The European Banking Authority (EBA), one of the main regulatory agencies of the European Union, warned banks about prudential risks of distributed ledger technology (DLT) on trade finance and due diligence processes in a report about financial technology effects on incumbent businesses, released on July 3. While underlying some opportunities, EBA has revealed three major issues related to DLT: legal and regulatory uncertainties and DLT heavy dependence on third party such as internet providers and nodes.
EBA has called on banks to be aware of fintech technologies because both being too active or too passive in this field possesses risks. The report has two special sections about effects form distributed ledger technology and the smart contract system that DLT enables: impact on trade finance and on customer due diligence (CDD) procedures.
EBA based its findings for trade finance on a case when companies streamline trade transaction through smart contracts. While acknowledging several opportunities like reducing cost and time, the banking authority has also underlined prudential risks.
“The use of DLT and smart contracts for trade finance poses several risks from a prudential point of view. Some are due to the immaturity of these technologies, while others relate to the legal and regulatory uncertainties or the difficulties entailed in designing the governance of such a model,” EBA noted in the report.
The EU regulator has identified problems with anti-money laundering and counterfeiting terrorist financing (AML/CFT).
“With specific regard to the AML/CFT regulation, as this technology potentially allows less physical analysis of documentation, DLT could lead to abuses for money-laundering and terrorism-financing purposes. Non-compliance with these regulations could carry large fines, with a material financial impact and possible reputation consequences.”
To assess DLT impact on CDD, EBA has examined the case of sharing verified customer data where the customer is required to be physically present.
“While this specific use case has not been seen to be implemented yet, there are a number of prudential risks that could arise, possibly related to potential compliance issues, lack of an adequate governance, dependence and concentration on third parties, legal uncertainty, unclear liability and ICT [Information and Communication Technology] risks,” EBA noted.
The EU regulator also revealed problems with DLT system of nodes.
“Moreover, as the network is formed by a number of nodes, a node with a lower security level could be used to gain illegitimate access to the DLT.”
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