If a blockchain became more critical to the financial system, how should it be governed?

Distributed ledger technology (DLT) can transform finance. But current approaches to how some blockchains (a form of DLT) are governed raise questions about the level of responsibility, accountability and control in relation to existing critical financial infrastructure.

Financial services can be reshaped by a number of new technologies, including DLT. DLT and programmable “smart contracts” could enable a different – ​​potentially simpler – network of relationships in financial markets, which could bring a number of benefits, including greater efficiency and increased resilience, if the technology is managed effectively.

Blockchains – a subset of DLT – underpin crypto assets. As of mid-December 2022, crypto assets had a total market capitalization of around $850 billion. Ethereum is the blockchain that hosts the most crypto-related activity: it hosts about 4,400 different tokens with a total market capitalization of about $380 billion, it accounts for over 60% of the total value locked in decentralized financial protocols, and it processes about one . million transactions per day.

Ethereum is an example of a “permissionless” blockchain, which means that participation in the network is not controlled by a central entity. In addition, anyone can propose changes to the network, although broad consensus among users is necessary for changes to be implemented. In contrast, a “permission” blockchain has a central entity that controls the access and privileges of network participants.

In September, Ethereum underwent a major operational event known as “The Merger”, which transitioned the blockchain to a ‘Proof-of-Stake’ consensus mechanism (more info at ethereum.org). The merger represented the culmination of years of planning and testing by a group of core developers, coordinated by the Ethereum Foundation (which plays a prominent role in the network but does not control it).

The merger highlights a number of questions about the governance of permissionless blockchains. The incident posed a number of operational and technological risks and therefore raises questions, including: what if it had gone wrong? Who would be responsible for, and have the authority to, coordinate a timely solution? Who would be liable/responsible for any financial loss caused to others as a result?

In the traditional financial system, critical financial infrastructure is regulated to deliver an appropriate level of responsibility, accountability and control. In the future, critical third parties providing material services to the UK financial sector (eg cloud service providers) may also be subject to regulatory requirements. So there is a question of what appropriate regulatory oversight of a blockchain might entail, should it become a more critical part of the infrastructure of the financial system.

Blockchains do not constitute critical financial infrastructure (yet). But they could conceivably become so in the future if crypto asset activity and its connection to the wider financial system continues to evolve. So it is important that relevant authorities find legal mechanisms and means of coordinated action to ensure that a corresponding regulatory outcome is delivered.

This post was prepared with the help of Andy Walters.

This analysis was shared with the fiscal policy committee in the 4th quarter of 2022.

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