Blockchain under UK legislation and regulation?

By William Garner, partner in Financial Services & Fundsat Charles Russell Speechlys

It is impossible to have any discussion involving Fintechthese days, without the possibilities offered by blockchain technology poppingup somewhere in the conversation. 

The race is on to turn blockchain technology from a systemallowing a small number of anonymous participants to deliver small quantitiesof crypto-currencies to each other, into a viable means of delivery andsettlement for financial instruments. Alongside this, we need to thinkabout the legal and regulatory implications of using this new technology, whichis emerging into a legal and regulatory environment developed to deal with avery different world – one that contemplated a centralised ledger and amonopolistic settlement process. The central concepts of a distributedledger and potentially open access are at odds with established systems and itis going to be difficult to reconcile them with the current regulatorylandscape.

The legal issues surrounding the use of a system usingblockchain technology that is governed by English law are generallypositive. It is highly likely that the English Courts would fall back onthe considerable body of legislation and case law in determining the validityof a commitment made, confirmed or settled through a blockchain process and theconsequences of any failure in that process. It should therefore bepossible to design a system using blockchain technology governed by English lawthat could be used to create or confirm legally binding obligations, pay ortransfer money, or validly transfer title to financial instruments and otherassets.

The regulatory position is very different; the applicationof regulation to any settlement or delivery system using blockchain technologyturns on the financial instruments being committed or settled through thesystem and its functionality. Most post-trade activities are outside thescope of regulation and there are many suggested uses for blockchain technologythat would most likely not require any regulatory approvals. Take forexample, collateral management: here it would be possible to envisage ablockchain system established between a closed and defined user group such as abroker and its clients, which could be used to manage margin that (due to theefficiencies of blockchain technology) could pay and release margin virtuallyin real-time. Such an arrangement is unlikely to require any regulatoryapproval.

Nevertheless, to realise the full potential of blockchaintechnology in clearing and settlement, it would need to be deployed on a massscale and as that would inevitably make such a system systemically important. This alone would attract the attention of the regulators. The mostobvious potential uses for blockchain technology would be in connection withthe settlement of transactions in financial instruments. Settlement is nota regulated concept, but operating as a central counterparty or clearing houseis, and would therefore require the operator of the blockchain system to seekexemption under the Financial Services and Markets Act 2000. The point atwhich the operator of the system would need to seek exemption would depend onthe nature of the financial instruments being settled through it and thefunctionality of the system.  

Even if the operation of a system using blockchaintechnology did not require the operator to be recognised as a centralcounterparty or clearing house, they may well be undertaking a range ofactivities that would bring them within the scope of regulation. One ofthe most basic potential uses for blockchain technology is its use as amechanism for making payments (as it currently does withcrypto-currencies). Any system being used to facilitate payments ispotentially within the scope of the Payment Services Directive (the PaymentServices Regulations 2009, in the UK) and anyone making payments through use ofa blockchain system to transfer cash would likely need to be authorised as someform of payment services provider. If the operator of the blockchainsystem was at any point providing liquidity into that system, they wouldneed to carefully consider whether they were undertaking the regulated activityof issuing electronic money.

Any blockchain system being used to create or confirmcommitments relating to the sale and purchase of financial instruments may wellfall within the scope of a trading system, and therefore require regulation asa Multilateral Trading Facility or Systematic Internaliser. If it alsowent on to settle those commitments, the operator could well be involved in theregulated activity of sending dematerialised instructions.

Probably the most significant regulatory challenge for anysystem employing blockchain technology is the clearing requirement imposed bythe Markets in Financial Instruments Directive and European MarketInfrastructure Regulation, which impose an obligation on participants totransactions in various financial instruments to submit those transactions toclearing. Therefore unless (and until) these regulations are modified toallow the use of systems employing blockchain technology, the opportunitiesoffered by it will unfortunately remain limited.