On June 6, 2019, the Financial Stability Board (the “FSB”), an international body that coordinates the work of national financial authorities, published a report on “Decentralised financial technologies” in response to a request by the Japanese presidency of the G20. The report, which was delivered to G20 finance ministers and central bank governors for their June 8-9 meeting in Fukuoka, Japan, considers the financial stability, regulatory and governance implications of the use of decentralised financial technologies (“Fintech”) such as those involving distributed ledger technology (“DLT”) and online peer-to-peer (“P2P”) platforms.
Applications and potential benefits of decentralised fintech
The FSB report identifies three different types of financial services decentralisation:
- Decentralisation of decision-making, which consists in moving away from a single trusted financial intermediary towards systems involving a broad set of users making financial decisions;
- Decentralisation of risk-taking, which involves shifting away from the retention of credit and liquidity risk on the balance sheets of traditional financial intermediaries; and
- Decentralisation of record-keeping, which entails moving away from centrally held data and records towards systems allowing the storage and access to data through an extended variety of users.
In the FSB’s assessment, technological applications to financial services which display all three forms of decentralisation seem unlikely to achieve an economically significant scale in the near term. The report notes that the majority of existing applications, instead, retain one or two of these forms of centralisation, but that there is nonetheless the potential for greater decentralisation in the future.
The FSB points out the distinction to be made between decentralised services and decentralised technologies. In fact, technologies that underlie decentralised provision of financial services need not, themselves, be decentralised. The large-scale adoption of some technologies may, in fact, require maintaining some degree of centralisation. Nonetheless, the increased implementation of such decentralised technologies is supported by existing and forthcoming ancillary technologies such as artificial intelligence, 5G cellular communications, the Internet of Things and edge computing, which can lower the barriers to functions traditionally carried by financial intermediaries.
The report focuses on DLT systems and P2P lending platforms, two technologies that are currently enabling financial services to be provided in a more decentralised manner. DLT enables the decentralisation of record-keeping by removing the need for a central ledger in which financial transactions are recorded. P2P platforms allow for the decentralisation of risk-taking and decision-making by providing direct interaction between users, yet avoiding the search costs that are otherwise incurred in the absence of a centralised financial intermediary such as a bank or insurance company.
The financial services that can be supported by DLT systems and P2P lending platforms include trade finance, capital markets, payments and settlements as well as lending services. DLT might benefit to trade finance by enabling participants from different trade sectors to interact and share information in an ascertainable way, hence allowing verification of information to take place in a decentralised manner and forgoing the need for financial intermediaries. The tokenisation of securities using DLT has the potential to further decentralise capital markets. Foreign exchange platforms are already using P2P technologies to directly match end-users, therefore complementing – and in some places replacing – traditional interbank payment systems for retail cross-border payments. Online lending platforms can make lending decisions without relying on conventional financial intermediaries by carrying out credit scoring on a granular basis, sometimes making use of novel sources of data on borrowers including social networks. The rate at which these technologies are adopted will depend on the efficiency gains offered by decentralised structures.
The application of decentralised financial technologies may reduce some of the financial stability risks associated with traditional financial institutions and intermediaries. For instance, the growth and dispersion of financial service providers could increase diversity among service providers in the financial system and reduce the systemic importance of some existing service providers. The use of decentralised financial technologies may also curtail operational risks: if appropriately secure, decentralised systems may be more resilient to cyber risks than highly centralised systems, particularly in terms of the integrity of their record-keeping and service availability.
Financial stability and regulatory risks
The FSB report identifies several financial stability risks associated with decentralised Fintech, including:
- New forms of concentration risks, considering that many activities in larger DLT systems, such as ownership of assets, control over source code and operation of the infrastructure, remain concentrated in a relatively small set of persons or entities;
- Greater procyclicality in the supply of credit, as P2P lending platforms may exhibit larger and sharper swings in their provision of credit than existing financial institutions;
- Diffused and unclear liability and accountability of participants, which may arise in a more decentralised financial system where participants can sometimes remain anonymous; and
- Diminished responsiveness to official sector interventions, such as the offering of liquidity facilities that have traditionally been granted by central banks to regulated financial institutions.
Loss of confidence in financial markets which may be caused by the cumulative effects of the above-mentioned risks may also aggravate threats to financial stability.
As examined in the report, the significant use of decentralised financial technologies may have implications on financial regulation and governance insofar as it affects the effectiveness and enforceability of current regulatory frameworks, particularly those focused on the presence of centralised financial entities. It may also increase jurisdictional uncertainty considering the increased ease with which providers of financial services are able to change their locations and migrate between jurisdictions. A more decentralised financial system may reinforce the importance of an activity-based approach to regulation, particularly where it delivers financial services that are difficult to link to specific entities or jurisdictions.
Recommendations to G20 financial authorities
The FSB recommends that G20 authorities address the applicability of current financial regulation to decentralised financial services and products, assess the ability of Fintech to fill gaps in financial supervisory systems, and apply regulation to decentralised financial services proportionally to the risks they pose and consistently across jurisdictions, in spite of certain jurisdictions’ technology-neutral approach to financial regulation. In so doing, regulators ought to establish early liaison with a wide group of stakeholders in order to ensure that regulatory objectives are considered in the initial design of technical protocols and to limit the emergence of unforeseen technological complications at later stages.
By Ana Badour and Jason Phelan
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