Blockchain vs. regulators and Pareto optimality
As the blockchain technology keeps getting more and more mainstream, SNL reports (gated link) that a top regulator, David Wright, the head of IOSCO (International Organization of Securities Commissions), believed that the blockchain could facilitate regulators’ role by giving them instantaneous access to a total market overview as well as to particular trades and their respective counterparties. He added that, as a result, collateral requirements could be slashed.
As SNL sums up:
Regulators hope that it could revolutionize financial infrastructure, potentially providing them with an omniscient and instant picture of every trade in a market, complete with information about price and the identity of all parties involved.
Wright put a particular emphasis on market abuse:
You know who’s bought the particular product, so that’s good from a market abuse perspective, of controlling market abuse.
He is right; at least partly. Blockchain could indeed seriously simplify and streamlin the infrastructure of financial markets. We have talked about this on this page a number of times, but it isn’t the topic of this post.
Where Wright gets it partly wrong, is when he believes regulators will still be needed to regulate financial institutions. Well, the thing with blockchain technology is that the system doesn’t even need many regulators anyway, because all trades are transparent and accessible by anyone. Intra-firm trade controls are outsourced to an informal and virtual third-party: the blockchain.
Consequently, the number of regulators could be drastically cut. And this is where regulators may end up not loving the blockchain so much.
Regulatory bodies have grown significantly since the crisis, have developed strong political links and influence and have become a bigger source of public sector employment. They have therefore become interest groups. Let’s look at some numbers.
In the UK, the FSA, previously the sole financial regulator in the country, used to employ a total of 1,796 staff as of early-2008. Within a year, it added 537 staff (+30% yoy). It was then split into two different entities, the FCA and the PRA, which as of March 2015 employed 4,034 staff. FCA staff number increased by 17% just in 2014. But the BoE is also now in charge of regulating banks, and its staff (which I believe include PRA staff) totalled 3,868. Meaning there are now 6,887 people who work in official regulatory bodies in the UK (the BoE wasn’t a regulator before the crisis). This is a 283% increase over the past seven years.
Now, I’d like to provide readers with similar numbers for the US and the EU, but given the complexity of the new regulatory frameworks in each of those jurisdictions, it’s a task that requires a little more than a short blog post. In the EU, the ECB and other EU regulators have taken over national regulators, although some implementation and monitoring remains in the hand of domestic authorities. In the US, well, the chart below (from The Economist) speaks for itself. So it’s hard to come up with a pre/post crisis comparison. But there is no reason to believe that the situation differs from that in the UK.
Note that the growth of state-related agencies with expanding powers creates particular Public Choice issues. I see a number of problems here:
- Regulatory bodies are unlikely to prove an exception to the rule and not transform into interest groups (i.e. the usual ‘we need more budget, more staff, more power’).
- Regulatory bodies could become victim of regulatory capture, in the pure crony capitalist tradition.
- The consequence of any of the two points above is that anything that is likely to disrupt this cosy business/regulatory model faces high hurdles, even if beneficial for society as a whole.
Let’s now factor in the blockchain. Despite the fact that a number of regulators clearly see the positive effects that this technology could have on financial markets stability and transparency, adopting it would lead to 1. a loss of discretionary power/influence, and 2. large job losses at regulatory bodies.
Consequently, regulators are strongly incentivised to slow down the adoption of blockchain-like techs. See this recent speech of SEC’s Kara Stein at Harvard Law School, which clearly illustrates the ambivalent stance regulators are in at the moment. Whether or not they eventually succeed as the whole industry moves towards its implementation is another question. Do expect some resistance nonetheless.
Finally, I’d like to point out the irony of this situation. Regulators are often appointed to correct what a number of (often Keynesian) economists view as ‘market failures’ (hint: they are wrong). Their idea is that, through appropriate regulation, a so-called Pareto optimal situation can be achieved: as a result of more stable markets, nobody ends up worse off, and at least a few people end up better off. Hence the irony of witnessing the same regulators effectively preventing us from reaching Pareto optimality through financial innovation. Public Choice theory is as valid as ever.
PS: Don’t get me wrong though. I am not saying that blockchain is the Holy Grail. But regulators are highly unlikely to be better placed than markets to understand the potential implications of widespread blockchain adoption.