How Public Blockchain Supports Regulated Financial Application — An ACT-based Solution
By Dr. David Zou, Chief Economist at HashKey Group and Wanxiang Blockchain
This research paper was published on 5 February 2021.
1. Background
Research and experiments on the application of central bank digital currency (CBDC), stablecoin and blockchain in post-trade processing have been carried out globally. With institutional investors stepping into this field, the crypto market is being standardized gradually. Since 2020, DeFi has emerged with continuous innovation, indicating great potential for programmable finance. Some DeFi projects have significant implications on the mainstream financial market. However, how to comply with regulations is still to be discussed.
An important question arises from such context: should regulated financial application be based on public blockchain or consortium blockchain? This is critical for the technology choice of financial application and the development of blockchain ecosystem, as two recent events reveal. First, switching of technology by Project Libra (renamed as Diem now). In June 2019, the whitepaper of Libra 1.0 proposed the plan to migrate from consortium blockchain to public blockchain as it provides greater openness to better support the vision of becoming the global financial infrastructure to enpower billions of people. In April 2020, the whitepaper of Libra 2.0 gave up the plan to migrate to the permissionless system while keeping its major economic features which would be achieved on a market-driven network with open competition. Second, in January 2021, the US Office of the Comptroller of the Currency (OCC) issued №1174 interpretive letter, permitting national banks and federal savings associations to participate in the validation, storage and record of stablecoin transactions as nodes on the independent node verification networks (INVN). OCC did not specify whether INVN is public or consortium blockchain, but its wording seems towards public blockchain.
It is a popular view for a long time that consortium blockchain is more suitable for regulated financial application as it requires permission and imposes restrictions on participants, and hence it is effectively compatible with regulatory requirements such as know your customer (KYC), anti-money laundering (AML), combating the financing of terrorism (CFT) and anti-tax evasion. However, the adoption of Quorum platform by R3 and JP Morgan in the financial industry is not satisfying, indicating key drawbacks of applying consortium blockchain in regulated finance. First, it is challenging to build trust among other institutions on a consortium blockchain platform developed by one institution. This contradicts blockchain’s role as a trust machine. Large institutions tend to build their own consortium blockchain platform as it is not difficult in the open-source environment. With immature cross-chain technology, it creates solos of blockchain, resulting in no network effect. Second, due to lack of economic incentives, there is little internal motivation to build and grow the community of consortium blockchain. Even R3, an alliance formed by multiple large institutions, is not very active in innovation. These large institutions not only do not collaborate, but even involute due to different needs.
In the past few years, major blockchain innovation concentrated in public blockchain. Driven by economic incentives, open-source and decentralized communities are highly active in innovation. New ideas and design have been continuously created, tested and evolved. Grassroots have outperformed institutions. In February 2021, IBM carried out significant staff cuts in the blockchain team. As a major supporter of Hyperledger, a leading consortium blockchain platform, IBM’s withdrawal is a blow on the technology advancement of consortium blockchain.
Public blockchain, with Ethereum as the representative, has developed a diverse ecosystem globally, gradually becoming the public infrastructure. The development of DeFi further shows the advantages of public blockchain based financial applications –no custody required and programmable. However, due to two reasons, the mainstream financial market has been paying attention to but avoiding it. First, as public blockchain requires no permission to connect and the addresses are anonymous, it is difficult to fulfil regulatory requirements on KYC, AML, CFT and anti-tax evasion. The previous public blockchain ICO hype also damages its reputation. Second, public blockchain faces TPS limitation in a decentralized environment. When transaction volume surges, the gas fee will increase, pushing up the trading cost. With the possibility of forks, public blockchain can only guarantee settlement finality in the sense of probability. Some also worry about the security of public blockchain itself.
2. An Initial Thought on “Public Blockchain + ACT” to Support Regulated Financial Application
With new technology, we need to review the suitability of public blockchain in regulated financial application. First of all, public blockchain is more secure than consortium blockchain when operating, fixing bugs and upgrading in the real and complex production environment. The theoretical security of consortium blockchain is, to some extent, the security in the greenhouse. Secondly, the new generation of public blockchain can outperform Ethereum in TPS capacity, gas fees and settlement finality, more suitable for regulated financial application than Ethereum. It is also compatible with Ethereum so the infrastructure and ecosystem built on Ethereum can be reused. Thirdly, public blockchain’s features of permissionless connections and anonymous addresses can be complemented by ACT, enabling it to fulfil the regulatory requirements on KYC, AML, CFT and anti-tax evasion. ACT refers to Authorization & Certification Token.
ACT was invented based on the decentralization of public blockchain. Yannis Bakos, a professor from NYU Stern School of Business, and his partners discussed blockchain’s decentralization in a research paper published in late 2020. They distinguish two standards of decentralization — in design and in practice. Public blockchain has better decentralization in design than consortium blockchain. However, “public blockchain + centralized governance” could be similar to “consortium blockchain + decentralized governance” in practice. The technology shift of Project Libra reveals the same. Decentralization is not the only goal of regulated financial application. Decentralized governance also cannot eliminate the drawbacks of consortium blockchain. However, the takeaway from the paper is that centralized governance can apply to public blockchain. For the gaps between public blockchain and the regulated financial application, if they cannot be solved on-chain or in a decentralized way, we can explore off-chain or centralized approaches. To meet the massive demand of regulated financial application, we cannot simply stick to the fundamentalism of centralization. We need to be flexible when applying it.
ACT is essentially a special NFT contract. ACT includes multiple fields which can be categorized into two types. One is certificate related. It is non-transferable and not easily changeable. When ACT addresses match to individual users, certificates correspond to off-chain ID, in order to fulfil regulatory requirements on KYC, AML, CFT and anti-tax evasion. When ACT addresses match to institutions, certificates correspond to their qualifications, representing the licenses they hold in a digitized, programmable way. The other type is authorization related. It can be transferred or modified. Authorization represents the programmable rights. For instance, whether a user is eligible to participate in STO transactions, or whether an institution is allowed to facilitate STO transactions as ATS. Authorization can be granted, withdrawn, transferred or rented.
Whether ACT fields belong to the certificate or authorization types, they are defined by off-chain centralized entities, meeting the compliance requirements in the mainstream financial market. A centralized entity can define multiple fields and multiple centralized entities can collectively define one field, depending on the needs. All these fields are recorded in one ACT. One public blockchain can support multiple ACT. However, all ACT own NFT features and hence, they can be managed by smart contracts as a whole.
Although public blockchain still technically allows permissionless access and anonymous addresses, ACT creates a “compliant domain”. In this domain, addresses are no longer anonymous. Instead, they are linked to off-chain identities of individuals and institutions. Transactions between addresses comply with regulatory requirements in mainstream finance. For example, STO can be transferred from one eligible investor’s address to another eligible one, but not to an anonymous address. An ATS-qualified institution can initiate STO AMM transactions, but an anonymous address cannot. Implementing restrictions on STO and ATS incurs significant compliance cost in the off-chain situation, but it is easy with ACT. There are other public blockchain activities outside the “compliant domain”, which can be carried out in parallel with the regulated ones.
By analogy with the language of linear algebra, ACT fields can be seen as the “basis” and the “compliant domain” is the linear space formed by the basis. With the flexibility of smart contracts, a lot of “bases” can exist on public blockchain, some or all of which can create different ACT “compliant domains”, to meet different requirements in banking, securities, insurance and trust in mainstream finance. Both “basis” and ACT “compliant domain” can be upgraded, corresponding to the regulatory changes in the financial market. The advantage of ACT is that it is almost indifferent technically whether it includes 10 or thousands of fields, creating greater scale effect compared to the regulatory and compliance practice in the real world.
With ACT, public blockchain becomes the infrastructure layer, following the principle of technological neutrality. ACT is the compliance layer, representing the regulatory requirements. On top of ACT, it is the application layer based on the programmability of smart contracts. The segregation of “infrastructure — compliance — application” layers is critical. We do not attempt to solve compliance issues at the infrastructure layer. Instead, we create the compliance layer to bridge the infrastructure and application layers. All public blockchain related smart contract functions and ecosystems sit at the infrastructure layer; all regulatory and compliance requirements are written on the compliance layer; and financial application only focus on the application layer. Such arrangement maximizes the efficiency of both application and business development.
The principle of technological neutrality is core to public blockchain infrastructure. It is also the key to success for many open networks. For example, some of the information transmitted on the Internet is legal while some is not. If we require the optical fibers, routers, and switches to only process legal information and block the illegal part, Internet will degenerate to silos of local area networks managed by institutions. In reality, regulating illegal online information is achieved via application nodes. Section 230 of the US Communications Decency Act provides immunity for Internet service providers from third-party contents and protects them to take down objectionable materials from good faith or to take technical actions to restrict such contents. European Union proposed the Digital Service Act in late 2020, making Internet platforms not liable for illegal contents if the platforms are not aware of such contents when storing other individual or institution’s data. However, if they are reported, the platforms need to remove any content infringing intellectual property rights, hate speech and terrorist content.
Blockchain, as the Internet of value, transfers value. Some value transfer is legal while some is not. If we require blockchain to only process legal value transfer, all blockchain applications will degenerate to silos of consortium blockchain managed by different institutions. However, as we all know, the functions of consortium blockchain as the Internet of value are limited, basically as the distributed database. Further development of open networks relies on the principle of technological neutrality. At any time, development is the priority. Once open networks scale, we will find solutions to tackle illegal information or illegal value transfer. We cannot refuse to be open because of its uncertainty. One of the key takeaways from China’s Reform and Opening-up is that when the window is open, fresh air will come in. So do flies. However, we cannot be afraid of opening the window because of flies. Taking Ethereum as an example, technical tools supporting ICOs are still available on Ethereum, and they are even more effective now than in 2017. But why do we seldom see any ICO now? It is worth pondering.
Although ACT can achieve significant scale effect, its operation is still complex. The new generation of public blockchain designed for regulated financial application provides better supports via ACT with higher TPS, lower gas fees and enhanced settlement finality. It brings great differentiation and division of labour to the evolution of the public blockchain ecosystem. Self-driven innovation on Ethereum can be migrated to such new generation of public blockchain supporting regulated financial application, after testing and enhancement, to accelerate the application of public blockchain in the mainstream financial industry.
About the Author
Dr. David Zou is the Chief Economist at HashKey Group and Wanxiang Blockchain. He is a research fellow at the Research Bureau of the People’s Bank of China and an associate research fellow and visiting scholar at the Financial Institute of the People’s Bank of China. Dr. Zou has years of extensive experience in top Chinese financial institutes including Central Huijin Investment, China Investment Corporation (CIC), where he worked as the Vice President in Risk Management Department, Senior Vice President and Chief of Staff to the Deputy Chief Investment Officer, and Nanhu Financial Corporation (NFC), where he is the founding partner who has helped the city of Nanhu near to Shanghai to develop its financial district and financial regulatory framework. Before joining Wanxiang Blockchain, Dr.Zou worked for Bitmain, a leading blockchain and AI firm, as the Chief Economist.
