Blockchain holds the dual promise of faster and cheaper transactions for financial services firms. But a lack of regulatory clarity about blockchain could slow innovation.
On Aug. 1, amendments to the Delaware General Corporate Law allowed certain corporate records including stock ledgers, corporate minutes and shareholder lists to be maintained via distributed ledger technology, including blockchain. Unfortunately, regulatory uncertainty stands in the way of full blockchain implementation by banks and other financial institutions. In order to encourage the adoption of blockchain and thereby make the U.S. financial system more transparent and resilient, the federal banking regulators — the Federal Reserve Board, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. — should create a working group on blockchain technology that, rather than propose new rules and regulations, would clarify the application of existing rules to blockchain technology. The Bank Secrecy Act’s know-your-customer (KYC) regulations would be a good starting point.
In evaluating compliance with these requirements, the regulators must determine that the supervised institution maintains procedures “reasonably designed to identify the beneficial owners” of corporate customers and verify the identity of natural person customers. This is a laborious process of collecting organizational documents, tax forms and other information. The process is inefficient because documentation must be provided to each financial institution at which the customer maintains accounts. KYC files must be periodically updated. Such updates are not uniform across financial institutions — with certain financial institutions demanding current versions of documents that have been originally provided, while others demand new documents or classes of documents, entirely.
In short, the current KYC system, marked by a lack of information sharing between institutions, encourages inefficiency and may allow a bad actor to be discovered by one financial institution while concealing itself from other institutions at which it maintains accounts. Blockchain cures many of these ills. KYC files could be maintained on a blockchain network with financial institutions acting as nodes. Each KYC file would be maintained as a block with a cryptographic hash identifying the customer. This would maintain customer anonymity and address data privacy rules, and financial institutions in the network would not be able to identify a particular customer’s file until and unless a customer relationship was created. Such a system would have the dual advantage of (a) reducing the time and cost associated with opening a customer account; and (b) immediately locking bad actors out of the U.S. banking system as soon as one institution uploads problematic information to the KYC file.
However, such blockchain reforms to the KYC process are unlikely to be adopted without the guidance of the federal banking regulators. Neither the Fed, OCC nor FDIC’s BSA guidance, nor the recent KYC regulations promulgated by the Financial Crimes Enforcement Network, contemplates the use of blockchain to maintain KYC files. Financial institutions are a naturally conservative group, and without guidance from the regulators affirming the sufficiency of blockchain to maintain KYC files, the industry will not likely adopt such reforms.
The Fed, with its experience in the payment system as a payments network operator, and the OCC, with its Office of Financial Innovation, would be the natural leaders of this effort, but leadership from all three regulators, including the FDIC, is essential to encourage adoption by the industry. Such guidance does not require a formal rulemaking process, but could be accomplished through an interagency Q&A document. KYC is only a beginning for the bank regulators’ blockchain guidance. The regulators could open such an effort to questions and comments from the industry, addressing issues such as corporate activities, payment systems and trading. Again, the purpose of the working group would not be to impose new rules and regulations on the industry, but to clarify how blockchain technology may be applied to existing regulations.
With the leadership and guidance of the federal bank regulators, this technology does hold remarkable potential to increase the efficiency and stability of the U.S. financial market.