© Philipp Paech. The following is an extended version of a thought first developed in
The Modern Law Review (2017) 80(6) MLR 1073-1110, with references.

Bitcoin internal dynamics

Bitcoin was originally conceived as a network comparable to a grassroots democracy. Its ‘libertarian’, anti-institutional motivation sat very well with the concept of a permission-less network open to all, where all information was public but users were generally anonymous, and where trust and mistrust where not an issue because a probabilistic method to determine whether record entries are correct, strong cryptography and the distributed, fail-safe set up made trust redundant.

However, Bitcoin could not possibly have remained aloof in the long run from the ideology and private interests of its stakeholders and was progressively compromised by the social and cultural context in which the technology operated.

In particular, the validation of blocks and the associated creation (‘mining’) of new bitcoins has grown into a business that is today characterised by low margins and thus by a high degree of market concentration on a few very powerful players; as a consequence, there are a handful of Bitcoin mining entities or associations that effectively control the network and have a large say in its further development. Also, a group of elite IT specialists run the system from a technical point of view, and these are effectively more influential than ordinary nodes given their superior knowledge and their role as gatekeepers between user consensus and computer code. As a consequence, Bitcoin has evolved into a highly centralised network, ruled by an increasingly oligopolistic market structure.

DLT in finance – Common and competing interests

That is the Bitcoin world – however, its internal governance is different from the internal governance of future blockchain or DLT financial networks set up by for-profit organisations such as banks, other financial institutions or Fintech companies. These networks will be set up either in a spirit of mutuality, assisting market participants to pursue common interests (in particular higher efficiency), or as services provided to wholesale or retail customers.

However, that does not necessarily mean that no internal governance issues may arise, quite to the contrary: once blockchain and DLT technology finds its way into financial assets and services, users may play different functional roles in the relevant networks, such as ‘passive’ nodes that do not contribute to the functioning of the network, or as ‘active’ nodes contributing resources such as computing power, giving them less or more formal or informal influence on the relevant governance decisions. Nodes will also be dissimilar on other grounds, for example because they generate higher or lower transaction volumes, because they join the network at an earlier or later point in time, because they have different nationalities or reside in different territories, or because they may or may not participate in markets outside that particular network and, if they do, have different roles and importance there, too.

Very much as in any other type of network, these differences will influence the degree of bargaining power of the network nodes when it comes to the internal governance of the network. Mindful of the fact that financial institutions associated in blockchain financial networks, while they will have some interests in common, are nevertheless competitors at various levels, bargaining power may be expected to be used to advance each node’s own economic goals by influencing the internal governance of the network, behaviour that may generate decisions detrimental to other, weaker, nodes. This phenomenon is well known from the context of traditional infrastructures: incumbents, in particular within a national market, used entry barriers of all sorts to discourage the entry of foreign competitors into their national markets. The EU has started tackling that problem about 10 years ago, enacting MiFID, CSDR and EMIR and even attempting to further soft-law standard market practices avoiding such kind of anti-competitive behaviour.

What kind of anti-competitive behaviour?

A blockchain financial network has several characteristics that are susceptible to discriminatory decision-making, thereby creating asymmetries within the network that could have a negative impact on the market as a whole.

  • The most important such issue is that of actual access to a ‘permissioned’ network, ie the possibility of excluding prospective new entrants or of only accepting them on unfair terms.
  • Furthermore, processes and standards specific to the network, such as data formats or timelines, could be designed in such a way as to make it easier for some nodes to comply with them than for others.
  • Also, the network could be designed so as to ensure that some nodes are able to extract more sensitive information about the dealings of their competitors than vice versa.
  • Lastly, standards for reporting transaction data to supervisors could be set so as to make compliance with regulation easier for some nodes than for others. There may be other examples.

Competitive distortions

Such a situation may be acceptable from the public policy point of view so long as blockchain-based networks in financial markets do not become dominant. However, once they do, these asymmetries can lead to competitive distortions. Weaker nodes may be unable to adjust their behaviour, in particular for lack of alternatives. In that scenario, blockchain networks would come conceptually close to infrastructures underpinning the financial market, ie they would become akin to exchanges, settlement or payment systems. Such infrastructures, however, are subject to neutrality requirements in providing their services, even though they are currently for-profit organisations. Hence, comparable rules would need to apply in the future to blockchain financial networks, ie they should have objective, risk-based, and publicly disclosed criteria for participation, permitting fair and open access.

Posted by Philipp Paech

Dr Philipp Paech joined the LSE in 2010 as an Assistant Professor of Financial Law and Financial Regulation. He is the Director of the LSE’s Law and Financial Markets Project and a research fellow at the Institute for Law and Finance in Frankfurt. Before joining the LSE, Philipp spent many years at the heart of international legal and regulatory reform of the financial sector, working from 2007-2010 for the European Commission’s Directorate for financial services in Brussels and from 2002-2006 for UNIDROIT in Rome. Philipp holds a doctorate from the University of Bonn and obtained the Diploma of EU Studies from the University of Toulouse. He is a qualified lawyer admitted to the Bar of Frankfurt.