FCA Releases Discussion Paper on Distributed Ledger Technology

by Reed Smith
Contact

Reed Smith

As discussed in our alert of 2 March 20171 global regulators are paying increasing attention to distributed ledger technology (DLT) (also known as blockchain). The European Securities and Markets Authority (ESMA)2 and the U.S. securities self-regulatory organisation, the Financial Industry Regulatory Authority (FINRA)3 both have asked for, and received, stakeholder feedback on issues around surrounding DLT, and the International Organization of Securities Commissions (IOSCO), has also recently published reports and held a roundtable with leading market analysts to discuss potential DLT issues.

Regulators globally are trying to understand industry participants’ and customers’ views on DLT’s potential perils and possibilities, as well as how DLT can potentially increase cost and time efficiencies and resiliency. Also, on 10 April 2017, the UK Financial Conduct Authority (FCA) published discussion paper DP17/3 on distributed ledger technology (FCA Discussion Paper). This followed a speech by the Executive Director of Strategy and Competition at the FCA, Christopher Woolard, at the Innovate Finance Global Summit. The FCA’s initiative on DLT follows on from its Project Innovate, which has included the creation of the FCA’s ‘regulatory sandbox’, whereby firms, including those developing DLT platforms, have been able to test innovative products and solutions in regulated financial services.4

The FCA Discussion Paper is aimed at users and providers of DLT technology in the financial services sector that falls within the FCA’s supervision. Generally, the tone of the FCA Discussion Paper is positive, noting and requesting examples of benefits of DLT, while recognising that DLT is a nascent technology and its uptake will ultimate depend on the willingness of firms to adopt it. Compared with IOSCO, which takes a more conservative approach towards public blockchains in its reports, the FCA is interested in feedback on the potential risks of closed networks that exclude non-incumbents.

The FCA encourages market participants to send their comments by 17 July 2017 through the online response form on its website. The FCA will then review the comments and publish a summary of responses or a formal consultation paper.

The issues being considered by the FCA include:

1. FCA's role in regulating DLT

The FCA generally takes what they define as a ‘technology neutral’ stance on emerging technology, looking to regulate the activities the technology facilitates rather than regulating the technology itself. The FCA Discussion Paper seeks to explore if DLT is so significantly different from existing technology accounted for in the current regulatory landscape that it requires unique regulation.

The FCA’s initial determination is that it does not see a reason to consider changes to the regulatory framework for DLT. However, if firms begin to integrate DLT into their current processes, some existing regulations will likely require changes. For example, existing regulations under the Senior Managers and Certification Regime would have to reflect how the allocation of individual responsibility within firms meshes with DLT often not having a central authorityRisks and opportunities

2. Governance and technology risk:

The FCA acknowledges that DLT can potentially offer a more resilient and efficient system than currently available in respect of the obligations on firms to maintain IT and cyber arrangements that prevent outages compromising the orderly functioning of markets.

The current method for recovering after a systems failure is for the relevant information to be moved to another location while the primary storage is fixed. However, with DLT, as the other nodes in the system would already contain the information, this time would be reduced.

In addition, DLT could prove to be more resilient than existing technologies through use of cryptography and a single successful hack being rejected by other nodes on the blockchain. However, the FCA also notes the risk that DLT may be susceptible to an error in its coding, which could potentially impact the entire network. Thus, the FCA points out that an effort must be made to ensure diligence and care in the iterations of code created to support this technology.

DLT and distributed data:

Regulatory reporting

Requirements to report on time and accurately measure assets and transactions are common features of current regulation. DLT can assist with generating real-time reports and even reporting as transactions occur. However, it is yet to be seen if firms are willing to commit the significant capital required to implement DLT. The FCA is interested in any live-tested cases.

DLT networks of regulated firms

The FCA has identified that, with the advances in storage and messaging speed, DLT could assist with required information sharing and more effective transaction monitoring, being better able to handle the large amounts of information which regulated firms must track and retain. There is also potential for DLT to assist with know-your-customer checks through verifying documents and through enabling an easy-to-monitor paper trail of transactions.

Recordkeeping and auditability:

There is potential for DLT to be used to reduce the discrepancies and costs in aggregating and verifying data from multiple sources. In relation to asset management, there could be an opportunity for transparency of ownership. Document verification through cryptography could bolster efforts at preventing fraud. DLT also can assist in complying with the FCA Protection of Client Assets and Money (CASS) 6 requirements, which restrict the comingling of client and firm assets, through keeping an accurate account and reconciling the client account and internal book on an intraday basis.

Smart contracts:

Smart contracts (or, as the FCA defines them, “blockchain functionality to execute pre-determined commands without further human intervention”) have the potential to save costs and reduce discrepancies through aggregating and verifying information from a variety of sources.

However, the FCA states that it “is unclear how smart contracts on DLT constitute a significant improvement on currently available systems. Arguably, the execution of commands conditionally on an event occurring pre-dates DLT and there are a wide range of vendor offerings which automate certain practices such as collateral management. Firms will, therefore, have to assess carefully their options in selecting the right product to automate their systems, whether it involves DLT or not.”

The FCA additionally notes that firms will also need to consider carefully if full automation is appropriate. This is in part because speed of settlement may not be the market preference, particularly if there are other aspects of trading which are not part of the system. Another potential risk of fully automated contracts to be considered is whether errors that are immediately replicated throughout a system would be easily correctable.

Consumer protection:

One of the FCA’s key functions is to protect consumers of financial services. Therefore they have also sought input from consumer groups and requested examples of DLT providing direct and tangible benefits to consumers. It seems that the FCA sees one of the main potential benefits of DLT to be increased competition in financial services for the benefit of consumers. This also ties in with potential concerns about closed-network DLT, whereby incumbent firms could limit new entrants to the market with negative consequences for competition.

3. DLT's compatibility with existing regulatory framework

Regulation has been altered due to innovation in the past, such as with the move from paper-based to dematerialised securities. The FCA seeks to engage with firms to gain clarification on the below, in particular:

  • Allocation of responsibilities. With the current regulated entities, significant obligations on the central party help facilitate a robust exchange; however, it is yet to be determined where the point of focus will be in the case of DLT technology.
  • Digital asset trading. Through examples from the regulatory sandbox, it appears that the firms engaging with the FCA are looking to move towards using DLT to underpin trading in assets. This change may come with potential regulatory issues around the classification of proprietary tokens, whose release may become akin to an initial public offering and face legal challenges requiring more specific regulation.
  • Collateral management. The FCA notes proposals by some firms to use smart contracts to reduce prudential requirements via automating the calculation and exchange of collateral. A benefit of this could be that DLT could potentially reduce the margin period of risk (MPOR) to less than 10 days. However, “firms would not be able to realize any reduced margin requirements unless legislation is updated to reflect a new, shorter market convention for MPOR, if DLT proves itself to allow for it”.
  • Data protection. The FCA refers to firms’ obligations under the Data Protection Act 1998 and guidance published by the Information Commissioner's Office (e.g., on the right to be forgotten) and how this might be potentially compromised by DLT. Although not cited by the FCA, we would note that firms’ enhanced obligations under the General Data Protection Regulation (due to come into force in May next year) will also be a key consideration for users of DLT; for example, how will the ‘right to erasure’ work with DLT architecture?

4. Summary and next steps

The FCA has traditionally taken a ‘technology neutral’ approach to regulating financial services. The current consultation paper, initiatives such as Project Innovate and the regulatory sandbox do, however, suggest that the FCA is seriously considering the implications of DLT and technology more generally. However, as its approach develops in this area, it will need to be satisfied that the use of DLT enhances rather than reduces competition and protection for consumers.

As mentioned previously, please note that the consultation closes on 17 July 2017. 


  1. reedsmith.com
  2. esma.europa.eu
  3. finra.org
  4. fca.org.uk

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Reed Smith | Attorney Advertising

Written by:

Reed Smith
Contact
more
less

Reed Smith on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.