Blockchain, Smart Contracts, and Financial Technology Hit the Federal Reserve
The Fintech sector has shown a lot of interest in the blockchain industry over the past year. With blockchain boot camps popping up, and large corporations adding blockchain developers to their roster of professionals, the Fintech industry is buzzing with this technology. Federal Reserve has recentley given blockchain and smart contract technology a closer look.
Earlier this year, on April 14, 2016, the Federal Reserve Board Governor Lael Brainard made a speech called “The Use of Distributed Ledger Technologies in Payment, Clearing, and Settlement.” This marked the first Fed speech about the blockchain’s benefits and the need for regulatory safeguards. Brainard highlighted how far society has come in terms of technology and financial services before addressing the implications, use-cases and risks of the distributed ledger technology.
Today, I will focus on newly emerging distributed ledger technologies and related protocols, which were inspired originally by Bitcoin, and their potentially important applications to payment, clearing, and settlement in the wholesale markets.
Governor Brainard discussed how Bitcoin’s underlying blockchain can benefit financial stability, particularly as it pertains to wholesale financial markets and the security and efficiency of the payment system. She noted that the Federal Reserve should approach these issues from the perspective of policymakers safeguarding the public interest. She then lists the innovative positives that the blockchain technology can provide.
- Peer-to-peer networking and distributed data storage provide multiple copies of a single ledger across participants in the system so that all participants have a shared history of all transactions in the system.
- Cryptography, in the form of hashes and digital signatures, provides a secure way to initiate a transaction that helps verify ownership and the availability of the asset for transfer.
- Consensus algorithms provide a process for transactions to be confirmed and added to the single ledger.
At the closing of her April speech, she mentions that the Federal Reserve should remain cognizant of the potential benefits of blockchain technology, and to make the necessary regulatory adjustments if the blockchain proves to be in the public’s best interest.
On October 7, 2016, Brainard revisited this speech addressing smart contract technology in addition to continuing her discussion about the blockchain’s publicized potential to improve payment, clearing, and settlements systems for trade finance, securities markets, and commodities and derivatives trading. Governor Brainard noted that due to the immutability of Ethereum’s cryptography and computer algorithms, transferring electronic records across a shared ledger could potentially lower the cost, and improve the security and speed of completing transactions by eliminating the middle-men. She said distributed ledgers could simplify the complicated cross-border recordkeeping involved in trade finance, lower counterparty risk in securities transactions, or even automatically enforce bond payment or other contracts. “For commodities and derivatives, there are projects to streamline some of the more antiquated corners of the markets. In markets that are heavily paper-based and lack any central means for coordination, distributed ledger technology could potentially be leveraged to provide coordination that facilitates exchange, clearing, and settlement of obligations.”
However, on the topic of smart contracts, she stated:
Although the idea of automating certain aspects of contracts is not new, and banks do some of this today, the potential introduction of smart contracts does raise several issues for consideration. For example, what is the legal status of a smart contract, which is written in code? Would consumers and businesses rely on smart contracts to perform certain services traditionally done by their banks or other intermediaries? Could the widespread automated interaction of multiple counterparties lead to any unwanted dynamics for financial markets? These and other considerations will be important factors in determining the extent of the application of smart contracts.
Regardless of the application, much of the industry is at a "proof of concept" stage of development. These proofs of concept are often simple, experimental uses of the technology on a small scale that help stakeholders understand the potential and limitations of the technology for a specific purpose, which in turn typically lead to refinements and more developed proofs of concept. As such, many potential applications are in their infancy, and the industry may still be several years away from an application that is ready to be fully implemented.
Even though Governor Brainard brought up the regulatory challenges the blockchain and smart contract technology face, her speech is only the first step to bringing smart contract technology into the Federal Reserve. Because of the notable potential of distributed ledger technology, financial authorities, both domestic and international, will follow these developments with keen interest. The Federal Reserve will publish a research paper later this year that will summarize some of the key findings from the industry engagement so far.
Going forward, we will continue to deepen our engagement with a range of financial institutions, technologists, multi-stakeholder consortia, and academic experts to refine our understanding of the new technologies, along with their possibilities and limitations, with a particular focus on our responsibilities for the payments system, as well as our oversight of financial market intermediaries. We will also continue to discuss these issues with other central banks and authorities around the world. We will work together to foster socially beneficial innovation, while insisting that risks are thoroughly understood, managed, and controlled.