Blockchain & Regulations: Let’s Flip the Conversation
RegTech Powered by Blockchain
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There continues to be plenty of discussion and activity around regulations when it comes to blockchain-backed products and services — well, mostly crypto-assets — and although still in a fragmented way, governments around the world are putting more formal and comprehensive legislative and regulatory frameworks into effect.
Nonetheless, rather than talk about the current state of regulatory efforts affecting blockchain-backed offerings, I’d like to flip this conversation to how blockchain and associated technologies such as smart contracts are an area of interest for the regulatory technology — aka RegTech — space, as they can be used to address challenges in a number of regulatory compliance and risk management use cases, including know-your-customer (KYC) and know-your-business (KYB) processes, and regulatory reporting and compliance in general.
KYC / KYB
KYC/KYB compliance is critical for preventing fraud and other financial crimes. If an organization enables customers to move money, it can be a target for money laundering. KYC/KYB checks consist of organizations — such as financial institutions — verifying the identity of individuals and/or companies they intend to do business with. Banks and other payment processing firms, in particular, are required by law to conduct KYC/KYB verification processes to minimize risks, otherwise they may face heavy fines, among other things. [According to research conducted by fintech firm Fenergo, fines for non-compliance with AML, KYC, and data protection regulations against the financial sector worldwide totaled US$5.4 billion in 2021.]
Current KYC/KYB practices involve plenty of redundant work, and limit the ability of financial institutions and other ecosystem participants to collaborate in order to do the necessary verification in an efficient and trusted way. Customers may be subject to onerous checks — the higher the stakes, the greater the scrutiny. At the same time, changes in regulations may create laborious obligations for organizations doing the checks, as well. KYC/KYB verification is typically not a one-stop process, and financial institutions, in particular, are required to conduct multiple checks and monitor transactions on an ongoing basis.
Distributed ledger technology (DLT) — e.g. blockchain — has what it takes to eliminate inefficiencies and redundancies from current KYC/KYB processes. Business processes that involve multiple parties that don’t necessarily trust each other, siloed data, heterogeneous systems, as well as disparate manual and semi-automated practices, are potential application areas for blockchain and associated technologies such as smart contracts.
Regulatory Reporting & Compliance
More broadly speaking, DLT has the potential to materially transform regulatory reporting and compliance as we know it, by providing a golden source of truth for all parties involved, which is viewable in real time, and on a need-to-know basis, allowing regulators to change the current ex-post-facto approach when it comes to reporting.
A blockchain-backed system could replace the inefficient process of locating and exchanging electronic or paper-based documents among multiple parties, which is not only costly and time-consuming for all participants, but also prone to error and fraud. Blockchain and associated technologies can reduce the reporting effort, and enable direct and real-time access to trusted data, without requiring manual interference from the parties involved.
Smart contracts running on a distributed ledger are not only beneficial in terms of efficiency — e.g. by automating specific workflows — but they can also cover the base for contract execution for regulatory reporting and strengthen control around regulatory compliance. In other words, regulatory requirements and obligations could become preconditions of smart contract execution, and the regulator itself would be a participant in the distributed-ledger-backed network.
Final Thoughts
The ultimate goal for any regulation is to take advantage of innovation and opportunities, while minimizing risks. Without a doubt, applying emerging/disruptive technologies to established ways of doing things — e.g. regulatory reporting — may have a systemic impact, which calls for caution; however, the benefits may also be wide-ranging, which calls for action.
We also need to bear in mind that this — as every scenario where the use of distributed ledger technology makes real sense — is a multiparty play, where you must have the buy-in from multiple participants that form part of a particular ecosystem. It is also a multidisciplinary journey, where financial, legal, risk, tax, technology, security, etc. matters intersect and need to be handled together. Not something that happens overnight.
Change may be painful, but not as painful as staying stuck…
