On March 3, 2017, industry leaders, policymakers, and academics converged at Yale Law School to discuss blockchain, a technology that some believe has the potential to disrupt current modes of providing core financial services and transacting in capital markets.  Over the course of the day, panelists debated the opportunities created by blockchain adoption, as well as the attendant risks, in the areas of payments, clearing and settlement, and smart contracts.  The roundtable finished by exploring the central bank perspective on blockchain, which is unique given that central banks supervise financial entities interested in the technology, but are also themselves evaluating the suitability of the technology for executing their mandates, whether related to the transmission of monetary policy or the renewal of wholesale payment platforms.

At the end of that day, both panelists and participants expressed the hope that the conversations sparked by the roundtable will continue.  We therefore thank the Yale Journal of Regulation (JREG) for providing a forum through Notice and Comment for further discussion.

As the roundtable organizer, I am providing the posting schedule here:

Tuesday, June 6th: Ross Leckow and Nina Kilbride on regulatory challenges.

Wednesday, June 7th: Christian Catalini on efficiencies created by blockchain and cryptocurrency.

Thursday, June 8th: Jessie Cheng on distributed financial technologies.

Friday, June 9th: Nancy Liao on settlement finality.

To orient readers who are interested in blockchain, but who have not been following the topic closely, this post provides a brief introduction in a question and answer format, and explains why blockchain matters.

• What is blockchain?
  • There is little agreement on the answer, given that the technology is rapidly evolving.  For purposes of the symposium, the word “blockchain” should be interpreted in accordance with its constituent elements.  Specifically, “blockchain” should encompass any technology that (i) permits transactions in goods or services between two parties to be validated and then gathered into a “block” electronically (i.e., a cryptographic unit containing or referencing the relevant terms of all validated transactions executed within a pre-determined period of time); and (ii) enables those blocks to be cryptographically “chained” in some order (i.e., linked together in an immutable fashion using hash technology). Blockchain is often associated with the mode of transacting using the virtual currency Bitcoin; however, it is more accurate to think of Bitcoin as a particular application of blockchain technology.
• What does blockchain enable?
  • Blockchain is one technology that allows for the creation of distributed ledgers. The word “blockchain” is often used interchangeably with the term “distributed ledger technology”; however, it is more precise to consider blockchain as comprising only one type of “distributed ledger technology.”
• What are distributed ledgers?
  • A ledger is a record “containing accounts to which debits and credits are posted.” See Merriam-Webster Dictionary. Some ledgers contain information of all transactions from an account. Other ledgers simply refer to summaries of relevant transactional information, with transactional details residing on a sub-ledger.
  • Currently, in finance and capital markets, most ledgers are considered centralized. Namely, they are maintained by one central entity, such as a bank or a financial market infrastructure (e.g., a clearing house). A bank, for example, would maintain a ledger with all client accounts, all transactions completed in those accounts over the period of a month, and the balances in those accounts at the beginning of the month and at the end of the month. The bank is supervised or regulated, which creates a presumption that ledger entries are accurate. Clients may keep their own ledgers. If a client discovers a discrepancy between its own records and that of the bank, it must convince the bank to change the relevant entry. This process is known as reconciliation, and is time-consuming and labor-intensive.
  • There are many definitions of “distributed ledger.” However, they share one key feature – namely, clients or market participants have some control over which entries should be added to the ledger, and have some visibility into the ledger. Clients or market participants, for example, may determine through protocols which entries are legitimate and the order in which legitimate entries should be added. Because they have voice in distributed ledger creation and can view the ledger, clients or market participants may no longer need to keep separate ledgers or to conduct reconciliations.
  • Certain distributed ledger configurations (g., the Bitcoin protocol) allow all participants (known as “nodes”) to participate equally in ledger creation; no one node has greater rights or responsibilities than others to update the ledger or maintain the integrity of its entries. Similarly, all nodes can store and access a copy of the ledger on its own server; whenever transactions are added to the ledger, all copies are updated in a synchronized manner.
  • Other distributed ledger configurations (g., those facilitated by financial industry consortia) differentiate nodes by function; some nodes will only have the ability to propose transactions for inclusion in the ledger, other nodes will also have the ability to verify that proposed transactions are legitimate, and still other nodes will determine the order in which blocks of legitimate transactions are chained together. Similarly, nodes may have differing levels of access to data on the ledger. For example, a bank node may be able to see that a transaction has occurred, but not the parties to the transaction or the size of a transaction, whereas a regulator that has a node would be able to see all transactional information.
• Why are distributed ledgers and blockchain technology of general interest? 
  • Ledgers are of general interest, because units of value and financial instruments increasingly have been recorded in digital form rather than held in physical form. In other words, they only exist as ledger entries.  As Andrew Hauser from the Bank of England noted at the roundtable, “the UK already has a real-time electronic central bank currency,” given that central bank reserves are around £325 billion, as compared to £68 billion in physical banknotes.  Similarly, Mark Wetjen of the Depository Trust & Clearing Corporation observed that, of the $50 billion in securities that his organization holds, he knows of exactly one security (a railroad bond) that still exists in physical form.
  • Distributed ledgers are of interest because they can facilitate value creation and transactions that would otherwise not occur. For example, virtual currencies have been created using distributed ledgers, the most well-known of which is Bitcoin. In contrast to fiat currencies or other private currencies, a virtual currency does not derive its value from the creditworthiness of the issuer, and the ledger evincing transactions and balances does not depend on governmental supervision or regulation to maintain its integrity.  Rather, the virtual currency is valuable precisely because it relies on a cryptographic protocol that obviates the need for central authorities to validate the transactions (such as financial market infrastructures) and for certain financial intermediaries (such as banks). Whereas virtual currencies have been attractive to those who engage in illicit activities, they also facilitate legitimate economic activity by decreasing settlement time and fees for payments between banks in two non-money center countries.
  • Distributed ledgers also add value by permitting central authorities and financial institutions to perform their existing functions in a more efficient manner.  For example, in August 2016, the World Economic Forum set forth nine “case deep-dives” that illustrate how distributed ledgers could eliminate current finance and capital market pain points. Regarding global payment, the World Economic Forum concluded that distributed ledgers can facilitate more efficient payment transmission and settlement in at least four ways: (i) simplifying Know-Your-Customer compliance by allowing financial institutions to access client profiles housed on a distributed ledger; (ii) replacing infrastructure (such as SWIFT or local clearing networks) by transmitting payment orders via smart contracts; (iii) eliminating the need for financial institutions to maintain nostro accounts (e., an account that a bank in Jurisdiction A maintains with another bank in a Jurisdiction B in the currency of Jurisdiction B, to facilitate transactions between Jurisdiction A clients in Jurisdiction B) by allowing other entities connected to the ledger to provide foreign exchange liquidity; and (iv) streamlining regulatory compliance by allowing regulatory nodes to monitor transactions in real-time.
• Why are distributed ledgers and blockchain technology of legal interest?
  • Existing legal and regulatory frameworks may simultaneously constrain distributed ledger benefits while inadequately protecting against risks. Recognizing this situation, supervisors, regulators, international financial institutions, and international standard setting bodies have been considering whether and how to clarify, supplement, or amend these frameworks.
  • For example, many jurisdictions differentiate between money and property. Virtual currencies have presented novel challenges, as they have features of both. Therefore, many jurisdictions have clarified how existing laws and regulations on, g., anti-money laundering and combating the financing of terrorism, taxation, and consumer protection, apply to virtual currencies and related service providers. However, other jurisdictions have either banned virtual currencies or remained silent on whether and how they might be subject to existing law and regulation.
  • Distributed ledger configurations allow unregulated entities to perform some of the same functions that are performed by supervised or regulated financial institutions (g., cross-border payments).  However, these distributed ledger configurations cannot avail themselves of statutory or regulatory protections (e.g., settlement finality) afforded to supervised or regulated financial market infrastructures or entities.  Users of the technology, as well as lawyers, will need to identify these discrepancies, which may lead to broader questions, including:
    • What are the benefits and risks of allowing unregulated entities to perform these functions?
    • Can the risks be managed without requiring such entities to submit to existing supervisory and regulatory regimes?
    • If the risks can be managed, then should the protections currently afforded to only supervised or regulated financial market infrastructures or entities be extended to distributed ledger configurations and unregulated or differentially regulated entities? Alternatively, should these protections be reconsidered for all infrastructure and entities, as market share in a specific function moves between incumbent institutions and new entrants?

Nancy Liao is an Associate Research Scholar in Law and the John R. Raben/Sullivan & Cromwell Executive Director of the Yale Law School Center for the Study of Corporate Law.This post is part of an online symposium entitled “Blockchain: The Future of Finance and Capital Markets?” You can read all the posts here.