Blockchain Regulation - More than Meets the Eye

By Tom Quaadman, Executive Director, Financial Reporting Policy and Investor Opportunity, U.S. Chamber of Commerce

Tom Quaadman, Executive Director, Financial Reporting Policy and Investor Opportunity, U.S. Chamber of Commerce

Much has already been written about the transformative power of blockchain technology, particularly as a method of dramatically improving the efficiency of payment, clearing, and settlement services. Even more impressive, though, is blockchain’s ability to transform our corporate governance structure, taking it out of the 20th century disclosure-based system and into actual real time reporting. Blockchain could also have a significant impact on developing countries, particularly with respect to real estate and exploration and harvesting of natural resources. These reforms could reduce compliance costs and help accelerate capital markets reforms across the globe.

"Blockchain would solve information asymmetry problems between buyers and seller and also eliminate the need for middlemen"

Blockchain in Corporate America

For those of you that aren’t familiar, blockchain is a decentralized and publically viewable ledger, which records transactions for all to see. Transactions on a blockchain are made secure through cryptography. Users of a blockchain have access to a copy of the ledger, and transactions are grouped into “blocks” and distributed to users when transactions are initiated.

Many financial services firms are exploring how this new technology can help make our capital markets more efficient, particularly with respect to the settlement of securities and other transactions. For example, instead of relying on a settlement process that could take multiple days, blockchain could make transfers of shares and cash instantaneous. These changes could enhance market liquidity and price discovery, particularly given the rising share of automated trading currently occurring in our markets.

However, blockchain technology could be used in even more novel and innovative ways. Given blockchain’s focus on transparency of ownership, we should be exploring how blockchain could impact corporate governance matters. For example, in the context of activist investors, maintaining a real-time open ledger of share acquisitions would help corporate management identify instances when they might be subject to attack by a “corporate raider.” On the other hand, blockchain could also provide investors and regulators with more real-time information about consequential share purchases by management, especially when those purchases are information-driven. In short, blockchain could have a dramatic impact on trading strategies, insider incentives, and the availability of additional takeover defenses.

Blockchain can also be a disrupter in terms of regulation and disclosure. Our current disclosure system is stilled geared to a 1930’s style paper bound annual report. Clearly technology has already displaced that system in favor of other information delivery systems, but the Securities and Exchange Commission has been slow to react. Blockchain could be a disruptive force as financial information can be available to regulators and investors in real time. This could upend current reporting mechanisms and provide regulators and investors with a clearer line of sight.

Accounting and auditing are other examples where blockchain could have a revolutionary impact. Currently, in addition to maintaining robust books and records, publically traded companies must maintain effective internal controls for financial reporting. As essentially a real-time ledger, blockchain could assist with transaction processing, reconciliation, and control as bookkeeping entries are moved to a central ledger. In that type of system, however, almost all corporate transactions would need to be moved to a blockchain in order to maintain an accurate system. In addition, the role of auditors could transform from auditing transactions to auditing the accuracy of a company’s blockchain itself.

In either case, widespread adoption of blockchain could serve as an extra validation tool and help companies maintain more accurate books and records at a potentially lower cost. One could also imagine the development of “real-time” audits, as a blockchain could record all financial transactions in real-time and provide auditors with a more complete record to work from.

Blockchain Abroad

Blockchain is also being used in novel and interesting ways in foreign countries, particularly in the developing world. As a public verification tool, blockchain can be used to ensure compliance with local law and international agreements in the origin of natural resources. For example, BVRio, a blockchain company based in Brazil, currently provides the ability to track the origin of timber harvested from the Amazon. This type of technology could be used to support compliance with environmental regimes with tradeable quotas, particularly in “cap and trade” systems.

In general, these products can also be used to address supply chain risks and compliance with local law. For example, as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act, companies must now certify in public filings that their products are free of “conflict minerals” from the Democratic Republic of Congo. This can be an exceedingly difficult compliance burden, requiring American businesses to expend millions of dollars each year to track down, calculate, and report information that arguably provides no material information to investors. However, through the use of blockchain, this difficult level of transparency is now achievable when every item in the supply chain is made part of the blockchain. In addition, this secure record of transactions would also be a dramatic improvement over a disclosure based given its real-time nature, which would alert a company when there may be doubts about compliance.

Finally, blockchain can be used in a very novel way to help developing countries establish robust and fully transparent land registries. Land title records in developing countries often contain serious errors or lack a complete history of registrations and sales. As a result, disputes over property ownership can arise frequently. Given that real property ownership is often the most efficient and effective method of building wealth, effective land registry systems are critical to developing local real estate and capital markets and generating wealth.

Blockchain can help solve these issues by creating a system to register and record land titles, essentially digitizing the real estate process. For example, there are several pilot programs currently in effect in Latin America, particularly in Honduras. As many have noted, blockchain would solve information asymmetry problems between buyers and seller and also eliminate the need for middlemen, such as a central land registry. This system would also help eliminate potential risks of fraud and the costs of determining whether a fraudulent transfer had occurred, since all transactions could be tracked down easily.

The Revolutionary Power of Blockchain

In short, blockchain has immense potential beyond traditional applications in capital markets and could dramatically transform several areas outside of the payment, clearing, and settlement space. Blockchain’s public verification benefits improve information flow and could equally benefit the corporate board room as much as buyers and sellers of real estate in developing countries. Policymakers should look forward to blockchain’s continuing development and application in novel contexts and should begin discussing how our legal system can be updated to accommodate this revolutionary technology.