The BIS released a report, which argues that asset tokenisation and distributed ledger technology (DLT) could create new ways to supervise financial risks.
In a working paper, entitled Embedded supervision: how to build regulation into blockchain finance, BIS economist Raphael Auer makes the case for "embedded supervision", namely a framework that allows compliance with regulatory goals to be automatically monitored by reading the market's ledger, "thus reducing the need for firms to actively collect, verify and deliver data".
The paper sketches out a design for such schemes and explores under which conditions DLT could be used to monitor compliance.
According to the paper, DLT makes possible the decentralised trading of asset-backed tokens, as well as decentralised financial engineering based on these tokens via self-executing contracts.
"As data credibility in such markets is assured by economic incentives, supervisors need to ensure that the market's economic consensus is strong enough to guarantee the finality of transactions and resultant ownership positions. Only in this case can supervisors trust the quality of the data in the distributed ledger," the paper adds.
To this end, the paper outlines a distributed and permissioned market in which "blocks" of financial contracts are verified by third parties.
These verifiers stand to lose a set amount of verification capital should the blockchain ever be reversed, thus voiding existing transactions.
The paper also investigates how the “same risk, same regulation” principle might be applied to the financial supervision of DLT-based markets, arguing that while regulation should remain technology-neutral, supervision should evolve in parallel with technology.
"Although DLT may not change the underlying risks, it might open up new ways of supervising these risks. So, instead of trying to fit cryptoassets into existing regulations, such as securities laws formulated long before the advent of DLT, it is worth asking how new technologies could serve to better monitor risks in financial markets," the paper argues.
The paper's main theoretical result is to show how much capital verifiers would have to stake so that no market participant would ever find it profitable to bribe them into reversing the transaction history.
As transactions would then be economically final, supervisors could then trust the distributed ledger's data.
The paper also discusses what kind of legislative and other arrangements would be needed to promote low-cost supervision, data privacy, and a level playing field for both small and large firms.
It argues that the main challenges would be to embed the concept of economic finality in the legal system and how to design rules for assigning responsibility in decentralised markets.
The paper states:
"The basic premise is that regulating blockchain-based finance should not require a departure from long-established principles on the regulation of specific economic activities. Rather, regulators and supervisors might consider investigating how their use of technology could evolve alongside that of the financial industry."
Finally, to implement embedded supervision, regulators would also have to acquire substantial technological know-how and be willing to adjust their operational approach to the technology that is being developed by the financial sector.