CAI0064
Written evidence submitted by R3
1. Background
1.1 Whether triggered by emerging regulation from multiple jurisdictions or a more general sense of urgency, crypto-assets, including the distributed ledger technology (DLT) that underpins them, have moved to the centre of policy debate and discussion around the world. Governments will now look to set their own balance between attracting inward investment and innovation against the need for robust consumer protection.
1.2 Cryptocurrencies have seen a surge in adoption since the pseudonymous Satoshi Nakomoto published his Bitcoin white paper in 2008. While mainstream institutions increasingly adopt and utilise DLT, some believe that crypto-assets could replace traditional fiat currencies and that blockchain will lead to an entirely new financial system; others believe that both are passing fads and that legacy, traditional structures will prevail. In R3’s view, the future of finance is neither decentralised nor anchored to legacy systems and approaches – it shall be a hybrid – an intermingling of new technologies like DLT and traditional business. Indeed, 91%[1] of banks are experimenting with DLT – a clear indicator that different forms of the technology, which famously underlies bitcoin, is an increasingly relevant part of the financial system.
1.3 As the leading DLT provider for major financial institutions and other businesses, R3 welcomes the opportunity to provide evidence to the Treasury Select Committee’s inquiry into the crypto-asset industry. As the UK Government looks to enact policies that balance attracting inward investment, fostering innovation and protecting consumers, R3 stands ready to provide evidence and serve as a resource on policy matters related to DLT and crypto-assets.
2. Introducing R3
2.1 R3 is an enterprise software firm enabling digital transformation through our trust technologies, connected networks, and regulated market expertise. With a foundation in DLT, our solutions are purpose-built for use in regulated financial industries, including by financial market infrastructures. As such, we believe that the creation and enforcement of carefully considered regulation from the UK Government and elsewhere has the potential to accelerate the technology’s adoption in financial services.
2.2 R3’s Corda is a scalable, permissioned, peer-to-peer (P2P) DLT platform that enables the building of applications that foster and deliver digital trust between parties in regulated markets.
2.3 We work closely with some of the world’s largest commercial banks, financial market infrastructures (FMIs) and central banks to explore the utility of Central Bank Digital Currency, asset-backed stablecoins and other financial services products. The transparency and security enabled by Corda has driven its adoption among some of the world’s most risk-sensitive institutions, including SIX Swiss Exchange through its SIX Digital Exchange (SDX)[2], as well as Nasdaq’s Digital Asset Suite[3].
2.4 The Depository Trust & Clearing Corporation (DTCC), one of the world’s more risk-sensitive institutions, chose R3 as its partner to develop and launch its Project Ion platform.[4] Project Ion, which recently entered production, leverages Corda to process an average of over 100,000 bilateral equity transactions per day. The project represents a profound shift in the way that the financial system operates. Corda enables DTCC to bring enhanced efficiency and risk management to financial markets, which ultimately results in greater trust and cost-saving amongst participants. This is achieved while maintaining the high standards of security and regulatory compliance expected of the industry, proving that DLT can be trusted even within the most stringent conditions.
2.5 Given R3’s extensive theoretical and practical experience in implementing DLT within the financial services industry, much of our response will focus in this area, referencing other areas of interest to the committee throughout the response.
3. Context
3.1 R3 recognises that distributed ledger, blockchain and ‘crypto’ are specific terms that are often used interchangeably despite the fundamental technical differences between them. Moreover, the industry has become associated with high-risk consumer investments – a perception that has been actively encouraged by some quarters of the industry and the media.
3.2 We appreciate that the committee and the UK Government has a clear understanding of the technology and its myriad use-cases, but it is important to acknowledge that the general understanding of distributed ledger and its various use cases is poor. This lack of understanding has created negative inertia towards the technology in some realms and, in our view, sets the background to the Committee’s inquiry.
3.3 Nonetheless, the use of DLT has a myriad of applications and, like any technology, has the potential to create significant opportunities and risks. In this context, we will offer thoughts and examples that will help to realise the significant benefits and offer suggestions to Government on how it can play a role in cultivating those benefits.
4. The UK picture
4.1 Against this backdrop, the UK’s approach to regulating DLT based financial products has been a sensible one, underpinned by the pragmatic and evidence-based thinking that has been the cornerstone of the country’s regulatory approach.
4.2 Based on our experience, there is every indication that the UK Government (via the departments of state, the Bank and the FCA) understand the need to strike the correct balance between consumer protection and driving innovation when governing DLT. Further, the former Chief Economic Secretary to the Treasury’s speech in April 2022 correctly identified how the adoption of carefully measured regulation could drive innovation and provide UK Plc. with a competitive edge:
Having robust and effective regulation won’t hinder innovation, it’ll actually boost it - by giving people and businesses the confidence they need to think and invest for the long-term.
4.3 Given the global leadership of the City of London, and the lower risk appetite of financial services firms post-2008, additional certainty around the rules governing the use of DLT will undoubtedly drive adoption. As incumbent leaders, it is doubly important that UK financial institutions benefit from such regulatory certainty to keep pace with innovation seen in a growing number of challenger jurisdictions, including the EU. This incumbency has provided the UK with significant economic, political and diplomatic leverage over many decades; its continuous renewal through thought leadership, innovation and adoption of new technologies should, therefore, be a core objective of any Government.
4.4 While the adoption of new regulation could always be quicker, R3 recognises that Government has been progressing at a deliberate and considered pace, balancing the competing pressures of the current economic instability, alongside the post-Brexit, post-Covid reordering of the UK economy. From our perspective, it is fair to summarise the UK’s approach to DLT regulation as one of a ‘fast-follower’.
4.5 This fast-follower approach typifies the work of HM Treasury and the Bank of England in their approach to Central bank Digital Currency. As one of the leading providers of solutions for CBDCs, R3 has been providing insight based on our Digital Currency Accelerator model:
This approach to developing a CBDC is in operation across multiple countries and R3’s Chief Technology Officer advises the Bank of England on its development as a member of its CBDC Technology Forum[6].
5. Financial Services and Markets Bill
5.1 The Government’s focus in this area culminated in several DLT focussed provisions within the Financial Services and Markets Bill, currently progressing through Parliament. This Bill aims to deliver on many of the promises outlined in former Minister Glen’s speech of April 2022, including bringing stablecoins within the ambit of UK payments regulation, enacted through amendments to both the Banking Act 2009 and the Financial Services (Banking Reform) Act 2013.
5.2 The Bill, if enacted, would grant HM Treasury flexibility to make and modify regulations as it deems appropriate in the area of DLT, but always in consultation with relevant statutory bodies such as the Bank of England, the Financial Conduct Authority (FCA) and others.
5.3 This level of discretion is necessary to allow for the evolution of the cryptocurrency market, which is likely to remain in a period of continuous transformation for the foreseeable future.
5.4 The Bill also provides for the creation of an FMI Sandbox, permitting HM Treasury the powers to temporarily derogate or modify legislation for the specific purposes of allowing experimentation by financial market operators. In keeping with the fast-follower approach, the FMI Sandbox shares many similarities with the EU’s DLT Pilot Regime, which comes into force in March 2023.
5.5 As HM Treasury considers the implementation of the FMI Sandbox, there are important lessons to draw from the experience of others. While a temporary derogation of regulation to facilitate the creation of DLT-based markets is an appropriate and measured approach, the market must be commercially viable to succeed. For example, FMIs will need to invest in underlying technology to operate within the sandbox. Should limitations on the size or volume of transactions be too great, any systemic risk avoided will come at the cost of low uptake of the scheme itself.
5.6 R3 is involved in the EU’s DLT Pilot Regime, working with customers to reduce this barrier to entry, but the challenges created by the market limitations imposed by the EU’s regulator have caused some to carefully consider the value of their participation. In this regard, the UK’s approach as a fast-follower provides it with some key advantages over other jurisdictions.
6. The role of the regulator vs the role of Government
6.1 The Financial Conduct Authority’s (FCA) role in ensuring the successful and safe adoption of DLT within financial services is crucial. They have already made direct interventions[7] around the promotion of crypto assets to the public and are at the core of delivering the UK Government’s vision for a DLT economy.
6.2 By convening two DLT Cryptosprints, the FCA has been successful in identifying key areas of focus, both in terms of how it regulates and the capabilities it must develop to do so.
6.3 Based on dealings with the regulator, both through our interactions and our participation in the Cryptosprints in particular, the FCA has demonstrated a genuine desire to foster innovation and seek input from industry in striking the correct balance.
6.4 R3 is supportive of the FCA’s stated intentions in this regard, as well as how they have pursued them thus far. However, we do have some concerns around the resources required to implement this shift in regulation. There are several factors that inform this concern, including:
- the existing responsibilities of the FCA and the pressures placed upon it by current market conditions;
- the finite availability of suitably qualified talent;
- the breadth of services and products within the crypto market in need of regulation; and
- the rapid technological developments within it.
6.5 The investment required in the FCA to meet the stated ambitions of the UK Government should not be underestimated. Ensuring that investment is commensurate to the challenge will be another factor determining whether the UK Government realises its ambitions for DLT’s contribution to economic growth.
6.6 It is also important that the role of the regulator be clearly defined. Traditionally, a regulator’s role is to steer and direct a market, but there have been signs outside the UK of a desire for regulators to guide Governments on the purpose of such markets.
6.7 Other jurisdictions, such as the US, have tipped that balanced unfavourably – placing higher expectations on their regulators to guide the administration into setting policy around blockchain[8]. While this has the effect of accounting for technical detail, it leaves questions around DLT and its strategic purpose left broadly unanswered.
6.8 Government can support regulators, and the market itself, by defining, at a high-level, what it believes the role and purpose of DLT instruments should and should not be, based on the interests of the electorate. For example, before stablecoins can be effectively regulated, the Government must determine what outcomes they want such products to deliver to the economy, if any.
6.9 The Financial Services and Markets Bill marks the first foray into settling some of these foundational questions and is much welcomed. The Law Commission’s ongoing review[9] into the legal status and treatment of digital assets will provide greater clarity still.
6.10 Further such leadership will be required if the Government wishes to ensure that the benefits of DLT are made available to all rather than just large businesses and a small sub-set of society. Regulatory clarity, above all other concerns, will be the biggest catalyst for technology adoption within financial services and this cannot and should not emerge without political leadership.
7.The global skills challenge
7.1 To most, DLT remains an obscure concept that is nonetheless having an ever-growing impact on their lives. For a small but-oft-publicised group, it has provided a digital alternative to the day trading craze that took hold in the 1980s – with all the consequences that entails. But for a steadily growing number, who are deeply invested in the technology, it demonstrates the clear potential to address countless social or economic issues that have been dismissed as ‘too hard to fix’. Chief among the challenges the UK faces in adoption is the size of this group, which is limited by a skill and knowledge gap.
7.2 Expert understanding of DLT and the technological underpinnings that make it unique is still held by a very small group of people. To expand the UK’s ability to benefit from DLT, the number of people with such knowledge must also grow. Such skill shortages will be a familiar refrain within committee members’ ongoing work to promote STEM in schools and further education. However, the challenges are particularly acute in DLT, as it combines the need for complex numerical thinking and cryptography with an acumen for information technology. While the popularity of such subjects, particularly among women, remains lower than current market requirements, there is an acute shortage of individuals that combine them both.
7.3 This presents challenges for the UK economy and education system but they are shared by most, if not all, developed countries. The UK, therefore, has an opportunity to seize global leadership in this area should it act decisively to equip the next generation of school leavers with the skills necessary to grow the DLT based economy.
7.4 While not all students will choose to pursue a career in this field, it is also important that a basic level of knowledge of DLT be achieved amongst the wider public. While regulators can achieve this to some degree with the purpose of protecting retail consumers, the process of increasing general levels of understanding for the benefit of the economy will be largely dictated by the job market and demand for skills. Consequently, life-long learning and education will be a key determiner of the UK’s future success in harnessing DLT for the prosperity and sustainability of the UK economy.
8. DLT and the Environment
8.1 The idea that DLT is an inherently energy intensive technology and, therefore, harmful to the environment has become a truism that has not been adequately challenged by the industry. It is certainly true that a subset of the technology – namely public blockchains like Bitcoin that rely upon proof-of-work to create consensus – consume ever increasing levels of energy. Indeed, this has prompted cryptocurrency providers such as Ethereum to move to a proof-of-stake model, but even these less energy intensive approaches consume power at a level that is material to both energy policy and global warming.
8.2 Like any company, organisations involved in the creation or use of such technologies can choose to mitigate their impact through indirect action such as carbon offsetting and many in the industry have chosen to take this route[10].
8.3 However, not all applications of DLT require resource-intensive consensus mechanisms to function. R3’s Corda, among some other DLT platforms, bypasses the need for proof-of-work and proof-of-stake. The implications for energy consumption is clear based on the indicative data shared overleaf.
8.4 While the quantum of difference between Corda and proof-of-work energy consumption is many orders of magnitude, this does not provide the complete picture. As a private, permissioned network, Corda benefits from the participants needing to share their identity, allowing them to form contracts between each other based on shared rules and processes that build mutual trust.
8.5 While such approaches cannot be used in every setting, it is perfectly suited to highly regulated use cases such as transactions between larger financial services institutions.
8.6 It is for this reason – and the fact that private permissioned transactions can often be completed at energy levels roughly equivalent to sending an email[12] – DLT can be as much a solution to global warming as it is a contributor. It is important, therefore, that Governments and industry understand this distinction before making broad-sweeping conclusions on the environmental features of DLT.
8.7 The application of DLT can also have a highly beneficial impact on fighting climate change. For example, corporate net zero commitments means that global demand for voluntary carbon offsets is predicted to rise from US $1 billion in 2021 to up to $50 billion by 2030.
8.8 Yet markets cannot reliably handle even today’s throughput. As a result of market structure, offsets are often misused, misreported and undervalued. This is compounded by the fact that carbon credits are not comparable across markets.
8.9 The incorporation of blockchain into carbon markets has made several operational improvements.
8.10 The first improvement is that decentralisation reduces the complexity of registering, trading and managing carbon credits. One example is the ESG1 platform, which generates public chain offsets directly from energy measurement software. Built by GuildOne Inc., it uses the Corda network and smart contracts to create an automated credit validation ecosystem.
8.11 Simplifying markets in this way has been shown to increase quota utilisation. A further example is AirCarbon in Abu Dhabi, which is building the first fully regulated carbon trading and clearinghouse in the world — a major development in a previously stagnant global market.
8.12 Another improvement is that the transparency that a shared ledger offers makes existing markets more reliable and open. This addresses market opacity, which has been the direct cause of “typical” problems such as lost quotas, illegal trading activity, fraud and repeated transactions.
8.13 By tackling accusations of ‘green washing’, which the industry has been consistently vulnerable to in the past, DLT is rebuilding credibility within the carbon trading market.
9. Concluding observations
9.1 The UK Government is approaching the regulation of DLT within the financial services sector as a fast-follower as compared to other jurisdictions. This is yielding some advantages by informing regulatory design based, in part, on the experience and challenges facing the earliest of adopters. However, it is important that the pace of regulatory development be maintained. The City of London’s future as the preeminent financial centre depends upon its ability to continuously reinvent and renew itself – DLT will be at the heart of this transformation for at least the next decade. Increased regulatory certainty, coupled with clearly articulated appetite, will serve to drive that transformation.
9.2 Whether adequately resourcing the regulator or creating the workforce the UK needs in order to maintain this transformation, education will also be a key determiner of success. For that reason, Government must consider how the current education system equips those seeking a career in this field and the rest of the workforce whose lives will be increasingly impacted by the emergence of DLT. Such considerations can form part of a wider STEM policy, but also requires some specificity given the rare combination of skills required to master the technology and applications.
9.3 Finally, the industry must work with Government to harness the power of DLT to tackle the blight of climate change and ensure vital solutions are not overlooked due to stereotypical views of the technology. Alongside this, Government must consider the long-term implications for its energy and environmental policy based on the ever-growing energy consumption requirements of proof-of-work mechanisms used by Bitcoin and others.
September 2022