This article, co-authored by Bourn Collier, an associate at Mayer Brown International LLP, looks at the recent developments in the worlds of digital currency and blockchain technology.
The Bank of England’s FinTech Accelerator program was launched by Governor Mark Carney in June.
It has seen the Bank work in partnership with FinTech firms to explore innovations to deal with challenges that a central bank, uniquely faces.
The Bank recently announced it had successfully conducted with PwC a proof of concept exercise involving the fictional transfer of a financial asset on the Ethereum protocol, among several participants including a central authority that could establish the supply of the asset and permissions to access and use the ledger.
The Bank, noted the potential benefits of distributed ledger technology including increasing system resilience. It nevertheless highlighted that it is open to working with other firms to overcome additional challenges it identifies with the technology, such as scalability and interoperability.
As the program develops it seems likely that a favourable regulatory environment for parties involved in distributed ledger technology will result given the Bank’s involvement.
Project Innovate Update
In tandem with the Bank of England, the Financial Conduct Authority (FCA) recently announced progress of its Project Innovate initiative whereby firms offering innovative financial products and services, including those based on automated advice and blockchain technology are given regulatory feedback on their business model and can apply to test their products and services with temporary FCA authorisation in the “regulatory sandbox”.
In a recent interview Chris Woolard, the FCA’s director of strategy and competition stated that a “small but significant number” of companies involved in Project Innovate are developing products and services incorporating Blockchain technology.
The FCA has also entered into co-operation agreements with the Australian Securities and Investments Commission, the Monetary Authority of Singapore and the Korean Financial Services Commission, the first two of which include a referral mechanism for innovative businesses seeking to enter the other’s market.
This comes at a time when many private consortia and groups are launching different distributed ledger technology applications which may have a significant impact – such as the utility settlement coin developed by UBS, Deutsche Bank, BNY Mellon and others.
Risk mitigation
Key concerns of regulators will be in mitigating risks with the new technology, several of which have become apparent recently, with the hacking of the systems of the Bitfinex bitcoin exchange and the Ethereum-based DAO (Decentralised Autonomous Organisation).
In neither case was the underlying ledger compromised (i.e. neither the blockchain nor the Ethereum protocol were altered), but weaknesses in the two systems were exploited – in the case of Bitfinex, the separate holding of multiple keys (the multisig feature) was compromised, while for the DAO, a user identified a flaw in the organisation’s automated smart coding for launch of and reward for project proposals (which the DAO would automatically fund following a user vote).
The main lesson being drawn by participants is of the relative soundness of private, permissioned ledgers, – both the DAO and Bitfinex were open to all users (“unpermissioned”).
Regulators including the Bank of England are in favour of such approach – also to avoid governance disputes such as recently arose regarding the size of blocks in the bitcoin blockchain.
Stricter regulation
In contrast to those services which use distributed ledger technologies to enable efficient transaction processing, exchanges which buy and sell digital currency are to face a stricter regulatory environment.
Many US States are looking to introduce regulation of Bitcoin exchanges and may follow the State of New York’s BitLicense regime.
Since its introduction in 2015, two businesses have received a BitLicense – Ripple Labs Inc. and Circle Internet Financial and commentators noted the cost and complexity of their applications.
While offering safe harbour under New York law, the obligations under the BitLicense are extensive.
In Europe, the European Commission has proposed that draft amendments to the Fourth Anti-Money Laundering Directive be agreed and implemented by December 2016 requiring that virtual currency exchanges and electronic wallet providers carry out customer due diligence and have a compliance regime in place.
On 5 September, the UK Treasury reported that a large number of Member States have concerns about this timetable and it seems likely that implementation will be delayed.
Within the industry there will be mixed views about regulation. Purists will regard any regulation to be the antithesis of the virtual currency movement.
In practice, such regulation is vital to the currencies’ continued existence and development. A research report into de-risking by banks commissioned by the FCA in May 2016 reported on difficulties that firms working with new payment technologies had in obtaining access to the banking system because of anti-money laundering concerns on the part of established banks.
Bringing virtual currency exchanges into the regulatory fold will increase their acceptance.
Further ahead digital currency exchanges will have to comply with new stricter cybersecurity standards (which will apply to service providers such as those supporting banking and financial market infrastructures) when the Network and Information Security Directive is introduced (by May 2018).
Whilst the position in the United Kingdom will be subject to the outcome of negotiations over Brexit, the reality is that certainly in the medium term, the UK will continue fully to implement and be subject to EU legislation.
If you’d like to find out more about bitcoin or blockchain technology, check out issue 10 of our popular tech magazine – The Blockchain Issue – here.