Blockchain technology--what's in store for Canada's economy and financial markets?

Author:Koeppl, Thorsten
Position::COMMENTARY NO. 468 - Report
 
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Blockchain technology has the potential to transform the financial sector. This study identifies and advises on the challenges facing regulators and policymakers.

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THE STUDY IN BRIEF

Blockchain technology has the potential to transform dramatically how a modern economy deals with maintaining and updating records. This innovation has already created lots of turbulence in financial markets and beyond. It will be a challenge to let markets figure out how to best use this technology while ensuring consumer safety and efficiency. Our goal in this paper is to unveil the potential of blockchain technology and guide regulators in how to approach the challenges this technology entails.

The most well-known examples of blockchains are found in the area of payments systems and, more generally, in financial markets. It is thus understandable that the financial industry is leading the charge to unearth the potential of this technology in order to find cost efficiencies, but also to recapture above normal profits. The potential application of this technology, however, reaches much further than merely being a currency like bitcoin or a record-keeping system. Early applications of this technology include smart contracts and attempts by governments to build universal online identification systems. Blockchain technology also introduces new concepts such as cryptographic communication protocols and distributed data storage that can increase the safety of electronic networks and offer potential cost efficiency.

We do not expect distributed ledgers to completely supplant traditional intermediaries, especially in areas where these intermediaries are of systemic importance or provide services that require a high degree of ad hoc coordination. Still, many elements of this new technology offer a unique opportunity for such intermediaries to modernize their infrastructures and offer their clients safer and cheaper systems. It is not clear, however, how to realize such benefits in a way that makes sure they are passed on to the economy as a whole.

This leads us to identify three major challenges and priorities for policymakers and regulators arising from blockchain technology:

  1. Design a principle-based regulation regime that achieves high safety standards, legal certainty and a stable environment for transactions based on distributed ledger technology;

  2. Ensure that this technology leads to appropriate end-user cost efficiencies rather than simply a redistribution of above-normal profits among intermediaries; and

  3. Determine areas where government involvement is advisable, be it in the role of facilitator for a private or public distributed ledger, or as a direct central node that applies elements of the technology but retains the monopoly of managing the ledger entries.

    In 2009, the first bitcoin transaction took place. Until recently, many people viewed the idea of such an alternative currency, which existed only virtually, as a mere curiosity, another strange development of the computer age. But times have changed.

    Many believe that distributed ledger technology often also labelled blockchain technology, which is the main idea that powers bitcoin--is ushering in a new era for the organization of our economies, businesses and markets. The Bank of Canada's recent announcement to explore the potential of blockchain technology for the Canadian payment system is prime testimony of this trend. (1) So what's in store for the Canadian economy from this new technology?

    A distributed ledger in its basic form is a digital record distributed among many participants connected by a network who have agreed on the rules for updating the ledger. This ledger is commonly maintained as a blockchain where records are collected into blocks of data and put into a chronological order with each block building on the previous one.

    Record-keeping through a ledger--such as ownership records, financial accounts or the safekeeping of securities--enables decentralized trading and contracting that are of crucial importance for a modern economy. Blockchain technology challenges the idea that these functions must rely on a centralized, public ledger or platform. Traditionally, neutral third parties have run public ledgers. Historically, the key challenge for successful economies was therefore: How can we ensure that a public ledger is safe and accurate, or in other words, how can the third party running the ledger itself be trusted?

    Bitcoin's revolutionary idea is that a blockchain can be used to solve this problem. Based on cryptography and a peer-to-peer network, the blockchain creates an online ledger that, once distributed among the network's participants, is tamper proof and available to verify transactions without the need for a trusted third party such as a middleman or intermediary.

    The most well-known examples of blockchains are found in the area of payments systems and, more generally, in financial markets. It is thus understandable that the financial industry is leading the charge to unearth the potential of this technology in order to find cost efficiencies, but also to recapture rents. The potential application of this technology, however, reaches much further than merely being a currency like bitcoin or a record-keeping system. Early applications of this technology include smart contracts and attempts by governments to build universal online identification systems.

    Our goal in this Commentary is to describe the essential features of blockchain technology, outline the economic drivers behind it and show where questions and concerns for public policy arise.

    Blockchain technology also introduces new concepts such as cryptographic communication protocols and distributed data storage that can increase the safety of electronic networks and offer potential cost efficiency. We do not expect distributed ledgers to completely supplant traditional intermediaries, especially in areas where these intermediaries are of systemic importance or provide services that require a high degree of ad hoc coordination. Still, many elements of this new technology offer a unique opportunity for such intermediaries to modernize their infrastructures and offer their clients safer and cheaper systems. It is not clear, however, how to realize such benefits in a way that makes sure they are passed on to the economy as a whole.

    This leads us to identify three major challenges for policymakers and regulators arising from blockchain technology.

    * First, blockchains and ideas associated with them push the frontier of what is feasible. New applications such as smart contracts have the potential to revolutionize the corporate world. While regulation should not stifle business experimentation, it is indispensable for creating a basic legal framework and putting standards into place that offer safety and stability. As one cannot pinpoint the institutions that will drive this change, it is best to employ a principle-based approach that moves away from institution-based to activities-based regulation.

    * Second, blockchain technology has already started to create turbulence in well-established areas where specialized intermediaries have performed critical functions for decades. Moving forward, policymakers have to be vigilant that blockchains are not used to reshuffle rents at the expense of users, but really do create cost efficiencies. (2) One way to achieve this goal is to engage in public-private partnerships to develop new systems that are stable, solve start-up problems associated with network externalities, and foster competition by ensuring fair access to blockchain-based systems.

    * Third, many potential blockchain applications are in areas highly important for the economy such as payment systems, financial market infrastructure or government databases. We do not deem it feasible to move toward a truly distributed ledger based on blockchain technology in many of these areas. However, some ideas from the technology can be used to improve existing systems, but applications in areas of critical infrastructure will often necessitate direct government involvement. Policymakers will thus be forced to make decisions to what degree small private networks can provide services based on blockchains and how governments engage with these networks. Prime examples are the Bank of Canada's Project Jasper examining the feasibility of an interbank settlement engine along with several foreign government projects to harmonize online identities.

    In summary, policymakers and regulators should focus on three priorities:

  4. Design a principle-based regulation regime that achieves high safety standards, legal certainty and a stable environment for...

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