Earlier this week, an NPR story fired up a campaign to force banks to absorb customer losses when business accounts are hacked.  It remains to be seen if legislation will change the Electronic Funds Transfer Act, but the campaign is a sharp reminder of what happens when law falls behind technological reality.  Regulators know this all too well – see our analysis of Treasury’s new inquiry into online marketplace lending as a critical case in point.  Blockchain processing, take warning.  The most exciting change in years for clearing and settlement will come to pass only if regulators come to love it.

There’s been a lot of buzz about blockchains in the past few months, and buzz turned into a strong signal when nine global banks earlier this week announced a new consortium to figure out ways to make blockchain processing work for them.  Several freestanding start-ups are also attracting significant industry and investor interest, with all of these ventures aimed at turning digital ledgers into the double-entry bookkeeping of tomorrow. 

Regulators really like this in theory – current market infrastructure is prone to breakdowns that pose severe operational risk, cost a lot, and concentrate risk into the hands of the largest dealers and exchanges.  Banks used to make buckets from their central role across the clearing-and-settlement spectrum, but a raft of new rules has combined with an array of empowered competitors (CCPs, anyone) to restructure clearing-and-settlement into a losing proposition. In theory, large banks could simply shutter clearing-and-settlement operations, but then the lights would go out across the financial system.

The upside of blockchain processing thus is evident, especially to the largest banks and their regulators.  Customers need to have clearing-and-settlement services and banks have long perched higher-margin products atop their infrastructure edifices.  Regulators very much want banks in the clearing-and-settlement business – if banks don’t do it, then others – such as they may be and whatever bits and pieces of the business they might do – won’t be under strong prudential supervision (if any). 

What’s the downside?  In thinking through blockchains, it’s critical at the start to work through what it fixes and how its fixes could go wrong.  For starters, skeptics will look at the new big-bank venture, review research about collusion risk in anonymized, digital-ledger systems, and think LIBOR.  That’s the first thing an expert in this field asked me about when the word “banker” came up, and he didn’t even know until I told him just how big they are.

Another unanswered question is the extent to which counterparties – especially banks – will aggregate data when using digital ledgers.  Data aggregation is a top regulatory priority not now faring well at any of the big banks.  Will blockchains make this better?  If so, that’s a big plus, but if so isn’t it even harder to tell one systemic counterparty from another until losses warp out of control?

An even bigger plus would come if blockchain design addresses operational risk and, thus, systemic resilience.  It is possible – certainly hopeful – that digital ledgers could erase all the speedbumps that can destroy financial-market axles under stress.  However, would blockchain processes rev up high-frequency trading across the markets to the point at which trades couldn’t be halted by automatic stays in a regulatory resolution?  If it does, then orderly resolutions are even more remote. 

Blockchain processing has tremendous promise, but only if it is designed from the get-go with regulatory concerns kept firmly in mind.  Software guys with cool “sandboxes” must play with sophisticated regulatory-policy analysts.  Legal issues aren’t the same as regulatory-policy ones – a look in the rulebook now won’t find much of relevance, but a failure to think about what the rules could be will lead to an enormous amount of aborted effort at considerable cost to so valuable an innovation.

Maybe blockchain processing will fare as well as electronic business banking – going for almost two decades before customer losses force regulators to rethink the model.  I doubt it – the pace of change and the magnitude of customers in the clearing-and-settlement space do not afford regulators the luxury of figuring this out on the fly.  Without advance, constructive policy analytics, blockchain processors – most especially those in big banks – could build the better mousetrap only to have it snap fast and hard on their own fingers.