Paying for Mistakes: How Blockchain Technology Can Reduce Regulatory Penalties and Compliance Costs

October 29, 2018

By: Gabriella Zak

A Blog based on the paper, “Building Blocks for Better Compliance: Can Blockchain Decrease the Burden of Financial Regulations?,” available here. 

Key Take-Aways:
• Financial institutions must report hundreds of data fields for every transaction they partake in.
• Reporting requirements necessitate complex data consolidation from multiple internal sources and external counterparties.
• Blockchain architectures simplify the consolidation process and may disintermediate data reporting service providers.

$1.28 per a line of incorrect or non-reported data
That’s how much financial institutions are fined by the Financial Conduct Authority (FCA) for non-compliance with transaction reporting requirements. Now, consider the millions of transactions taking place every day for thousands of different instruments on hundreds of trading venues.

Within the E.U., each transaction needs to report 65 data fields under MiFID II alone. Take into account EMIR and REMIT, and the number of reporting fields per a transaction reaches into the hundreds.

With all this data, it’s easy to see how numerous small errors can proliferate into enormous fines.
For example, in 2017 Merrill Lynch was fined £34.5 million by the FCA for incorrectly reporting 68.5 million derivative transactions. But this isn’t the first time the bank has penalized. In 2015, Merrill Lynch was fined £13.3 million by the FCA for incorrectly reporting 35 million transactions.

Compliance costs and penalties can only be expected to continue to increase unless a new approach to regulation is adopted. Blockchain may be this transformative approach.

Why Are There So Many Errors?
Accurately collecting and reporting all the necessary transaction data is by no means an easy task. Not only do firms need to consolidate their own internal data, they also need to supplement it with data from the transaction’s counterparty. To understand the scope of just one regulation, Figure 1 shows MiFID II’s 65 transaction reporting fields and their respective data source.

Figure 1: MiFID II’s 65 transaction reporting fields.

Source: Ignite G2M

Beyond the sheer volume of reporting fields scattered amongst multiple parties, firms struggle to consolidate their own data. As financial institutions grow both organically and through acquisition, multiple autonomous technological systems host business processes. And these various systems may record the relevant reporting data in disparate way. The systems’ inability to interoperate leads data to become siloed within each autonomous framework. Attempts to bridge the gaps usually involve costly manual reconciliation processes and additional layers of software systems.

What’s the Current Approach to Compliance?
Specifically for MiFID II, financial institutions have employed Approved Reporting Mechanisms (ARMs). ARMs are third-party entities who are authorized to provide transaction reporting details on behalf of an investment firm. They’re the MiFID II equivalent of trade repositories under EMIR.

But while ARMs may appear to reduce a firm’s burden of transaction reporting, a significant portion of the work is still placed onto the firm itself. A financial firm still needs to provide the ARM with a single output of all the aggregated data in which they have ownership of. The same issues of internal firm data consolidation resurface.

Furthermore, ARMs are ultimately a quick-fix to the latest regulation of MiFID II. When newer regulation comes into force, additional internal and external systems will be needed. Another data reporting service, analogous to an ARM, will most likely be implemented.

Is Blockchain Really a Solution?
Enterprise blockchains can address many of the challenges currently incurred due to transaction reporting requirements. It provides a systemic approach both to internal and external data consolidation. And if implemented with the right platforms and infrastructures, blockchain may even disintermediate third-party data reporting services providers like ARMs.

Blockchains enable data to be accurately and immutably disseminated to multiple parties and stored within their own records. As a transaction passes from one participating party to another for digital signature, each entity can add their relevant reporting information. In the case of R3’s Corda, this information is then sent to each entity that has been permissioned to view it. If all transaction parties have access to all the relevant reporting information, there is no need for an ARM.

Consolidation of internal reporting data may also be solved by adopting blockchain technology. Data no longer needs to flow through multiple layers of in-house systems and manual processes in attempt to create a complete view. A firm’s transactions and corresponding information could be consolidated into the institution’s blockchain ledger. Again, all of this is done in an accurate and immutable way, eliminating the need for manual reconciliation processes.

Regulatory compliance applications are already being built. Project Maison, was part of the FCA’s BARAC initiative to explore the automation of regulation and compliance on blockchain technologies. The successful pilot delivered a near real-time method for mortgage transaction reporting, lowering the costs of regulatory compliance while greatly reducing data inconsistencies and manual intervention.