Embedded supervision: how to build regulation into decentralised finance
Focus
How might so-called decentralised finance (DeFi) be regulated and supervised? This paper argues that asset tokenisation and the underlying distributed ledger technology (DLT) open up new ways of supervising financial risks. We then put the case for "embedded supervision", a framework that lets compliance with regulatory goals be automatically monitored by reading the market's ledger, thus reducing the need for firms to collect, verify and deliver data.
Contribution
The paper sketches out the basic design for embedded supervision. It then models a decentralised financial market and shows under what conditions supervisors can trust the data from a distributed ledger.
DLT enables decentralised financial engineering based on self-executing contracts and deployed atop distributed ledgers such as Ethereum. If such innovations take root, they will drive the development of financial markets through new forms of transparency and data credibility. However, as data credibility in such markets is assured by economic incentives, supervisors need to ensure that the market's economic consensus is strong enough to guarantee the finality of transactions and resultant ownership positions. Only in this case can supervisors trust the quality of the data in the distributed ledger.
To this end, the paper outlines a distributed and permissioned market in which "blocks" of financial contracts are verified by third parties. These verifiers stand to lose a set amount of verification capital should the blockchain ever be reversed, thus voiding existing transactions.
Findings
The paper's main result is to show how much capital verifiers would have to stake so that no market participant would ever find it profitable to bribe them into reversing the transaction history. As transactions would then be economically final, supervisors could then trust the distributed ledger's data.
The paper also discusses what kind of legislative and other arrangements would be needed to promote low-cost supervision, data privacy, and a level playing field for both small and large firms. It argues that the main challenges would be to embed the concept of economic finality in the legal system and how to design rules for assigning responsibility in decentralised markets.
Abstract
The emergence of so-called "decentralised finance" (DeFi) and a shadow financial system of cryptocurrency exchanges and stablecoin issuers raises the challenge of how to apply technology-neutral regulation so that similar risks are subject to the same rules. This paper makes the case for embedded supervision, ie a regulatory framework that provides for compliance in decentralised markets to be automatically monitored by reading the market's ledger. This reduces the need for firms to actively collect, verify and deliver data. The paper explores the conditions under which distributed ledger data may be used to monitor compliance. To this end, a decentralised market is modelled that replaces today's intermediary-based verification of legal data with blockchain-enabled credibility based on economic consensus. The key results set out the conditions under which the market's economic consensus would be strong enough to guarantee that transactions are economically final, so that supervisors can trust the distributed ledger's data. The paper concludes with a discussion of the legislative and operational requirements that would promote low-cost supervision and a level playing field for small and large firms.
JEL codes: D40, D20, E42, E51, F31, G12, G18, G28, G32, G38, K22, K24, L10, L50, M40.
Keywords: decentralised finance, DeFi, tokenisation, asset-backed tokens, stablecoins, crypto-assets, cryptocurrencies, CBDC, regtech, suptech, regulation, supervision, Basel III, proportionality, blockchain, distributed ledger technology, digital currencies, proof-of-work, proof-of-stake, permissioned DLT, economic consensus, economic finality, fintech, compliance, auditing, accounting, privacy, digitalisation, finance, banking.
