This article was written by Scott Farrell and Roslyn Hinchliffe.
As blockchain use moves from brainstorm to pilot, issues of real world interaction arise. These cannot be solved solely from within the blockchain application itself. They need collaboration between the architects and engineers of the new systems and the participants and policymakers of the marketplaces which are destined to use them. This use is just as important as its technology and its technology should be designed with its use in mind. In this Alert, we set out a six question health-check worth running as part of creating, investing, using or regulating a blockchain application which is meant for use in “real-world” finance.
It is easy to be delighted, dazzled or disappointed, by hype and jargon and finance is a field which has always enjoyed a healthy dose of these. Distributed ledger technology, such as blockchain, amplifies that hype and expands that jargon. This obscures genuine and appropriate issues which consumers, financiers and regulators need to consider. These issues arise through the lens of the use proposed for the blockchain application. They are important for all financial market infrastructure, not just decentralised infrastructure like blockchain. So that they do not get outshone by the brilliance of the new technology we summarise them here and give some guidance to applying them to a blockchain application.
- The Design Question. Will this use of blockchain be efficient?
- The Tech Question. Will this use of blockchain be safe?
- The Data Question. Will this use of blockchain share data appropriately?
- The Governance Question. Will this use of blockchain be fair?
- The Compliance Question. Will this use of blockchain be legal?
- The Systemic Question. Will this use of blockchain keep the system stable?
The first three of these are technical as they relate to aspects of the blockchain itself. The last three are non-technical as they consider the relationship between the blockchain and its users and participants. These six questions interrelate and a successful networked application of blockchain which integrates with our financial system should be able address each. A little more on each of these is set out below.
This Alert does not seek to explain blockchain and assumes some knowledge of it. Our one page explanation of blockchain in the finance and financial markets can be found here.
The Design Question. Will this blockchain be efficient?
Blockchain architecture does not suit every application in financial services. It is best suited to creating a cumulative unchangeable record of truthful information without there being a single trusted record keeper. Its benefits are more apparent the wider the participation in the system. This makes it important to understand how a blockchain application is actually being used for a financial services facility, including who its users and participants are to be. If enough of the potential advantages of the technology would not be realised then the use of the blockchain application for a financial services facility may not be efficient.
The Tech Question. Will this blockchain be safe?
There are many variants of blockchain platforms. Each has its own features, strengths and weaknesses which needs to be understood. Whichever variant is used it is important that the technology used is robust, reliable and secure. This requires consideration of the track record of the blockchain platform being used, the potential for interoperability and the compatibility of information standards. It also includes consideration of the cyber-security of the system, both internally and externally, including at its frontiers, where it takes information from other sources. If the blockchain application is not reliable and secure then its use for a financial services facility may not be safe.
The Data Question. Will this blockchain share data appropriately?
Blockchain is a database technology. It works on data collection, storage, sharing and use. Perhaps the most fundamental question is exactly what data is being kept on the distributed ledger: is it a simple transaction, “hash” (a coded identifier of a transaction), or is it something executable (a “smart contract”, for example). Also important are the rules for keeping that data private from outsiders, as well as insiders such as other users or participants. Increasingly critical are the rules for sharing data with regulators. The data security mechanisms also need to be understood as does the searchability of that data. If the blockchain application does not have meaningful controls on data use then the sharing of data by the blockchain application for that financial services facility may not be appropriate.
The Governance Question. Will this blockchain be fair?
Each blockchain or blockchain application has its own rules about how it works and the rights and obligations of the users or participants in it. These rules are critical in understanding how the blockchain may behave if something unpredictable happens. For example, it is important to know if there is someone who effectively operates, owns or oversees the blockchain (this could happen despite its distributed or decentralised nature). It is also important to know what consensus mechanism is being used as this determines what is the “truth” which is to be recorded on the blockchain. If the blockchain application does not have clear and balanced rules then its governance may not be fair.
The Compliance Question. Will this blockchain be legal?
Although a blockchain can be used to create an eco-system for entities to transact without the need for external conflict-resolution mechanisms, it does not exist outside of any legal system which binds its participants or users. For example, if a blockchain is being applied to regulated financial services then the blockchain will not escape that regulatory reach. To understand this issue there are plenty of questions worth asking such as which legal system applies, how flexible must the blockchain application be to comply with law, does it conflict with regulation and whether it could be supported by the legal system. If the blockchain application is not consistent with the legal framework in which it must reside then its use for a financial services facility may not be legal.
The Systemic Question. Will this blockchain keep the broader system stable?
Although a blockchain use may commence with few users and participants, it is possible for network effects to result in it becoming quite important to many users and participants very quickly. As the numbers of users and participants increase, the potential for them to be detrimentally affected if any issues develop with the blockchain increases as well. This systemic risk can develop with any important financial market infrastructure. Whilst this may be thought of “as a good problem to have” when the blockchain application is first starting, it presents a significant risk. For this reason it is worth considering how the blockchain application will scale, how it would be affected by the failure of a number its participants and whether there are plans for managing its own failure. If this planning for the systemic effect of the success of the blockchain application has not been done then its use for a financial services facility may not help keep the the broader system stable.
Of course there is much more which can be said on each of the questions set out above. But the framework, aspects of which should be familiar to those who look closely at risk and regulation of financial services and markets, can be developed further – including into powerful comparative tools.
What does all of this mean?
This framework for conducting a health-check on blockchain applications which are to be used to deliver financial services should be useful for regulators, investors and potential users. It is important because the context of what a blockchain application is to do, in the real world, is critical to working out its impact and what will impact on it. An advantage of using this framework is that it allows people from a non-technological background to participate in considering and constructing this new financial infrastructure. Given the tremendous potential for blockchain applications to transform the delivery of financial services, it is important to use this and other tools to “kick the tyres” before “lighting the fires” on a blockchain application in financial services.