Introducing “Embedded Regulation” for Blockchain Markets

How could Blockchain-based financial markets be regulated and supervised? The Bank of International Settlements-BIS has come out to be in favor of constructing regulation into markets that are blockchain-based. BIS is an international financial institution owned by central banks which promotes international monetary and financial cooperation and serves as a bank for central banks.

A BIS economist composed a working paper which supports that blockchain and digital ledger technology-DLT and asset tokenization introduce new ways to control and manage financial risks. The paper presents arguments on how asset tokenization and underlying DLT make way for new ways of managing financial risks.

What is supported is that Blockchain enables the decentralized trading of asset-backed tokens and that it is also able to solve financial problems through the use of smart contracts.

“Embedded supervision” is also encouraged which will supposedly be a regulatory framework which will allow regulators to manage a tokenization market automatically by reading its ledger. In this way, the need for firms to actively collect, verify and deliver data will be reduced.

As stated in the paper’s introduction:

“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”.

The proposal includes a “distributed and permissioned market in which blocks of financial contracts are verified by third parties”.

If the blockchain is reversed, then the verifiers would lose a predetermined amount of capital. It is said that the research determines the amount of the capital the verifiers have to stake so that it would never be profitable if a third party tried to bribe them and convince them to reverse the transaction ledger.

One of the main findings of the papers is that supervisors would be able to trust the distributed ledger’s data as the transactions would be financially final.

What is also reviewed by the paper are the legislative and operational requirements for such a scheme to be functional and how embedded supervision could enable low-cost supervision and provide a “level playing field” for all firms.

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Published on: 20/09/19