The Bank for International Settlements (BIS), the so-called central banks’ bank, published a report in May assessing how automated supervision could help regulate and supervise decentralized finance (DeFi) markets.
The emergence of DeFi and a shadow financial system of cryptocurrency exchanges and stablecoin issuers have raised questions among regulators about how to apply technology-neutral regulation so that similar risks are subject to the same rules. Lawmakers in Europe, the U.S. and elsewhere claim that they are planning to regulate crypto using the principle of same risk, same rules. Still, they have struggled to design an efficient and operational legal framework applicable to all digital assets. For instance, Europe has initially left out non-fungible tokens (NFTs) from the MiCA regulation.
The BIS report makes a case for a regulatory compliance framework in decentralized markets to be automatically monitored by reading the market’s ledger. This reduces the need for firms to actively collect, verify and deliver data. In a decentralized market, today´s intermediary-based verification of legal data would be replaced with blockchain-enabled credibility based on economic consensus.
The paper notes that the same principle that applies to distributed ledger technology (DLT) builds credibility with a decentralized data structure based on economic consensus and can be used to supervise the system. Compliance monitoring would then be automated by relying on the trust-creating mechanism of decentralized markets for supervisory purposes.
One key aspect of the embedded supervision is that the market´s economic consensus has to be strong enough to guarantee the quality of the data contained in the distributed ledger. The paper argues that embedded supervision goes much further than simply reading a distributed ledger. Data is not necessarily valid just because it is stored in multiple places. In today’s compliance process, the trustworthiness of data is guaranteed by the legal system, the relevant authorities and the threat of legal penalties. In DLT-based markets, by contrast, economic incentives assure data credibility, and supervisors should examine that the economic consensus is so strong that once a transaction is final, it is no longer profitable to reverse it. These economic incentives would render it very difficult to tamper with the ledger and the supervisor could rely on the data.
But even if the DeFi market has a strong consensus mechanism, a second hurdle is that embedded supervision can only function as part of an overall regulatory framework backed by an effective legal system. This means that the legal system and its institutions must provide a solid connection between the real and the digital worlds. Although cryptography and distributed ledgers can prove the transfer of asset-backed tokens from one entity to another, the connection between the underlying asset and the digital token must ultimately be guaranteed by the legal system, the BIS explains, which alone can underpin the ownership of assets such as real estate or shares in a brick-and-mortar business.
See also: BIS: Cross-Border Crypto Payments Need New Regulatory Framework
This may represent a challenge in many legal systems, where to conclude a transfer of ownership, a central registry needs to be involved. The BIS notes that a decentralized financial system would need to be solidly rooted in both the legal system and supporting institutions such as land registries or rating agencies.
In addition to these two key issues, a strong economic consensus and a supporting legal system, the BIS also suggests that a supervisor would need to monitor aspects of decentralized markets, such as the verification market and the governance of decentralized systems, to ensure a level playing field for entrants.
Read More: 90% of Central Banks Working on CBDCs, BIS Reports
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