Embedded Supervision: Building Regulation into Public Blockchain
Digital Ledger Technology (DLT) is revolutionizing how we interact with financial systems. With the rise of Central Bank Digital Currencies (CBDCs) and stablecoins, it's offering us a decentralized data structure based on economic consensus. This offers exciting opportunities to improve financial regulation. At IntraSettle, we believe the path forward lies in "embedded supervision."
Embedded supervision is a concept that harnesses the trust-creating mechanism of decentralized markets for supervisory purposes. This novel approach provides a regulatory framework where compliance is automatically monitored by reading the market’s ledger, significantly reducing the need for firms to actively collect, verify, and deliver data.
Revolutionizing Supervision with DLT
The real potential of DLT lies not merely in the decentralization of data, but in replacing the traditional trustworthiness of data, guaranteed by legal systems and authorities, with economic incentives. This transforms the supervisory framework, allowing for compliance to be tracked and enforced using the economic consensus created by the decentralized market.
In practical terms, for a bank holding CBDCs or stablecoins, compliance with Basel III capital standards could be verified automatically by analyzing ownership of balances and associated risk weights in the relevant distributed ownership ledgers. Similarly, in a token ecosystem, the complete asset backing of a stablecoin could be monitored automatically.
Addressing Data Challenges with Embedded Supervision
Embedded supervision addresses the ongoing conflict between data availability, cost of data collection, verification, and privacy. It reduces the expenditure on compliance that significantly burdens financial institutions and, more so, smaller firms. Cryptographic tools can be employed to report aggregated financial exposures to the supervisor without disclosing underlying individual transactions, maintaining the confidentiality of firms and their customers.
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However, it is essential to note that embedded supervision extends beyond simply reading a distributed ledger. It focuses on ensuring the data's credibility, which is ascertained by economic incentives in DLT-based markets, and exploring the conditions under which the market's economic consensus is strong enough to guarantee the data quality contained in the distributed ledger.
Guiding Principles of Embedded Supervision
There are four guiding principles of embedded supervision. First, it must function as part of an overall regulatory framework backed by an effective legal system and supporting institutions. Second, it can be applied to decentralized markets that achieve economic finality. Third, it needs to be designed within the context of the economic market consensus, considering market reactions to automatic supervision. Lastly, it should promote low-cost compliance and a level playing field for both small and large firms.
Embedded supervision should help bring about a more stable financial system that offers high-quality services at the lowest possible cost. The "fintech opportunity" should be harnessed to promote low-cost financial service provision and a level playing field for incumbents and potential market entrants.
Conclusion
As we venture further into the age of DLT, CBDCs, and stablecoins, we should not merely attempt to fit these technologies into our existing regulatory frameworks but seek ways to integrate our regulatory systems into them. IntraSettle firmly believes in the potential of embedded supervision to revolutionize the world of financial regulation and supervision. By leveraging public blockchain and economic consensus, we can make the compliance process less burdensome for firms and more efficient for regulators, paving the way for a more equitable and efficient financial system.