Federal Reserve raises concerns over blockchain

By:
Peter Lee
Published on:

The Fed’s white paper on blockchain shows the extent of concerns about instability in the $12.6 trillion-a-day US payments system as it adapts to new technology. It also puts tech providers on warning of bank-like regulation.

At the TechCrunch Disrupt event in London in early December, David Rutter, chief executive of R3, declared that wholesale financial markets will see substantial activity on distributed-ledger technology in the next three to five years.

He announced that R3 will have a first product in the market by the end of 2017.

R3 is the financial innovation firm attempting to coordinate a multitude of efforts among a 70-strong consortium of banks and buy-side firms to develop blockchain-based financial services.

As blockchain turns from pie-in-the-sky into reality at the core of the wholesale payments system, regulators are growing nervous. In December, the US Federal Reserve released a white paper on the potential impact of distributed-ledger technology on payments clearing and settlement, emphasising that regulators must be convinced of the security of any technology disrupting a system that processes approximately 600 million transactions a day, valued at over $12.6 trillion in the US.

The Fed has now put emerging software and technology firms providing blockchain underpinnings for wholesale financial markets on notice that they may be deemed to have taken on a financial intermediary role and will "likely need to acquire some type of charter or license to provide services or conduct activities that involve the holding and transferring of assets on behalf of households and businesses".

The nature of such regulation remains open to question, but is likely to be much more onerous than the so-called BitLicence that the New York Department of Financial Services has set up for crypto-currency firms.

The Fed says: "It may be useful to explore the pros and cons of a special banking charter with requirements that differ from traditional banking licenses based on the more limited scope of services provided."

Far from dismissing the blockchain, the Federal Reserve acknowledges its potential to improve traditional payment services, services that now operate on decades-old infrastructure, that have adjusted slowly to changes in technology – increasing end-users’ calls for speed and convenience – and to growing security threats.

Blockchain proponents make much of the use of the latest encryption technology to secure data distributed across the nodes in a permissioned network, but experience teaches that anything that can be hacked will be hacked. The Fed worries about the large number of potential entry points into any widely distributed ledger system and the potential for increased exposure to cyber-attacks: "If the system’s encryption is compromised, distributed-ledger technology arrangements may be particularly vulnerable."

Robert_Palatnick-160x186

Robert Palatnick, DTCC

It’s not just regulators that worry. Robert Palatnick, managing director and chief technology architect at the Depository Trust and Clearing Corporation (DTCC), speaking at a London event on disruptive technology, recounts his surprise at a recent meeting with hedge fund managers to discuss the potential for DTCC to move on to distributed ledger: 

"They asked us: 'Why are you looking at blockchain? It’s OK for everyone else to be doing experiments with it, but you are the market structure. We need you to be completely solid and always there.'"

The Fed clearly fears that adopting such a transformative change at its very processing core raises the possibility of temporary instability in the financial architecture. The Fed also recognizes that developments are gathering pace and that initial estimates that real-world applications for blockchain in payments, clearing and settlement were years away from full implementation may have to be revised. The blockchain is moving past proof of concept and into pilot testing now.

"There have already been announcements that the technology will be used within the next year or two in actual production environments," the Fed says.

It may be even sooner, if Rutter is correct.