United States: CFTC Considers Blockchain Technology

Last Updated: August 1 2016
Article by Nikiforos Mathews and Jonas Robison

The disruptive effects of blockchain technology on the financial system may take several years to materialize. Nevertheless, in preparation, regulators are increasingly focused on understanding potential uses of blockchain technology and considering related legal issues. Many regulators are already familiar with bitcoin, the popular virtual currency underpinned by blockchain technology.1 As discussed below, the bitcoin blockchain, which records and makes publicly available every transaction ever made in that virtual currency, is a "distributed ledger" created by a "consensus algorithm" that ensures that each local copy of the distributed ledger is identical to every other local copy. It is widely expected that such distributed ledger technology ("DLT") will be used in the future to track the ownership of financial, legal, physical, electronic, and other types of assets and, as discussed below, to automate the performance of certain contracts.

The CFTC has begun to consider the implications of DLT with respect to the derivatives markets. For example, a meeting of the CFTC Technology Advisory Committee (the "TAC") on February 23, 2016 featured a panel presentation, titled "Blockchain and the Potential Application of Distributed Ledger Technology to the Derivatives Markets."2In addition, CFTC Commissioner J. Christopher Giancarlo has recently given numerous speeches on the topic to various groups, including Markit Group and the Depository Trust & Clearing Corporation.3 An overview of DLT is provided below, followed by a summary of certain points, including legal considerations, from the TAC meeting and Commissioner Giancarlo's speeches.

Overview of DLT

DLT promises to profoundly enhance traditional "ledgers," which have been used to record money, property, and other assets for millennia. All participants in a distributed ledger have their own identical copies of the same ledger, and any changes to the distributed ledger are quickly reflected on all copies. Participants are able to update the distributed ledger with new entries, but cannot retroactively change the distributed ledger. A distributed ledger can include any type of information that can exist in traditional paper form. The security and accuracy of a distributed ledger is ensured through mathematical and computation processes known as cryptology.

The "blockchain," the central innovation that makes DLT viable, enables ledger entries to be aggregated into "blocks" that, through cryptology, are added to an ever-expanding "chain." Blockchain technology was invented in 2008 to create to create bitcoin, a type of peer-to-peer virtual currency. However, being essentially an asset database, a distributed ledger can also track financial, legal, physical, electronic, and other types of assets.

Certain distributed ledgers also allow a layer of applications called "smart contracts" to be incorporated into the ledger. As discussed below, the terms of a smart contract consist of logic that can operate on the data within the ledger. By automatically performing such operations, a smart contract could automate or eliminate manual processes that the performance of a contract otherwise would involve.

TAC Meeting

The recent TAC meeting featured panelists from clearinghouses, providers of trade processing services and others. The panel presentations and subsequent discussion including the CFTC Commissioners covered several topics. These topics included, among others, possible applications of blockchain technology to derivatives, the appropriate point(s) of the derivatives post-trade lifecycle that should involve DLT, and certain legal issues that could be implicated by the application of blockchain technology to derivatives.

  1. Post-trade lifecycle

In contrast to current labor-intensive reconciliation systems, the use of a distributed ledger in the post-trade lifecycle of a derivatives transaction is expected to: (i) create substantial operations efficiencies through automation; (ii) reduce the time interval between trade and initial settlement; (iii) release capital; and (iv) reduce bilateral counterparty risk.

DLT may allow dealers and other market participants to create smart contracts for derivatives that automate tasks and functions traditionally performed by back-office, middle-office, collateral management, and other personnel. Derivatives contracts are essentially legal agreements with "algorithms" (i.e., logical instructions that can form the basis of computer code) described in legal language.

Certain distributed ledgers currently in development would allow participants to develop and enter into derivatives smart contracts. Such "programmable" distributed ledgers could publish and record not only trade and settlement records but also the terms and "output" of a smart contract, such as contract valuation, settlement of variation margin payments, calculation of initial margin, custody of initial margin, novation and netting, and management of closeout in connection with a counterparty default.

The panelists discussed how a derivatives smart contract could handle the entire lifecycle of a derivative, as both a ledger and a means of automatically computing and implementing post-trade logical processes. Programmable DLT could create a "golden record" of, for example, variation margin movements as well as the computations involved in those movements.

The panelists also discussed the use of non-programmable distributed ledgers. In that case, market participants would manually update a distributed ledger to record information related to a derivatives transaction. Such intermediation and manual processes would differ from the smart contract context, in which such updates would be automated.

  1. Possible blockchain application

As an example of a smart contract, one panelist presented a derivatives trading application using a particular "programmable" distributed ledger.4 The demonstration featured two hypothetical counterparties entering into a trade on the trading application. The application gathered certain trade-related data. The application also provided an identity system (accessible only by authorized parties) in which each counterparty could check the other's know-your-customer status, swap dealer registration status, reputation scoring that could be used to calculate counterparty credit risk, and other information.

The application included a user-friendly interface into which the counterparties would input the type of swap, underlying asset, notional amount, and other terms. In response to market changes or a credit rating downgrade, collateral would be transferred automatically between a trading account and an escrowed collateral account contained within the distributed ledger. Used in this way, the programmable distributed ledger is intended to provide transparency and immutability, as well as efficiency.

  1. Certain legal issues

The panelists also addressed whether an alternative legal regime should apply to computational contracts on a programmable distributed ledger. As an alternative to traditional documentation, parties to a derivatives contract could enter into an agreement providing that they will be bound by the relevant code on a programmable distributed ledger and the output generated by such code in connection with that contract. Such an agreement could provide that recourse against a defaulting counterparty will be limited to the collateral posted.

Certain of the panelists noted that the transparency and immutability of derivatives based on a distributed ledger should provide regulators substantial information regarding types of transactions being entered into, collateral being used, and similar items.

During the panel presentations and subsequent discussion, certain panelists suggested that regulators and other interested parties explore how various legal regimes, such as the bankruptcy laws and Title VII of the Dodd-Frank Act (i.e., the provisions of the Dodd-Frank Act governing derivatives), may accommodate programmable DLT.

Markit Group Speech by Commissioner Giancarlo

Over the past two years, Commissioner Giancarlo has given numerous speeches focused on DLT. In his most recent speech on the topic, he stated that DLT "could be the biggest technological innovation in the financial services industry and financial market regulation in a generation or more." He elaborated that distributed ledgers have the potential to: (i) reduce some of the dependence on a trusted-third party; (ii) mitigate centralized systematic risk; (iii) defend against fraudulent activity; and (iv) improve data quality and governance. He also stated his expectation that DLT will develop hand-in-hand with "smart" derivatives that can value themselves in real-time, report themselves to data repositories, automatically calculate and perform margin payments, and even terminate themselves in the event of a counterparty default. In addition, he noted that DLT could enable market participants to significantly reduce their enormous infrastructure, operational, and settlement costs.

Commissioner Giancarlo also addressed the regulatory implications of DLT. Specifically, he stated that DLT could mitigate the operational, transactional, and capital complexities that U.S. and non-U.S. regulators impose on market participants. He also pointed out that DLT, by providing a real-time distributed ledger, possibly coupled with "modern cognitive computing capabilities," could have helped financial regulators recognize anomalies in market-wide trading activity and diverging market exposures and allowed a "far prompter, better-informed, and more calibrated regulatory intervention" during the 2008 financial crisis.

Finally, the Commissioner advocated that the CFTC and other regulators take a "do no harm" approach to DLT. In particular, he outlined five practical steps that regulators should take to encourage DLT innovation:

  • designate technology savvy teams to collaborate with companies to address how existing regulatory frameworks apply to products and services derived from DLT and other innovative technologies;
  • foster a regulatory environment that allows companies, working collaboratively with regulators, to develop and test innovative solutions without fear of enforcement actions and regulatory fines;
  • participate directly in financial technology proofs of concept to advance regulatory understanding;
  • work closely with innovative financial technology companies to determine how rules and regulations should apply to "21st Century" technologies and business models; and
  • provide a dedicated team to help companies navigate through the various state, federal, and foreign regulatory regimes across jurisdictions.

We will continue to monitor blockchain market developments, including potential and actual uses of DLT applied to derivatives.

Footnotes

1 Previous issues of Derivatives in Review, available here, have covered bitcoin regulatory developments.

2 CFTC's Technology Advisory Committee Meeting Rescheduled for February 23, 2016, CFTC (available at: http://www.cftc.gov/PressRoom/Events/opaevent_tac022316).

3 Keynote Address of Commissioner J. Christopher Giancarlo before the Markit Group, 2016 Annual Customer Conference New York, Blockchain: A Regulatory Use Case (May 10, 2016) (available at: http://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo-15). Special Address of CFTC Commissioner J. Christopher Giancarlo Before the Depository Trust & Clearing Corporation 2016 Blockchain Symposium (March 29, 2016) (available at: http://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo-13).

4 Note that the bitcoin blockchain allows the transfer of value but not programming applications within the blockchain. As such, the bitcoin blockchain is not a "programmable" distributed ledger.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Nikiforos Mathews
Jonas Robison
Events from this Firm
20 Sep 2018, Seminar, Tokyo, Japan

Orrick's Total Access Japan Event Series provides entrepreneurs business, tactical, and legal education through complimentary panels and seminars and networking events. The next event will take place on Thursday, September 20 from 6:00 pm to 7:30 pm.

21 Sep 2018, Conference, Florida, United States

Employment partner, Michael Weil will be participating in The Intellectual Property Law Institute’s 2018 Conference.

26 Sep 2018, Conference, New York, United States

Employment Partner, Mandy Perry and Chair of Orrick's Global Employment Law Practice, Mike Delikat will be participating in the Global Business Protections 2018: International Restrictive Covenants and Confidential Information Conference.

 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions