Blockchain technology has expanded rapidly in financial markets in the last year, drawing concern among financial regulators.
The European Securities and Markets Authority (ESMA), an independent European Union authority, has released a paper on distributed ledger technology (DLT) as it applies to securities markets, including the possible benefits and challenges. ESMA believes DLT is expanding in the securities market, posing new opportunities and risks.
In response, the Coin Center, a non-profit research and advocacy organization that monitors public policy issues facing decentralized blockchain technologies, took issue with one of ESMA’s conclusions, that “open” or pemissionless blockchains may not be appropriate for financial services.
ESMA Explores DLT
ESMA’s 34-page discussion paper explores DLT’s capabilities in the financial sector in detail. While the Coin Center takes issue with some of ESMA’s observations, the ESMA claims it has not advocated a position pro or con on DLT. ESMA wanted to explore DLT from a public policy perspective.
The ESMA published its discussion paper to seek stakeholders’ views on its assessment. ESMA noted it is too early to form a definite opinion on whether DLT will address issues such as financial activities, market participants and market infrastructures in an efficient way.
ESMA noted DLT could create challenges on the safeguards brought by recent securities’ market regulations, such as if new risks are not addressed by existing regulatory frameworks. DLT could speed the clearing and settlement of certain transactions by reducing intermediaries involved and making reconciliation more efficient.
ESMA Cites DLT Benefits
DLT could also facilitate the recording of ownership of securities and the safekeeping of assets by promoting a unique reference database, by limiting the ambiguity of contract terms, by expanding the automation of processing, and making reconciliation more efficient.
The paper also explores the use of smart contracts. It noted smart contracts could reduce the uncertainty attached to contract terms and increase the automation of the processing of corporate actions.
The DLT could improve the collection, consolidation and sharing of data for reporting, risk management and supervisory purposes by increasing the amount of information available from a single source and making access easier and faster. The DLT could also reduce the counterparty risk of securities transactions.
A reduction of costs is a main benefit of DLT. In post-trading activities, for example, DLT can streamline middle and back office processes with the automation of some tasks.
ESMA Cites DLT Risks
Risks cited include scalability, interoperability with existing systems, the need to settle in central bank money (fiat currency), governance and privacy issues.
Fair competition and orderly markets are another risk factor the discussion paper addressed.
Unless adequate controls are established, some network participants could exploit the information recorded on the network, such as trades made by competitors or their inventories, to manipulate the market.
Coin Center Takes Issue
The Coin Center took issue with ESMA’s conclusion that blockchains may be “inappropriate for financial services” in a letter to the agency.
ESMA noted DLT used for financial services would differ from the blockchain designed for bitcoins several ways. While the bitcoin blockchain is an open “permissionless” system, the DLT that is likely to be used in financial markets would be a permissioned-based system with authorized participants only.
“This difference is important to keep in mind because it has a number of consequences in terms of potential benefits and risks,” ESMA noted.
All permissioned-based systems remain in the proof-of-concept stage of development. None are, as-of-yet, securing high-value information, the ESMA noted.
The Coin Center took issue with the implied superiority of permissioned systems in terms of security, privacy and efficiency.
Regarding efficiency, the Coin Center noted that permissionless blockchains have slow settlement speed. They also have limited throughput.
Nonetheless, these limitations are not “fundamental” to the technology, the center noted. Bitcoin’s transactions per second (TPS) exists due to an arbitrary value in its software code that can be changed. Ethereum has no such limit to TPS in its code. Ethereum’s faster block time and higher theoretical throughput indicate the growth of technology in the permissionless sector.
Improvements have been researched in both bitcoin and Ethereum, including proof-of-stake, consensus sharing and the Lightning Network, the center noted. These technologies could deliver higher throughput than modern centralized payment or clearing intermediaries.
Regarding security, permissionless and permissioned systems are similar in that they are trustworthy to the extent that a majority of validators are acting honestly, the center noted. Permissioned systems, the center argued, have two fundamental security weaknesses compared to open systems.
In a permissioned system, there is an entity that identifies and grants credentials to consortium members. If this party is corrupt, it could shift the balance of power on the network by granting more participatory rights to one or another member than was agreed upon by the other members.
Second, the nature of an identified consortium can make it easier for some subset of members to find each other and collude to defraud the rest of the network.
Consensus Technology Evolves
Some have suggested that open consensus mechanisms are not suitable for financial services applications since they are not sufficiently private, the center noted. Bitcoin presents an example of this weakness: bitcoin address pseudonyms are too easily identified and users’ transaction histories are too vulnerable to public scrutiny.
However, there are a variety of solutions, the center noted. One is to build only closed, consortium-consensus networks for sensitive use cases.
R3, the banking technology consortium R3, has described its Corda distributed ledger as containing a digital document that records the content and current state of an agreement between two or more parties who have a legitimate reason to see it.
Zero-knowledge proofs are a cryptographic tool to prove important facts such as a transaction being valid, without revealing any other information aside from the proof.
Integrating zero-knowledge proofs into an open consensus blockchain could allow a decentralized open set of transaction validators to prove recent transactions were appropriately funded and not double-spent, without revealing additional information about who sent whom how much.
This technology, pioneered in the open, permissionless blockchain space, may be most likely to satisfy the desires of ESMA with respect to financial DLTs, the center noted.
“We urge ESMA to avoid writing-off open technologies,” the center concluded. “As we have explained, nothing fundamental to these technologies makes them inappropriate for use in financial markets.”
Images from Shutterstock and ESMA.