The paper sketches out the basic design for embedded supervision. It then models a distributed ledger-based financial market, and shows under what conditions supervisors can trust the data from a distributed ledger.
DLT makes possible the decentralised trading of asset-backed tokens, as well as decentralised financial engineering based on these tokens via self-executing contracts.
As data credibility in such markets is assured by economic incentives, supervisors need to ensure that the market's economic consensus is strong enough to guarantee the finality of transactions and resultant ownership positions. Only in this case can supervisors trust the quality of the data in the distributed ledger.
To this end, the paper outlines a distributed and permissioned market in which "blocks" of financial contracts are verified by third parties. These verifiers stand to lose a set amount of verification capital should the blockchain ever be reversed, thus voiding existing transactions.
The paper's main theoretical result is to show how much capital verifiers would have to stake so that no market participant would ever find it profitable to bribe them into reversing the transaction history. As transactions would then be economically final, supervisors could then trust the distributed ledger's data.
The paper also discusses what kind of legislative and other arrangements would be needed to promote low-cost supervision, data privacy, and a level playing field for both small and large firms. It argues that the main challenges would be to embed the concept of economic finality in the legal system and how to design rules for assigning responsibility in decentralised markets.
Full working paper on BIS
© BIS - Bank for International Settlements
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