dFMI: Governing Blockchain Based Financial Market Infrastructure
In our last post, we considered the ingredients needed for Financial Services participants to realise the full benefits of blockchain protocols. We discussed the first ingredient, asset tokenization, which allows for a new post trade business model where participants can interact directly with one another without the need for a settlement intermediary.
In this post, we explore how a distributed Financial Market Infrastructure (dFMI), a Financial Market Infrastructure (FMI) based on a blockchain protocol, could have a system of governance that satisfies the relevant legal and regulatory frameworks and takes advantage of the improved economic mechanism features that blockchain can offer.
Regulation of FMI
Systems that transfer value using fiat currency typically need to be regulated as FMIs, or their juridictional equivalent, at the point that they achieve significant volumes. This is no different for systems based on blockchain protocols where the system itself is distributed and collectively operated by the members of that system. In this case, the FMI will simply govern the multiple nodes and the underlying protocol making up the network.
Financial Market Infrastructures, distributed or not, will typically have to adhere to a set of global principles and responsibilities in addition to any specific local rules and regulations. These principles are set out by the Bank For International Settlements (BIS), a club of Central Banks, that produces frameworks such as these to guide its members when formulating national regulation. The first two principles are Legal Basis and Governance.
Legal Basis refers to the law which takes precedence over issues that arise where events need to be resolved in courts. For dFMI, a key issue is that of settlement finality. Take the recent Stella paper’s view on Delivery-Versus-Payment (DvP) in a Blockchain environment:
... From a risk perspective, … the absence of fully synchronised process steps could expose participants to principal risk if one of the two counterparties does not complete the necessary process steps.
The point here is that the referenced protocol leaves open the possibility of settlement or principal risk because of a lack of full synchronisation. In turn this means that situations could arise where a legal challenge could be mounted regarding the timing of a settlement versus the timing of a bankruptcy, which could harm the smooth functioning of the market and have a knock-on impact for many participants. Having a Legal Basis would mean that the FMI would need to have a set of clear and transparent legally enforceable rules to govern such a situation so that the market could function as normal even if such an event were to occur.
While Legal Basis must be the same for both FMI and dFMI, we believe elements of Governance may be different. This difference is a question of whether and what elements should be baked into the blockchain protocol, if any.
Does dFMI need Off-Chain Governance at all?
One of the original philosophies in the public blockchain space was the idea that “Code is Law”. This was sometimes mistakenly interpreted to mean that code will somehow replace law. The generally accepted meaning, however, is the one ascribed to Lawrence Lessig; this describes how the underlying protocols of a software network essentially govern the usage of that network.
Although it would be natural to try to follow this concept in dFMI, the ideal has so far proved to be very difficult to satisfactorily implement even in the public blockchain space. A major reason for this, as we have seen with Bitcoin, is that the goals of different user communities can result in deadlock over changes to the underlying protocol.
These disagreements arise from differing opinions about how to modify the protocol itself to handle a changing exogenous environment. It is not yet possible to embed in current protocols the means to handle all future protocol changes. There is significant research in this area; views differ as you can see here and here.
The way that these communities have resolved these differences so far has been through a hardfork that results in two different chains. But this is not a satisfactory solution when considering financial assets representing off chain assets with legal and regulatory standing. Imagine sorting out the ownership rights of a security recorded on blockchain when it is hardforked and both forks continue with different user communities. The issue for off-chain assets held on-chain is that off-chain legal reality needs to be represented in the protocol governance. Although this could be considered a variant of the Legal Basis issue noted earlier, it is also a governance issue: which fork represents the ‘real’ security? In fact, one could say that the governance of blockchain issue boils down to the simple question of how to deal with hardforks or hardfork proposals.
In addition, the open access model for public blockchain is not suitable for regulated financial markets. Ultimately, the identity of the participants is a critical part of legal recognition of their financial contracts and is also a requirement for the policing functions, such as Anti-Money Laundering or sanctions screening, carried out by existing financial market intermediaries of all types.
For these reasons, we believe that financial market blockchain needs a governance function and that the public blockchain is not yet suitable for the task.
Governance of FMI versus Governance of dFMI
There is no standard model for FMI legal entity setup.
Many FMIs, such as stock exchanges, started as member owned mutual societies, but demutualised around the turn of the 21st century. More recently, models have appeared that split FMIs into a scheme owner function versus a scheme operator function. The term “scheme” in this usage can be taken to mean the set of rules and technical standards that are followed by the FMI. Examples include Bacs and Vocalink.
In order to understand why these models exist, we need to consider the motivations behind them.
First mutualisation versus demutualisation. Many FMIs started from the need of financial market participants for a common service amongst themselves delivering non-competitive functions that reduced financial risk, operational costs or both. Since that need was shared by the group, they often pooled resources to provide it in a mutual form where they hoped that they would not pay an “economic rent”.
The positive side of the mutual model, from a member point of view, was that the members had an interest in the stable functioning of those markets. They would ensure the appropriate allocation of resources and would “self-police”. They also had a much greater expertise to create appropriate rules and would also buy into rules that they had created.
As markets morphed, arguments for demutualisation arose. These arguments revolved around creating a quicker response to market changes and competition, widening the governance model and increasing the sources of funding.
Both models have their drawbacks. But we will argue in a future post that appropriate economic mechanism design can actually meet the goals of demutualisation by leveraging the incentives of mutualisation. For example, elements like systems upgrades or new features can be incorporated into an economic mechanism design.
A second problem that neither mutualisation nor demutualization could really solve was that of creating and adhering to a set of rules that serves the interest of parties not directly using the services of the FMI, but who relied, indirectly, on it.
Mutualisation, as noted above, does a good job when the rules concern the interests of the members. However, the importance of financial markets means that any issues impact society as a whole, almost instantly. It is possible that an action that is good for society, may not be especially beneficial to the existing members of a mutual FMI. In the same vein, a demutualised for-profit corporation may also have an incentive to under-allocate resources and capabilities that benefit public interest responsibilities versus those that generate greater profits.
The usual solution to this is to ensure that FMIs have the appropriate amount of regulation. The BIS principles mentioned earlier give a framework for that regulation. But this solution also has problems. It drives monopolistic tendencies as the FMI itself is incentivised to need substantial resources to ensure complete control over the network. Furthermore, the ensuing network effect makes it hard for new FMI entrants to drive innovation which could either complement or replace existing solutions, a feature that is not to the benefit of the members or users. And most crucially, regulation drives a centralisation of risk, a feature that is not to the benefit of the members or society as a whole.
Other corporate forms have been tried to address this “societal good” problem. One such is to split the FMI entity into two parts: a not-for-profit regulated scheme owner (the FMI) and an unregulated for-profit scheme operator. The idea here is to separate the interests of the rule setter and the ultimate decision maker from the economic incentives associated with operating the systems and processes associated with the scheme.
As the scheme provider, the FMI has the following characteristics:
- It is specifically regulated to ensure stability in the financial
assets it is associated with and
- It MUST have resources associated with ensuring that it adheres
and contributes to that stability on an ongoing basis.
As scheme provider, the FMI can govern things like limitations on those who can use the asset (access limitation or conversely fair access). It can also set the rules for things like legal settlement finality, which depends on the ability of the FMI to operationally guarantee that no transfers can be made by a bankrupt counterparty and at the same time guarantee the safe functioning of transfers for all other counterparties.
A good example of this type of structure exists in the UK. The Cruickshank Report commissioned by the UK Chancellor of the Exchequer in 2000, came to the conclusion that Clearance Scheme ownership and management should be split from infrastructure operation and delivery to encourage competition. This resulted, in 2002, in the split of BACS into two entities, Bacs Limited, the payment scheme owner, and Vocalink, the payment scheme operator.
While there is no clear answer as to whether separating responsibility into an independent scheme owner versus scheme operator or combining them into one entity leads to a better outcome in general, our view is that a split model using blockchain would. Explicitly the split would be:
- A permissioned blockchain system that incorporates economic mechanism design into the protocol to provide the FMI service in a form similar to a member mutual, and
- A scheme owner for the specific off-chain financial asset held on-chain that protects the legal standing and stability of said asset.
Here are examples of some distinctions that could be drawn between the functions:
The combination of a split model combined with member owned and run infrastructure is different to traditional exchange of value or settlement models. However, it starts to look much more like the models for market trading. For example, NASDAQ was founded by the National Association of Securities Dealers (NASD), a Self-Regulatory Organisation (SRO). In this case a group of dealers agreed to an organisation and a set of rules by which they would trade with and oversee each other on a peer-to-peer basis.
dFMI: a new type of entity?
One of the themes of our first post was how new technology would take us back to a tokenized form of assets that had existed in the past. In this post, we offer dFMI as a new type of entity, but with features of the old mutual model returning some of the advantages associated with that model.
We believe that the public blockchain is not ready for the task of governing financial market infrastructure. However, inspired by public blockchain, a permissioned blockchain with an inbuilt incentive model, represents a new, revolutionary type of institution for economic co-ordination. It reduces the transaction costs for peers to interact with each other by eliminating the need for a central coordinating body and its monopolistic tendencies. The members are responsible for the network. This type of governance is suitable for the operational elements of an FMI and our next post will examine this in more detail.
In addition to a member owned blockchain, dFMI will require a regulated entity that is responsible for ensuring that the rules and technical standards are appropriate and meet any regulatory requirements and, in particular, provide Legal Basis and Governance. We, therefore, envision a split structure to take advantage of the potential of blockchain whilst safeguarding the stability and other attributes of financial market infrastructure. A regulated entity providing a set of standards for peer-to-peer interactions is a very familiar construct from the market trading world!
The split of responsibilities needs to be carefully divided so that responsibility is clear in all situations. And that responsibility will need to be reinforced with the appropriate economic and regulatory incentives. With the right model, dFMI could represent a leap forward in governance.
Future posts will build on this concept of a new type of entity, examining the network economics, interoperation, technological decentralisation and privacy, for the dFMI context.
Head of Services & USC Consortium Executive, Clearmatics
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Read our first blog post on Distributed Financial Market Infrastructure here.