Op-Ed: Blockchain – Innocent Until Proven Guilty

An open letter to the regulator by Dawid de Villiers and Seshree Govender of Webber Wentzel

Dawid De Villiers Partner At Webber Wentzel (LR)

Dear Prospective Blockchain Regulator

A belated warm welcome to the age of Blockchain. In the last five years or so we have witnessed this technology’s ability to redefine the very nature of processes and role players, we hold dear in the financial services industry. Given a few years, the right regulatory landscape and a shift in the mindset of the industry’s collective consciousness, Blockchain technology has the potential to change fundamental ideas and concepts currently entrenched within the financial services industry.

How? Well, Blockchain technology, as with most products of the Fintech movement, is underpinned by a “millennial”philosophy that seeks to better harness the benefits of free flow information, the shift toward more consumer orientated product development processes and integrate systems with greater adaptability. Accordingly, should Blockchain successfully integrate into the financial services industry, crystalised concepts and institutions such as the need for financial intermediation, single point information storage and centralised clearing and settlement may no longer exist.

The Mission of the Regulator

The benefits of Blockchain technology have been well documented in various platforms for the last couple of years.  So too has the fear of security breaches and the platform being utilised as a means to defeat the current consumer protections instilled in the financial services regulatory framework.

As such, we get it – there is definitely a need to regulate this innovation in technology. The devastation alone that a breach or failure in the Blockchain system may cause, certainly calls for regulation. However, as is the case with all innovation, amidst the calls for regulation there is also a need for deference and patience, given the infancy of Blockchain technology.

The Keys to the Blockchain

Blockchain is essentially a record keeping system, albeit a sophisticated and virtually bulletproof record keeping system, against which information is verified, cleared and settled. In other words, a key aspect of the Blockchain system is its inherent ability to adapt and continuously develop its core purpose which is to provide a secure manner of transacting between people without a third party verifying the information provided by the transacting parties.

This inherent commitment to security and transparency is premised on three basic characteristics of the Blockchain system:[1]

  1. A decentralised clearing  or responsible authority
  2. the multi-member consensus approach to enhance transparency[2]; and
  3. the irrevocable chain and its reluctance against judicial or regulatory intervention 

The decentralised authority

Blockchain is premised on the idea that no one institution or person ought to bear the overall responsibility of verifying the authenticity of the information (block) to be added to the chain or regulating the Blockchain itself. Blockchain operates on the foundation of a decentralised verification system that serves the functions of clearing and settlement based on information held by each member of the Blockchain network.[3]

The efficacy of this decentralised verification system rests on the fact that the record held by each member of the network is a replica of the chain and as further blocks are added to the chain, the records of each member updates to reflect the record of the Blockchain.[4]

Therefore, if the replica record held by one member is fraudulently altered so as to manipulate the verification process a block undergoes, the relevant block would still not accord with the other members’ versions and as such creating an inherent checks and balances system in respect of information verification before a block is added to the chain.

This decentralised verification system negates the need for a single entity to be responsible or liable for the information that is entered into the Blockchain system.[5] This is because all participants on the Blockchain network serves the function of and is responsible for the accurate verification of information.

It is arguable that regulation that undermines the function and purpose of a decentralised system by requiring a central entity to maintain authority in respect of the Blockchain is counterintuitive to the very purpose of Blockchain. The concept of a decentralised system is to ensure that no one entity, which is susceptible to various faults and weaknesses, as is any other entity, is tasked with ensuring the validity of transactions that operates through the Blockchain.

In an ideal Blockchain system, every member connected to the Blockchain network bears equal responsibility and liability for ensuring that transactions and information are in accordance with the information record instilled in the Blockchain.

Accordingly, we submit that the Blockchain system requires the financial services industry to start thinking of the concept of liability, responsibility and consumer protection as a function performed by every member of the Blockchain network as opposed to a single central entity.

Multi-Member Consensus Approach

Blockchain, in line with the calls for increased transparency in the financial services industry, seeks to secure and generate an irrevocable and transparent record of transactions. This transparency is achieved through an irrevocable record that (i) is continuously verified by each member of the Blockchain network and (ii) such verification is not reliant upon the internal processes of one particular entity. [6]

In order to illustrate this, let us consider the hypothetical scenario of a securities exchange where the central securities depository, the issuer, the stockbroker and the central securities depository participant are all members of a Blockchain network. Should the broker (in processing a sell order) claim that their client is the owner of securities forming the subject of the sell order, this information (block) will be distributed to the various members within the Blockchain network and if it is determined that such information does not accord with the Blockchain record (held by each member) the information will be rejected and will not form part of the Blockchain, resulting in a failed trade.  

This system of multi-member consensus clearing ensures that each member, on an automated basis, applies the same diagnostic approach to the verification of information against the same record, irrespective of the internal processes of each member.  Accordingly, each member of the chain is always cognisant of the acquiesced process adopted in determining whether a block should be added to a chain. [7]

This system affords transparency to transactions processed through a Blockchain, bearing in mind that due to the flexibility of Blockchain, the system can be restricted depending on the particular needs and purpose of the Blockchain network.[8]

The built-in transparency feature of the Blockchain network arguably negates the need for the regulator to administer and enforce further transparency requirements. The regulator should rather focus on the members of the Blockchain network and not the technology itself. Regulation within this context should aim to create criteria for persons who are permitted to form part of particular Blockchains. In this way, the regulator could ensure the integrity of the Blockchain and its members without inadvertently hampering innovation or undermining the core function of Blockchain.

The Irrevocable Chain

Conservative critics of Blockchain have argued that a critical flaw of Blockchain is its resistance against judicial and regulatory intervention.[9]

Let us take for example an instance where an investor is of the belief that a block in the Blockchain incorrectly reflects the factual position and contests the accuracy of the Blockchain in a court or an equivalent regulatory forum. The question that arises in this context is whether the judiciary or the regulator should have the overarching power to alter the Blockchain record in light of such a claim.

It is crucial to note that the strength and validity of Blockchain are solely dependent upon the irrevocability of the chain. In other words, the moment an institution, judiciary or regulator is empowered to alter the Blockchain; it compromises the chain in its entirety.

Accordingly, we submit that the regulator should exercise restraint in permitting regulatory or judicial intervention in the Blockchain, bearing in mind that one cannot simply oust the jurisdiction of a court.

Rather, a regulatory presumption should be adopted. The central premise of the presumption should be that the Blockchain is presumed to be correct unless evidence is adduced to illustrate otherwise. The judiciary, as well as regulators, should bear in mind the essential characteristics of Blockchain which is to enable various intuitions within the network to verify the information contained within the network. Therefore, unless there is clear evidence of manipulation or contamination of the information, the members of the network, or the verification process itself, the judiciary or a regulator should refrain from intervening in a Blockchain. 

Taking all of the above into account, the position of a prospective Blockchain regulator is an unenviable one. Such a regulator may in the immediate future be tasked with attempting to balance the benefits and industry need for Blockchain against the potential exploitative weaknesses that may be inherent in the system. How does a regulator balance the need for investor protection against the restraint from overburdening a budding and innovative field within the industry?

It is submitted that the solution is two-fold:

  1. Understanding the purposes and core functions of Blockchain and the manner in which it differs from current industry practices and at the same time realising that while Blockchain is termed an innovation, its purpose and process are not novel. Blockchain is merely a more effective and secure means of performing the already existing function of record keeping, clearing and settlement. Regulation should thus not aim to prescribe the process of Blockchain by seeking to codify or label the Blockchain system. 
  2. An understanding that the inherent features of Blockchain are based on principles of transparency, investor protection and security. As such, regulation should seek to enhance the framework in which Blockchain operates rather than further regulating its core principles.

Caution must be exercised by the prospective regulator to ensure that a “throw the baby out with the bathwater” approach is not inadvertently implemented in the regulation of Blockchain.

The challenge will be to strike this balance by ensuring investor protection while at the same time encouraging the innovation and development of technology within this budding industry.

Kind Regards

The millennial financial services industry

 

For more information visit www.webberwentzel.com 

Follow Webber Wentzel on Twitter: @WebberWentzel

 FOOTNOTES:


[1]IMF Staff Discussion Note: Virtual Currencies and Beyond: Initial Considerations (January 2016)

[2] Brave New Coin: Digital Currency Insights “A Gentle Introduction to Blockchain Technology” (2016)

[3] “Distributed Ledger Technology: Beyond block chain” A report by the UK Government Chief Scientific Adviser (2016)

[4] Brave New Coin: Digital Currency Insights “A Gentle Introduction to Blockchain Technology” (2016)

[5] “Distributed Ledger Technology: Beyond block chain” A report by the UK Government Chief Scientific Adviser (2016)

[6] Brave New Coin: Digital Currency Insights “A Gentle Introduction to Blockchain Technology” (2016)

[7] Brave New Coin: Digital Currency Insights “A Gentle Introduction to Blockchain Technology” (2016)

[8] Barclays “Blockchain: Understanding the potential” (2015)

[9] Oliver Wynman and Euroclear “Blockchain in Capital Markets: The Prize and the Journey” (2016)

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