Regulations & blockchain: the challenge of technological neutrality

Technological neutrality is obviously not a new issue, but the speed and scale of technological progress means that it arises to a greater and more frequent extent than before. The advent of blockchain and, through it, distributed ledger technology (DLT), is a perfect and recent illustration.

Without going into excessively technical detail, it may be said that blockchain, which was originally devised just for bitcoin, has quickly emerged as a new means of registering ownership of many other digital assets and financial securities in particular. Unlike existing systems, the unique feature and strength of this new technology is that a trusted third party is no longer required to validate the transfer of ownership; instead, responsibility for this validation can be shared by consensus between a community of members known as miners.

Previously, validation of a transfer of ownership of digital assets was centralised within an entity, namely the issuer (for registered securities) or a trusted third party (for bearer securities), such as the central securities depository (CSD) or custodian, through registration in a securities account, a form of registration that, contrary to DLT, could therefore be described as centralised ledger technology (CLT). Ultimately, DLT and CLT merely appear to be different technologies used to achieve the same result, which is the validation of a transfer of ownership.

The problem with the current regulations is that they do not attempt to stipulate how a transfer of ownership should be recorded, just how this should be achieved through CLT. This is understandable, however, since, in view of the shortcomings of CLT, the Legislature had to impose the use of trusted third parties duly authorised and monitored by a supervisory authority in order to make the system secure for securities offered to the public or traded on a stock exchange, such as listed securities. The advent of the new DLT means that use of these trusted third parties now only seems to be required for the old CLT.
And who knows whether or not, in the relatively near future, there will be a new, third method for registering the ownership of digital assets?

Unfortunately, having regulations that respect technological neutrality is easier said than done. In any case, regulations cannot ignore the capacities and limitations of current technology. It does not seem very feasible to set regulatory requirements that cannot be met with existing technologies. This makes regulations necessarily conditional on technology. As such, it seems difficult to avoid reviewing the regulations whenever there are major advances in technology, and this is clearly the case with blockchain and DLT. So what happens next?

There seem to be two possible approaches:

• The first is to supplement the existing regulations whenever they explicitly refer to an older technology, adding the newer technologies available at the same level.

This was done in France, for example, when Article R211-1 of the French Monetary Code was simply supplemented with a reference to the new system: “financial securities are only realised through registration in the securities account of the owner(s) or for the benefit of the owner(s) on a shared electronic recording device”, the term shared electronic recording device referring to the blockchain technology used as a substitute for the securities account.

• The second approach would be to look for the common denominator of the older and newer technologies.

 i.e. the ultimate objective sought in view of the two fundamental principles of market integrity and investor protection. In the current case of digital assets, the law should be able to stipulate the expected level of investor protection regardless of the technologies used. This is an intellectual approach that seems more appropriate than the first, but is probably more difficult for lawmakers to formally implement.

Internal diagram - SG Group

While for centralised ledgers, it was customary in France to make a distinction according to the method of ownership (namely registered versus bearer securities), for distributed ledgers it would appear that the relevant distinction should instead be based on the type of digital asset involved, i.e. cryptocurrency or tokens with an issuer.

Regardless of the approach taken, another problem needs to be considered.

Although DLT appears to be superior in many ways to CLT alone, this is, unfortunately, no longer the case when CLT is made secure by the involvement of trusted third parties. As a reminder, DLT was originally devised for bitcoin and the level of protection for investors offered by bitcoin and other cryptocurrencies is clearly lower than that provided for by the current regulations for investors in financial securities, not to mention the potential for money laundering or terrorist financing, which are facilitated by the anonymity of cryptocurrency holders. Thought therefore needs to be given to how to supplement DLT so that there is a comparable level of protection and supervision for financial securities registered in a blockchain (known as tokenised securities) and financial securities registered in a securities account.

As the difference between financial securities and cryptocurrencies mainly lies in the existence or absence of an issuer, the answer to the problem should lie in the interlinking of the regulatory requirements of issuers with the operational requirements of miners (see flow chart). Of course, discussions are already underway and it seems that the approach may depend on whether a blockchain is public or private.