Tag: Bank of England

The press release issued by the Bank of England on 3 November 2022.

Monetary Policy Summary, November 2022

The Bank of England’s Monetary Policy Committee (MPC) sets monetary policy to meet the 2% inflation target, and in a way that helps to sustain growth and employment. At its meeting ending on 2 November 2022, the MPC voted by a majority of 7-2 to increase Bank Rate by 0.75 percentage points, to 3%. One member preferred to increase Bank Rate by 0.5 percentage points, to 2.75%, and one member preferred to increase Bank Rate by 0.25 percentage points, to 2.5%.

As set out in the accompanying November Monetary Policy Report, the MPC’s updated projections for activity and inflation describe a very challenging outlook for the UK economy.

Since the MPC’s previous forecast, there have been significant developments in fiscal policy. Uncertainty around the outlook for UK retail energy prices has fallen to some extent following further government interventions. For the current November forecast, and consistent with the Government’s announcements on 17 October, the MPC’s working assumption is that some fiscal support continues beyond the current six-month period of the Energy Price Guarantee (EPG), generating a stylised path for household energy prices over the next two years. Such support would mechanically limit further increases in the energy component of CPI inflation significantly, and reduce its volatility. However, in boosting aggregate private demand relative to the August projections, the support could augment inflationary pressures in non-energy goods and services.

Other fiscal measures announced up to and including 17 October also support demand relative to the August projection. The MPC’s forecast does not incorporate any further measures that may be announced in the Autumn Statement scheduled for 17 November.

There have been large moves in UK asset prices since the August Report. These partly reflect global developments, although UK-specific factors have played a very significant role during this period. The MPC’s projections are conditioned on the path of Bank Rate implied by financial markets in the seven working days leading up to 25 October. That path rose to a peak of around 5¼% in 2023 Q3, before falling back. Overall, the path is around 2¼ percentage points higher over the next three years than in the August projection. The higher market yield curve has pushed new mortgage rates up sharply. Financial conditions have tightened materially, pushing down on activity over the forecast period.

GDP is expected to decline by around ¾% during 2022 H2, in part reflecting the squeeze on real incomes from higher global energy and tradable goods prices. The fall in activity around the end of this year is expected to be less marked than in August, however, reflecting support from the EPG. The labour market remains tight, although there are signs that labour demand has begun to ease.

CPI inflation was 10.1% in September and is projected to pick up to around 11% in 2022 Q4, lower than was expected in August, reflecting the impact of the EPG. Services CPI inflation has risen. Nominal annual private sector regular pay growth rose to 6.2% in the three months to August, 0.6 percentage points higher than expected in the August Report.

In the MPC’s November central projection that is conditioned on the elevated path of market interest rates, GDP is projected to continue to fall throughout 2023 and 2024 H1, as high energy prices and materially tighter financial conditions weigh on spending. Four-quarter GDP growth picks up to around ¾% by the end of the projection. Although there is judged to be a significant margin of excess demand currently, continued weakness in spending is likely to lead to an increasing amount of economic slack emerging from the first half of next year, including a rising jobless rate. The LFS unemployment rate is expected to rise to just under 6½% by the end of the forecast period and aggregate slack increases to 3% of potential GDP.

In the MPC’s central projection, CPI inflation starts to fall back from early next year as previous increases in energy prices drop out of the annual comparison. Domestic inflationary pressures remain strong in coming quarters and then subside. CPI inflation is projected to fall sharply to some way below the 2% target in two years’ time, and further below the target in three years’ time.

In projections conditioned on the alternative assumption of constant interest rates at 3%, activity is stronger than in the MPC’s forecast conditioned on market rates, although GDP is still expected to be falling at the end of 2023. CPI inflation is projected to be a little above the target at the end of the second year. However, it falls more than a percentage point below the target at the end of the third year.

The risks around both sets of inflation projections are judged to be skewed to the upside in the medium term, however, in part reflecting the possibility of more persistence in wage and price setting.

The MPC’s remit is clear that the inflation target applies at all times, reflecting the primacy of price stability in the UK monetary policy framework. The framework recognises that there will be occasions when inflation will depart from the target as a result of shocks and disturbances. The economy has been subject to a succession of very large shocks. Monetary policy will ensure that, as the adjustment to these shocks continues, CPI inflation will return to the 2% target sustainably in the medium term. Monetary policy is also acting to ensure that longer-term inflation expectations are anchored at the 2% target.

The labour market remains tight and there have been continuing signs of firmer inflation in domestic prices and wages that could indicate greater persistence. Currently announced fiscal policy, including the MPC’s working assumption about continued fiscal support for household energy prices, will also support demand, relative to the Committee’s projections in August. The Committee will take account of any additional information in the Government’s Autumn Statement at its December meeting and in its next forecast in February.

In view of these considerations, the Committee has voted to increase Bank Rate by 0.75 percentage points, to 3%, at this meeting.

The majority of the Committee judges that, should the economy evolve broadly in line with the latest Monetary Policy Report projections, further increases in Bank Rate may be required for a sustainable return of inflation to target, albeit to a peak lower than priced into financial markets.

There are, however, considerable uncertainties around the outlook. The Committee continues to judge that, if the outlook suggests more persistent inflationary pressures, it will respond forcefully, as necessary.

The MPC will take the actions necessary to return inflation to the 2% target sustainably in the medium term, in line with its remit. The Committee will, as always, consider and decide the appropriate level of Bank Rate at each meeting.

The press release issued by the Bank of England on 27 October 2022.

Sam Woods sets out how independent regulators can support the UK as a global financial centre.

It’s a great pleasure to be here in the Egyptian Hall again – thank you Lord Mayor for hosting us. I’m afraid my remarks are even less amusing than they usually are when I inflict this annual speech on you all. But that’s because tonight’s topic is deadly serious.

I want to use this speech to talk about how prudential regulation can contribute to the competitiveness of the United Kingdom as a financial centre, and to long-term economic growth. My argument can be boiled down to three points:

• First, financial stability is the single most important ingredient of competitiveness in financial services. Delivering that stability must remain the core purpose of prudential regulation here in the UK.
• Second, there is a good case for Parliament to require the regulators to place more weight on growth and competitiveness as part of post-Brexit reforms in which our role as a rulemaker is expanded. If Parliament agrees to make that change we are ready to embrace it.
• Third, there are good ways of making that change and bad ways of making it. We fully support the Financial Services and Markets Bill as introduced to Parliament, because it strikes a sensible balance between the competing considerations at play.

Regulation versus growth?

Too much debate on this topic is premised on a simplistic trade-off between regulation and growth. In that view of the world, the way to promote growth is simply to de-regulate: either by releasing capital that would otherwise be tied up in prudential requirements, or by cutting through red tape to reduce compliance costs.

A related view says that you can become a global financial centre by watering down standards, to attract international business with the promise of lighter regulatory burdens.

Badly designed regulations can indeed reduce a country’s relative attractiveness as a place to do business, and should be removed or reformed. We have of course inherited some such rules from our time as a member of the EU, and probably also some that we have devised ourselves without any help from Brussels. The Financial Services and Markets (FSM) Bill before Parliament will require us to focus more on this aspect of regulation, which we are ready and willing to do.

However, it may also be true that if you saw the keel off a yacht, for a little while and in light winds it may go a bit faster. Despite this, there are probably more sensible ways for sailors to make themselves more competitive, particularly if they want to compete globally and be able to navigate heavy weather without drowning.

My point is that a well-designed regulatory regime supports economic growth, and that a credible regulatory framework is a necessary precondition for hosting a very large global financial centre. There is a balance to be struck here: on the one hand, to do its job here in the UK prudential regulation must be robust, global and independent; on the other, it must be proportionate and suitably open to innovation. Having left the EU it is right that we strike a balance that works for the UK and contributes to global financial stability, but we should do this with care and avoid suddenly all rushing to one side of the boat.

Robust

The single largest contribution prudential standards can make to economic growth is by reducing the frequency and severity of financial crises. It is absolutely clear from the history of financial crises that in order to achieve this to any tolerable degree prudential regulation must be robust. It took many years for the UK economy to recover from the 2008 financial crash – but in contrast, the stronger regulation we’ve put in place since 2008 has allowed us to navigate more recent severe shocks such as those resulting from the energy and Covid crises.^footnote[1]

Now of course you would expect me to make that point. But the case for robust standards is about more than just avoiding crises. Strong financial regulation also promotes economic growth in a subtler way. It helps to create a high trust environment where you can do business without constantly being worried about your counterparties falling over. This brings down risk premia in the financial sector – reducing the cost of lending for households and businesses, and promoting productive investment – and makes the UK an attractive place in which to do international business.

This gets to an important point: the world’s largest financial centres are not places with low standards. They are places with high, consistent standards, where you can do business with confidence. Any attempt to become a global financial centre by competitively de-regulating would be self-defeating by its nature: major international financial institutions want a safe harbour, not a wild west.

It may be possible to become a regional centre of offshore finance by undercooking regulation. Some such minor centres exist. But I see no reason why the UK would seek that status. We are already, by some measures, the leading global centre of international finance. We should not be complacent about that status – but we should be clear that our reputation for strong regulation is an asset, not a liability. You don’t get to the top by racing to the bottom.

Global

Well-designed regulation must also be global. By this I mean a couple of things.

First, adherence to globally agreed standards.^footnote[2] Having a consistent rulebook across jurisdictions makes it far easier to do cross-border business, and allows international centres like London to host global business.

Being seen as a good citizen also enhances the credibility and reliability of the UK as a place to be based. And make no mistake: the world is watching. In a recent report on the United Kingdom’s financial sector, the IMF described UK financial stability as a global public good.^footnote[3]

Second, a global approach means openness to international business, and establishing a level playing field on which firms from different home jurisdictions can compete. As part of this, we should avoid disadvantaging our own firms with needless ‘gold plating’ of international standards. At the same time, we are open, indeed welcoming to overseas firms that want to operate here. They can do so with confidence that the playing field is level and the referee is unbiased.

Again, I want to emphasise that the UK is already well ahead of the game on this score. We host 91 branches of international banks with total assets of £8.4 trillion. The IMF said this ‘puts the UK in a category by itself as a large host of international activity’ and we are ‘largely unique’ in our openness to international banks operating as branches. We also play host to many major subsidiaries of global banks, and a major international insurance market. This is not something that just happens without a lot of work to support it – most importantly in implementing international standards, but also in day-to-day supervision which enables us to manage the considerable risks involved by working closely with our counterparts in other jurisdictions. To facilitate this openness, we have recently updated our approach to international bank supervision and have put in place co-operation arrangements with nearly 50 jurisdictions.^footnote[4]

Independent

Which takes me to the next point – independence.

Independent regulation is at the core of what we do in the PRA.

There’s an extremely well-documented link between the independence of regulators and financial stability^footnote[5], but independent regulation also enhances our competitiveness in other ways. In part this is by ensuring that regulation is consistent and predictable: by removing regulation from day-to-day politics, Parliament can ensure that regulators follow more timeless objectives. This in turn provides certainty to businesses that the regulatory framework will be relatively stable over time.^footnote[6]

Our independence is the basis for our international credibility. Independence is widely accepted as international best practice, and indeed is enshrined in the global standards which the UK has signed up to.^footnote[7] I believe our record of independence is a big part of why authorities in other countries are content for their firms to operate here at such scale.

Of course, independent regulators must be transparent and accountable so we strongly support the measures in the FSM Bill to enhance our accountability to reflect our new powers. “Independence” is also a carefully circumscribed term in this context – it really means operational independence, to deliver objectives which are set for us by Parliament.

Given this, I think we should be very cautious of any measure that would undermine – or be perceived to undermine – the independence of regulators from government. In particular, ministers have indicated that the government may amend the FSM Bill to introduce an ‘intervention power’. We do not know exactly what this power will look like, but a power which allowed ministers to override regulatory decisions just because they took a different view of the issues involved would represent a significant shift away from a model of independent regulation. Leaving aside the evidence on financial stability, some might think that such a power would boost competitiveness. My view is that through time it would do precisely the opposite, by undermining our international credibility and creating a system in which financial regulation blew much more with the political wind – weaker regulation under some governments, harsher regulation under others. These are not features which would make the UK a more attractive place for international firms to do business in.

I appreciate of course that I am ill-placed to advance this argument, for the simple reason that it looks self-interested coming from the regulator. But all of my experience in this field tells me, as a citizen of the UK, that this point is true.

Proportionate

On which note, you might comment that of course, as a prudential regulator, I would say that competitiveness is all about high standards. But I appreciate that there is a limit to this logic and that we should recognise the need to minimise unnecessary regulatory burdens. Regulations that are excessively tight, or which are unnecessarily costly or complex to comply with, are negative for growth and competitiveness. Effective regulation needs to be proportionate, and only create burdens when necessary to achieve its objectives.

Unnecessary or badly designed regulations can damage the financial sector’s productivity, imposing a dead-weight cost as firms spend resources on compliance rather than providing services. This raises the cost of finance to the real economy, harming economic growth. And they make the UK less attractive as a place to do business, while adding to the cost base of UK firms.

So while we have no appetite to remove regulations that maintain financial stability and whose absence would lower important standards, we also recognise that unnecessary burdens should be removed. To quote the Chancellor who established the PRA, we have no desire to establish the ‘stability of the graveyard’.

Innovative

Regulatory reform is about more than just stripping away regulations. It is also about innovating within the regulatory framework, to keep pace with technological, economic and societal changes.

This includes creating regulatory regimes for new forms of finance. Fintech, stablecoins and the like will only make a positive contribution to the economy if they can operate in a stable, high-confidence environment.^footnote[8]

It also includes helping industry adapt to changing risks. Our work on operational and cyber resilience is an example: we create a coordination mechanism that allows firms to converge towards best practice. Feedback from industry has been strongly positive on this point.

And it includes reducing barriers to entry and growth, so that innovators can enter the market and competition can drive productivity.

Regulatory reform^footnote[9]

Our exit from the EU undoubtedly offers significant opportunities to revisit regulations that just don’t make sense for the UK, particularly in the context of proportionality and innovation. This is a major priority for the PRA and we are already working intensively on early priority areas. I don’t want to prejudge that substantial package of work, and we will of course take an open, consultative and evidence-based approach to bringing forward policy proposals – including through regular dialogue with industry, Parliament and other stakeholders. But the programme includes:

• Solvency II reform. I won’t dwell too long on this one, as I have spoken on it (at much greater length than most humans can tolerate) elsewhere.^footnote[10] But by reforming the insurance rules we have inherited from the EU, we hope to: enable insurers to invest in a wider range of assets, supporting economic growth; strip unnecessary bureaucracy away from the regime; and ensure the regime is credible, by fixing weaknesses in its design and calibration which could pose risks to insurance policyholders if left unaddressed. We issued a discussion paper on Solvency II in April, setting out our assessment of the reform package. We received very substantial feedback from industry and other stakeholders on our DP, and we hope to be able to publish a revised assessment very shortly.
• We are also using our post-Brexit freedoms to develop a simpler prudential regime for smaller banks.^footnote[11] This ‘Strong and Simple’ project will deliver a more proportionate and less complex regime for smaller firms, while ensuring standards remain strong. We will also be considering the future regime for mid-tier banks.
• We are implementing the final set of post-financial crisis Basel standards for banks – known as ‘Basel 3.1’. In doing so we will maintain the UK’s reputation for adherence to global standards, supporting our international competitiveness, and we will also have careful regard to other jurisdictions’ implementation of the standards. We will be bringing forward a comprehensive Basel 3.1 consultation by the end of this year.
• We are also looking at reforms to remuneration standards in banking. Ever since it was first introduced, the PRA has set out its concerns around the prudential effectiveness of the EU’s bonus cap – and these concerns have been widely reported. We also intend to look more broadly at the whole structure of rules around remuneration. We will consider how these rules, which are a patchwork of EU and UK regulations, can be streamlined and made more effective and proportionate. In doing so, we will be clear that rules around remuneration are an important tool to ensure decision-makers and risk-takers have the right incentives. My own view, based on personal experience as a Treasury official through the global financial crisis, is that the 100% cash-out at year-end approach to bonuses which was common in banking up until 2008 was an important part of what drove the financial system over the cliff, and we should have no appetite to return to that heads-I-win tails-you-lose approach. But in the context of our competitiveness as an international financial centre I think it’s also sensible for us to take another look at the set of rules in this area, with more of a global view now that we are out of the EU.
• Reporting rules are also ripe for simplification. Currently, under the inherited EU framework, we collect some data we don’t need because our reporting standards were a compromise across 28 member states with different needs. This puts an unnecessary burden on firms, and it’s a burden we want to remove. We have already removed some reporting requirements from insurance firms, particularly smaller firms, and will be consulting in the coming months on easing insurance reporting burdens further; we will then begin a review on the banking side.
• We will be reviewing our enforcement policies to make them clearer and create options for quicker outcomes.
• We are making our rules more accessible and user-friendly. This is a significant task but we have already started by publishing a Policy Index of our prudential and resolution policies, which received over 10,000 views in its first month.^footnote[12] And we plan to bring our policies together on one user-friendly website, streamline our materials, and adopt a more coherent approach to the structure and language we use in future.
• Following our discussion paper last year, the Bank of England and PRA are moving forward to create a regulatory framework for systemic stablecoins. This will allow both non-banks and PRA-regulated banks to innovate in this space. The Bank will consult on this new regulatory regime in the New Year.

Growth and competitiveness

All of this is already under way while Parliament considers whether to add a secondary growth and competitiveness objective to our mandate. We need to be careful not to get ahead of those decisions by Parliament, but at the same time in view of that debate we are leaning more heavily on existing parts of our mandate (in the form of our “have regards” and remit letter) which cut in the same direction.

Our authority derives from Parliament and we are accountable to Parliament for our exercise of it. Accordingly, if and when Parliament agrees to give us a new secondary objective we will take it forward with vigour, including in the areas listed above. This will require an evolution in our mindset, and this is appropriate given the change in our role – it is not unreasonable to require that, if we are to take on some functions which were conducted with political input when we were a member of the EU, then we should take more explicitly into our consideration some of the objectives which motivated that input. To this end we have already published a paper explaining how we would propose to approach policymaking in the future, including our new objective if Parliament sets it for us.^footnote[13]

But as we make this shift we must do it carefully and without undercutting the primacy of safety and soundness in governing our actions.

The UK’s reputation for robust, independent and open regulation is a hard-won asset, and it is a vital part of what makes the City an unparalleled global success story. The PRA and the Bank of England are committed to preserving this reputation, while also designing a proportionate and innovative regulatory regime which allows the UK economy to thrive. I look forward to working with you all to achieve these goals.

My thanks to Hugh Burns and colleagues across the PRA for their help in preparing this speech.

The press release issued by the Bank of England on 19 October 2022.

Speech

“You can fool some people sometimes,

But you can’t fool all the people all the time.”

Bob Marley and the Wailers

Introduction

It is a rare day when the media have not reported on a fascinating development in the crypto-sphere. Sometimes we read about success, such as the transition of Ethereum to proof of stake (PoS) from proof of work (PoW); Other times we read about failure, such as the collapse of the “stablecoin”, Terra, and the subsequent meltdown of many crypto assets and centralised crypto entities.

There are undoubtedly many factors that underpin the success and failure of business endeavours, from the quality of the business plan to the acumen of the leadership team. Sound governance underpins these factors, and sustained business success cannot be achieved without it. Given the importance of risk management for financial resilience, sound governance is also critical for financial stability.

That makes governance of crypto and decentralised finance relevant to my role as an external member of the Bank of England’s Financial Policy Committee (FPC), and is what motivates my talk today. It is particularly exciting to give this talk here because of the excellent work of the UCL Centre for Blockchain Technologies. Thank you for the invitation.

The history books are full of instances when faulty governance in traditional finance led to both failure of a particular financial institution, and financial instability. Just look back to the global financial crisis (GFC) when generalised weakness in risk management frameworks led to limited understanding and control of balance sheets. Remember Bear Stearns, where the concentration of mortgage securities had been increasing for several years and was beyond their internal risk limits?^footnote[1] Lehman Brothers, of course, is another example.

When it comes to the crypto ecosystem, technology alone cannot get around the fact that decisions must be taken, and how well these decisions are governed is central to trust in the system and its ultimate success.

I hope it will become clear in the first part of my remarks that decentralised structures for providing financial services do offer the opportunity to reimagine governance. I will also talk about why so called “DeFi” structures are presently far from being as “democratic” or “decentralised” as some would have you believe, and why there are limits to just how decentralised governance in the crypto ecosystem can actually become.

In the second part of my talk I will suggest ways that the crypto industry could strengthen governance. The underpinnings for public trust need to be built on best practice in governance, shared codes of conduct, and high expectations for transparency.

It is not all about the industry, however, so I will also talk about how the official sector should support sustainable innovation by building the right legal and regulatory infrastructure.

What’s at stake?

Let me start with what I mean by governance. Every organisation needs to establish decision rights: what decisions need to be made, who is responsible for making them, how and to whom they are communicated. They involve processes to ensure accountability, transparency, and empowerment. Governance matters because it establishes rules of engagement and controls that produce organisational effectiveness and efficiency.

There are two aspects of crypto governance that create opportunity.

The first is the possibility of organisational structures based on a greater degree of decentralised decision making than in traditional finance. Given this, some crypto proponents aim to challenge traditional economic institutions of capitalism – firms, markets, and potentially governments.^footnote[2] While mutualisation of organisations is not a new phenomenon, this new form is made possible by blockchain technology and smart contracts; which allows financial services to occur at scale, with less recourse to an intermediary than in traditional finance. Of course, there is nothing stopping more traditional organisational structures with more centralised governance structures from adopting similar technology.

The second opportunity is that the governance itself can spur growth by framing decision making as a game or an activity in which participants have something at (or to) stake.^footnote[3]

The successful completion of Ethereum’s project – called “the Merge” – is a recent example of what can be achieved under the right circumstances. It has reportedly reduced the use of electricity of the Ethereum ecosystem by over 99%.^footnote[4] This is an important milestone because Ethereum is presently the backbone of the crypto ecosystem. Bitcoin may have the largest share in terms of market capitalisation, but most of the action is happening on the Ethereum blockchain. Ethereum has over 4 times the number of transactions per day as Bitcoin and hosts nearly 1,000 unbacked crypto asset tokens, all the major stablecoins and over 100,000 Non-Fungible Token (NFT) projects.

Governance of this project looks quite familiar in a couple of ways:

1. It was fairly centralised. The project was coordinated by the Ethereum foundation that oversaw a core development team, rather than a fully decentralised community. Given the complexity of the project, this centralisation was a necessary mechanism to accelerate the project.^footnote[5] Vitalik Buterin – one of Ethereum’s key founders was understandably quite influential, although he did not have unilateral decision-making power.
2. There were parallel runs and extensive testing. Almost two years ago, Ethereum developers created a new network called the “Beacon Chain” that uses the PoS validation mechanism. It ran in parallel to the PoW-based Ethereum network. They also conducted trial runs over a number of years, prudently delaying the project on a number of occasions given outstanding issues and the amount of money at risk. Their checklist of “readiness” milestones ahead of the Merge^footnote[6], shows efforts to be transparent about the project.

The project did, nonetheless, move the dial on governance in a couple of ways. First, the ultimate decision to move to the Beacon chain was a pre-programmed, automated event without any human intervention. This is in stark contrast to traditional operational programmes that may be heavily scripted, but also have checkpoints where teams will coordinate on progress and take decisions.

Second, the Merge would not have succeeded if a critical mass of ETH holders had not staked their ETH to the Beacon Chain, either directly or via staking pools like Lido and Coinbase. Put another way, if enough Ethereum token holders and developers had instead opted to move their assets and projects to an alternative PoW blockchain, the PoS network would have been too vulnerable to attacks to be viable.

This accomplishment hopefully foreshadows further success as Ethereum works on upgrades to lower transactions times and costs, and will inspire other platforms to learn from this experience.^footnote[7]

Some DeFi supporters might use this experience as evidence that the governance worries of the Fear, Uncertainty and Doubt (FUD) crowd are overblown. They may also question whether traditional notions of governance are even needed in a world of smart contracts and the ability of token holders to vote with their feet.

Let me say that, as a mentor for the Blockchain stream of the Creative Destruction Lab (CDL) at University of Toronto Rotman School of Management, I have been fortunate to meet many entrepreneurs who have promising business models and an impressive drive to make the world of finance a better place.

Still, there are a number of serious deficiencies in governance in the crypto ecosystem that need more attention than they are getting today. I am not claiming governance in traditional finance is perfect. But what’s at stake for crypto and DeFi is the ability to make meaningful inroads into providing services to households and businesses in the real economy.

Limits to decentralised governance in practice

I said earlier that technology alone cannot get around the fact that decisions must be taken in the crypto ecosystem. At a minimum, someone is making decisions regarding the system code, and influencing whether it will deliver what it says it will.

There are important concentrations of power in “decentralised” finance.

In theory, those decisions could be taken in a completely decentralised manner. In practice, however, the governance of critical decisions is not completely decentralised even in a permissionless blockchain such as Bitcoin. In fact, the consensus mechanism and other governance protocols can lead to undesirable concentrations of power.

For instance, a few individuals who have accumulated significant voting rights can dominate; by that I mean individuals who hold the lion’s share of a particular crypto token. There are data to support this; a recent study shows that, among the top 10 proof of stake platforms by market capitalisation, the top ten validators held between 23% and 88% of the stakes, while the top 50 held between 47% and 100% of the stakes.^footnote[8] Incredible.

There are also issues regarding transparency. For instance, in 2018, a small number of Bitcoin software developers were made aware of a bug that could open the door to a denial of service attack and allow the creation of bitcoins in excess of the cap of 21 million. The time log of events shows that a decision of relatively few was made to disclose the DoS aspect of the bug, but to withhold the more damaging information regarding potential breach of cap and implications for inflation until after the patch was completed 3 days later.^footnote[9]

This raises questions about who is accountable for decisions and outcomes. There is a rich debate in the United States regarding whether the core protocol developers should be held accountable as fiduciaries.^footnote[10] And the CFTC’s recent enforcement action against token holders of Ooki DAO is a live case study of the extent to which governance token holders can be held liable.^footnote[11]

Concentrations of power can also be achieved “on chain” through governance attacks, where an attacker gains enough voting rights to dominate decisions or influence enough token holders to vote in a biased manner. In April, an attacker used a flash loan to obtain a majority of governance tokens in Beanstalk, a decentralised, credit-based stablecoin protocol. They got away with around $77 million by passing their own malicious proposal and quickly implementing it.^footnote[12] The month after that, Terra blockchain halted operations to avoid potential governance attacks following the collapse of its Luna token.^footnote[13]

The hard lesson here is that, when tokens are transferable, special care is needed to ensure that their supply, distribution and price accurately represents the community members who are invested in the project. Some protocols such as Compound employ fail-safes against this kind of governance attack, such as a mandatory waiting period before enacting the vote result.^footnote[14] Another idea getting attention at the moment is the idea of soulbound (i.e. non-transferrable) tokensOpens in a new window, linked to an individual’s identity.^footnote[15]

My final example of concentration of power relates to miners in PoW systems and validators in PoS systems. They determine which transactions are executed and when, which affects market prices. This opens the door to front-running and other forms of market manipulation, where the resulting profit has even earned its own term “maximal extractable value” (MEV).^footnote[16] Whether this activity is illegal or not is an important question. Equally important is whether market participants should put up with miners potentially taking some unspecified pound of flesh in a system that purports to be “trustless”.

If the miner and validator communities were truly distributed, I imagine this “extractable value” would be easier to accept. Unfortunately, the facts show that these communities are quite concentrated. One study found that fewer than 50 miners control half of the mining capacity for Bitcoin, since the incentives are to pool computing power in order to win the race in terms of getting paid for validating transactions.^footnote[17]

There are limits to how decentralised governance can become

There are some good ideas on how to improve the governance of decentralised decision making. For instance, some have suggested the idea of quadratic voting to mitigate the issue of concentration in decision-making. Under this mechanism, 1 vote would cost 1 token, 2 votes would cost 4 tokens, 3 votes would cost 9 tokens and so on.^footnote[18] Even though owning more tokens would still mean enhanced voting rights, the ability of large token holders to dominate would be reduced.

Nonetheless, I think there are hard limits to how decentralised a system can become in practice.

One reason is that knowledge is power. Fixes like quadratic voting would not change the fact that only the insiders who are heavy-duty coders have the expertise to propose and engage with protocol updates on “off chain” governance forums. That is because most people have little idea of how the protocol works, or what impact proposed updates will have. Full transparency in the face of such serious asymmetry of understanding has its limits in terms of ensuring truly distributed governance. Moreover, only a small number of core developers are entrusted with “commit keys” that allow them to make changes to the code that have been agreed upon.^footnote[19]

Another reason is that we live in an inherently uncertain world. That means there can never be a set of smart contracts for every situation, and centralised decision making will always be needed when the unexpected happens.

This is really just a practical point. Even in organisations with traditional governance set ups, governance mechanisms can be a problem in a crisis because they take too long. The on-chain voting process on the blockchain platform Tezos is currently divided into five governance cycles (each lasting roughly two weeks): a proposal period, a testing-vote period, a testing period, a promotion-vote period, and an adoption period.^footnote[20] In platforms like this, any event that requires urgent action is unlikely to be resolved promptly through the usual governance process.

That’s why many DeFi protocol teams retain emergency powers to unilaterally step in when they see fit. Polkadot, an open source blockchain platform and cryptocurrency, allows for emergency referenda to be initiated by an assigned technical committee.^footnote[21] Others, such as MakerDAO, can implement an emergency shutdown functionality whereby a smart contact can suspend its normal operation and return the invested assets to their owners.^footnote[22]

The idea of emergency powers is not universally embraced in the crypto community, as Solend found out the hard way last summer. Solend, which supports tokens such as Solana and USDC, made plans in June to use emergency powers to gain control of the platform’s largest account or “whale account” to avoid a crisis that would have made the protocol unviable. It gave its governance token holders only one day to vote, and the community reacted very negatively about the “seat of the pants” governance.^footnote[23] Ultimately the emergency powers were reversed.

Aside from the need to deal with emergencies, some crypto-based systems are explicitly designed with various nodes of centralisation to make it easier to use; think centralised exchanges, wallet-providers and various aspects of governance. For example, Binance recently mitigated the cost of a significant bridge hack on its Binance Smart Chain by quickly coordinating just 20 of the validators on its network.^footnote[24]

Standing up for market participant rights and financial stability

As with traditional finance, these issues, and the financial losses that inevitably accompany them, are bound to eventually lead to a punishing loss of trust in this new ecosystem. Many people have already lost savings through fraud, scams and outright theft. Growth in the number of crypto scams in the UK has spiked so much in recent years that they are now the most common type of scam reported to the Financial Conduct Authority (FCA).^footnote[25] In the US, over $1bn in crypto related scams had been reported since 2021, affecting more than 46,000 people.^footnote[26]

Institutional investors in DeFi are focused on reputational risk, not just financial risk, and will expect to see better governance and outcomes on this front. While many people who are long crypto today may still have faith in their bet, those who want to finance their first home or save to send their kid to school typically need more than faith; they need trust. I cannot help but think of the well-known Bob Marley lyrics that say “You can fool some people sometimes, but you can’t fool all the people all the time.”

The window for the crypto industry to improve its approach to governance is narrowing: regulated firms in traditional finance are increasingly applying the underlying blockchain technology to traditional capital markets.^footnote[27] They will be in a better position to capture this market if the crypto industry does not get its house in order, if only because they have more familiar and battle-tested governance. There are a number of examples out there, such as Onyx Digital Assets – JPMorgan’s blockchain-based network for digital assets trading, and the HQLAᵡ DLT platform for securities finance and repo.

A good place to start for DeFi is with industry-led mechanisms that develop codes of conduct and best practices. For instance, institutional investors may ultimately want to see high standards around disclosures in financial statements, sources and uses of funds, conflicts of interest and related parties, regardless of whether the activity is subject to regulatory requirements or not. These expectations could include regular audits of the code, and disclosure of how rights to change the code are determined and who holds the “commit keys.”

The industry should be proactive here in order to build safe bridges to the real economy, rather than wait for regulators. It is good that UCL’s Blockchain Centre research program includes the elaboration of best practice standards, and that groups like the “Crypto Market Integrity Coalition” are working on a market surveillance code of conduct.^footnote[28]

The official sector must also support this process by providing the necessary legal and regulatory infrastructure. This work is underway: crypto asset firms operating in the UK are already subject to Anti Money Laundering rules since 2020, and pending legislative changes the FCA will regulate how qualifying crypto financial promotions are offered in line with other high-risk investments. Legislation bringing stablecoins used for payments into regulation is currently going through the UK Parliament; and a consultation on the wider regime for crypto assets is expected to follow.

Separately, some important issues remain, particularly related to the legal framework. Addressing this in a timely manner is critical because consumers and businesses in the DeFi sector should have the same protection of the law as those who are spending, investing or banking in traditional finance.

There are many elements to building legal certainty. One that the Law Commission of England and Wales has recently investigated relates to whether crypto assets are regarded as property under national law.^footnote[29] Another element relates to dispute resolution processes, which are needed for transactions that take place on-chain using digital payment mechanisms, including those that are cross border.^footnote[30]

Crypto is global, which means that international harmonisation is critical. Progress has been made in some areas, such as guidance clarifying that a systemically important stablecoin arrangement primarily used for making payments would be expected to observe the Principles for Financial Market Infrastructures set out by the CPMI and IOSCO committees.^footnote[31] One clear expectation of systemic stablecoin arrangements is that governance should allow for “timely human intervention as and when needed.” Another expectation is that systemic stablecoin arrangements will be owned and operated by identifiable legal entities that are ‘ultimately controlled by natural persons’ (real human beings).

Much more needs to be achieved, particularly in the coordination of regulation of the crypto ecosystem beyond the traditional financial sector.^footnote[32] The Financial Stability Board’s latest recommendations on regulatory and supervisory approaches to stablecoins and other crypto-assets, published last week, are helpful in this respect.^footnote[33] So will be IOSCO’s work on crypto-asset market integrity and investor protection issues.

Conclusions

Let me conclude by saying that now is the perfect time to build good governance into the system, even if it still feels like early days for decentralised financial services. Concentrations of power in PoW and PoS systems, and other flaws in governance of crypto and DeFi, have already contributed to all-too familiar issues; top of the list are business failures, illegal activity and financial losses for investors. If left unchecked, this state of affairs will erode trust among investors in crypto-based financial services and their customers, and could lead to financial stress more broadly.

Governments and regulators still have work to do to build supporting legal and regulatory infrastructure. Finance is global but regulation is local, so coordination across borders is essential.

It is in the interest of the private sector to be proactive. Major investors must “get up, stand up” to demand change. It is critical that industry adopt best practices and codes of conduct to reinforce trustworthy behaviour and culture. We need to face the practical limits to decentralisation that come from asymmetrical understanding of the system and the inability to plan for every eventuality in an uncertain world. Given the promise of innovation in financial services, I think this effort is worth it.

I would like to thank the following for their input to and helpful comments on these remarks: Stephane Amoyel, Andrew Bailey, Sarah Breeden, David Geen, Bernat Gual-Ricart, Amy Lee, Maighread McCloskey, Grellan McGrath, Irina Mnohoghitnei, Ali Moussavi, Raakhi Odedra, Magda Rutkowska, Greg Stump, Cormac Sullivan, Henry Tanner, Andy Walters, as well as colleagues at the FCA and HMT.

The press release issued by the Bank of England on 18 October 2022.

On 28 September 2022, the Bank of England’s (Bank’s) Executive postponed the start of sales of UK government bonds (gilts) held in the Asset Purchase Facility (APF) in light of market conditions at that time. The first gilt sales operation was scheduled to take place on 31 October 2022 and proceed thereafter.

In light of the Government’s fiscal announcement now scheduled for 31 October 2022, the first gilt sale operation will now take place on 1 November 2022.

The Bank currently expects to conduct APF gilt sales operations in Q4 2022 at a similar size and frequency as had been previously announced, with any shortfall as a result of the earlier postponement relative to its previous sales plan incorporated into sales in subsequent quarters.

For Q4 2022, these APF gilt sales operations will be distributed evenly across the short and medium maturity sectors only. These sectors are defined as: gilts with a residual maturity of between 3-7 years (short), and those with a residual maturity of between 7-20 years (medium). The maturity split of gilt sales for subsequent quarters will be considered ahead of Q1 2023.

The dates and sizes for the individual auctions will be confirmed in a Market Notice, which the Bank expects to publish at 6pm on 20 October 2022.

The Bank will continue to monitor market conditions closely, and where appropriate factor that into the design of its sales operations.

The Monetary Policy Committee (MPC) has been informed of these operational changes. As set out previously, the MPC’s decision at its September meeting to reduce the stock of purchased gilts is unaffected and unchanged.

The press release issued by the Bank of England on 11 October 2022.

The Bank continues to monitor developments in financial markets very closely in light of the significant asset repricing of recent weeks. It has also been working with the UK authorities to address risks to the resilience of Liability Driven Investment (LDI) funds arising from volatility in the long-dated government bond (gilt) market.

On 28 September, the Bank announced that, in line with its financial stability objective, it would make temporary and targeted purchases of gilts to help restore market functioning and reduce any risks from contagion to credit conditions for UK households and businesses.

As previously announced, the Bank plans to end these operations and cease all gilt purchases on Friday 14 October.

On 10 October, the Bank announced additional measures to support market functioning and an orderly end to its gilt purchase scheme. These included the launch of a Temporary Expanded Collateral Repo Facility (TECRF) through which banks would be able to help to ease liquidity pressures facing their client LDI funds through liquidity insurance operations, and the expansion of the scale of its remaining gilt purchase auctions.

The purpose of these operations is to enable LDI funds to address risks to their resilience from volatility in the long-dated gilt market. LDI funds have made substantial progress in doing so over the past week. However, the beginning of this week has seen a further significant repricing of UK government debt, particularly index-linked gilts. Dysfunction in this market, and the prospect of self-reinforcing ‘fire sale’ dynamics pose a material risk to UK financial stability.

Therefore the Bank is announcing today that it will widen the scope of its daily gilt purchase operations also to include purchases of index-linked gilts. This enhancement to our operations will be in effect from 11 October 2022 until 14 October 2022 alongside the Bank’s existing daily conventional gilt purchase auctions.

These additional operations will act as a further backstop to restore orderly market conditions by temporarily absorbing selling of index-linked gilts in excess of market intermediation capacity. As with the conventional gilt purchase operations, these additional index-linked gilt purchases will be time-limited and fully indemnified by HM Treasury. The Bank has also consulted with the Debt Management Office.

As announced on 10 October, the Bank stands ready to purchase up to £10bn of gilts each day, of which up to £5bn will be allocated to long-dated conventional gilts and up to £5bn to index-linked gilts. The pricing of this additional operation will reflect its nature as a backstop and that this is not a monetary policy instrument. The total size of these auctions will be kept under review. All purchases will be unwound in a smooth and orderly fashion once risks to market functioning are judged to have subsided.

The Bank will temporarily pause its CBPS sales operations this week. Confirmation of these restarting will be included as part of the Bank’s regular operational announcements.

The Bank will publish a Market Notice confirming operational details of the Bank’s index-linked gilt purchases.

The press release issued by the Bank of England on 28 September 2022.

As the Governor said in his statement on Monday, the Bank is monitoring developments in financial markets very closely in light of the significant repricing of UK and global financial assets.

This repricing has become more significant in the past day – and it is particularly affecting long-dated UK government debt. Were dysfunction in this market to continue or worsen, there would be a material risk to UK financial stability. This would lead to an unwarranted tightening of financing conditions and a reduction of the flow of credit to the real economy.

In line with its financial stability objective, the Bank of England stands ready to restore market functioning and reduce any risks from contagion to credit conditions for UK households and businesses.

To achieve this, the Bank will carry out temporary purchases of long-dated UK government bonds from 28 September. The purpose of these purchases will be to restore orderly market conditions. The purchases will be carried out on whatever scale is necessary to effect this outcome. The operation will be fully indemnified by HM Treasury.

On 28 September, the Bank of England’s Financial Policy Committee noted the risks to UK financial stability from dysfunction in the gilt market. It recommended that action be taken, and welcomed the Bank’s plans for temporary and targeted purchases in the gilt market on financial stability grounds at an urgent pace.

These purchases will be strictly time limited. They are intended to tackle a specific problem in the long-dated government bond market. Auctions will take place from today until 14 October. The purchases will be unwound in a smooth and orderly fashion once risks to market functioning are judged to have subsided.

The Monetary Policy Committee has been informed of these temporary and targeted financial stability operations. This is in line with the Concordat governing the MPC’s engagement with the Bank’s Executive regarding balance sheet operations. As set out in the Governor’s statement on Monday, the MPC will make a full assessment of recent macroeconomic developments at its next scheduled meeting and act accordingly. The MPC will not hesitate to change interest rates by as much as needed to return inflation to the 2% target sustainably in the medium term, in line with its remit.

The MPC’s annual target of an £80bn stock reduction is unaffected and unchanged. In light of current market conditions, the Bank’s Executive has postponed the beginning of gilt sale operations that were due to commence next week. The first gilt sale operations will take place on 31 October and proceed thereafter.

The Bank will shortly publish a market notice outlining operational details.