were out of the way and share it with you now. Oh, and just in case you’re wondering if it’s worth it, here’s the summary:
In April 2017, the FCA published Discussion Paper (DP) DP17/03 on Distributed Ledger Technology (DLT) to stimulate a dialogue on the regulatory implications of current and potential developments of DLT in the financial markets.
The FCA explored the potential risks and benefits of DLT applications in financial services and whether it could promote the FCA’s statutory objectives of promoting effective competition, financial market integrity and financial consumer protection. The FCA specifically asked about tested DLT use cases and whether the future application of this nascent technology could face undue regulatory hurdles or create undue risk.
In this feedback statement, the FCA:
- summarise the feedback the FCA received on their Discussion Paper (DP)
- set out their response to the feedback received, and their views on certain recent developments
- explain the next steps.
DLT was first used in Bitcoin, a digital commodity or so-called currency, as a means to facilitate peer-to-peer payments without a central third party. Today, however, market participants are exploring the benefits and risks of other use cases in financial services, most of which involve sharing data amongst multiple network participants, and do not need to involve digital currencies.
DLT is a highly customisable and versatile technology that firms can use to underpin the issuance, trading and clearing of financial instruments, to keep and share records and to facilitate regulatory reporting or enhance transaction monitoring.
After a period of small scale testing, so called proofs-of-concept (POC), and various initiatives to develop more specific DLT systems for use in financial services, market participants are beginning to start deploying DLT systems.
The FCA’s aim is to be alive to current and potential developments involving DLT, to keep pace with them, and to strike a proportionate regulatory balance between the risks and opportunities they present. The FCA see regulation as an enabler of positive innovation based on new technologies as well as a means of containing undue risk. Their regulatory philosophy (subject to any risks to their objectives) is to be ‘technology-neutral’, and the FCA asked whether their current rules are flexible enough to accommodate appropriate use of DLT and similar innovative technologies.
In the DP, the FCA noted that using DLT in financial services could enhance administrative efficiency, improve operational resilience and reduce the costs of regulatory reporting. All of these could lower financial and technical barriers to entry and enhance competition. The FCA explored specific DLT applications in various areas such as asset management, payments and regulatory reporting. The FCA also said the distinctive properties of some DLT applications might create new or uncertain risks that could result in consumer harm.
The FCA received 47 responses from a wide range of market participants including regulated firms, national and international trade associations, technology providers, law firms and consultancies. The FCA also hosted an international regulators summit in April 2017 to discuss innovative technology in financial services from a global perspective. The FCA discussed the emergence of new financial markets underpinned by DLT including the use of digital currencies, smart contracts and Initial Coin Offerings (ICOs). This was followed by a two-day industry conference in June 2017 where the FCA further explored the use of DLT in financial services.
Through their Innovate initiatives, including the regulatory Sandbox2 and Techsprints3 , the FCA have gathered unique hands-on experience with a wide range of DLT applications. Of 58 Sandbox firms, 22 have used DLT which makes it the most popular technology employed in the Sandbox and highlights the genuine interest and high demand for testing with the FCA.
The FCA have drawn on this experience, and various cases the FCA have explored through Innovate, throughout this feedback statement.
Highlights of feedback
The DP was positively received. Respondents expressed particular support for maintaining a ‘technology-neutral’ approach to regulation and welcomed the open and proactive approach to new technology, including the Sandbox and RegTech initiatives. They suggested that this will support competition and improve consumer outcomes in financial services.
The feedback suggested that current rules are flexible enough to accommodate applications of various technologies, including the use of DLT by regulated firms. Nearly all respondents generally agreed there are no substantial barriers to adopting DLT under the FCA’s regulatory rules and no changes to specific rules were proposed. But some respondents doubted the compatibility of permissionless networks with the regulatory regime (see chapter 2).
All respondents suggested numerous benefits and risks of using permissionless and permissioned DLT networks in financial services. But they said those risks heavily depend on the specific application of DLT.
Respondents who commented on ICOs agreed with the FCA’s view on the risks to consumers and that the legal and regulatory position of each ICO proposition has to be assessed case by case (see chapter 3).
Most respondents were particularly interested in the use of DLT in the capital markets sector, for example underpinning market trading infrastructure, including the use of smart contracts. They said they would have to be clearer on legal issues such as the legal status of digital assets and the enforceability of smart contracts before they considered using those solutions at scale (see chapter 4).
Many respondents suggested that DLT solutions could deliver regulatory requirements more efficiently than current systems, substantially reducing costs for firms and regulators alike (see chapter 5).
Some said DLT could facilitate the secure sharing of data between multiple participants.
However, most said that the current reliance provisions in the Money Laundering Regulations do not incentivise firms to share know-your-customer information or foster any enhanced level of cooperation (see chapter 6).
Overall, most respondents strongly supported continued direct engagement by the FCA and other financial services regulators to foster innovation and ensure appropriate regulatory safeguards are in place at the outset.
All respondents highlighted the global nature of DLT. Seeing a consequent need for international cooperation, they urged the FCA to collaborate proactively with other national and international regulatory bodies and industry associations, to make possible a globally harmonised approach to DLT.
In the subsequent chapters, the FCA cover in more detail the following issues that respondents discussed:
- Operational risk (including outsourcing and network security)
- Digital currency (including digital currency derivatives and ICOs)
- Digital asset trading and smart contracts
- Regulatory reporting
- Financial crime
- General data protection regulation.
The FCA also summarise the next steps they will take in chapter 8. In brief, these are:
- The FCA will continue to monitor DLT-related market developments, and keep their rules and guidance under review in the light of those developments, although the FCA have not identified a need to propose specific changes at this juncture.
- The FCA will continue their close engagement with DLT use cases and industry stakeholders through their Innovate initiative.
- At the international level the FCA will work closely with national and international regulatory bodies to shape regulatory developments and standards.
- At the domestic level the FCA will engage further with other regulatory authorities to ensure a coordinated approach in the UK.
- Having already issued an alert warning consumers of the speculative nature and high risks of ICOs, the FCA will gather further evidence on the ICO market and conduct a deeper examination of the fast-paced developments. Their findings will help to determine whether or not there is need for further regulatory action in this area. The FCA have taken the immediate step of highlighting how an ICO-related innovative business proposition needs to be designed if it is to satisfy the ‘consumer benefit’ criterion for access to the facilities of their Innovation Hub (see chapter 3).
If you want to read the whole report, click here.
– This article is reproduced with kind permission. Some minor changes have been made to reflect BankNXT style considerations. Read more here. Image by Zapp2Photo, Shutterstock.com