4 Considerations to Mitigate Risk
Among the chief concerns of those using blockchain (and its critics) is the lack of transparency. Currently, users can unwittingly violate OFAC sanctions, among other regulations. Clifford Chance’s Wendy Wysong and Ali Burney explore how businesses can guard against the risks inherent in using blockchain technology.
with co-author Ali Burney
Blockchain, the technology that underpins digital currencies such as Bitcoin, has the potential to drastically alter the global financial system. For example, trade finance will likely become cheaper, faster and more accessible through this technology. However, developers and market participants must consider the extraterritorial reach of U.S. economic sanctions and the magnitude of the penalties for breach.
Blockchain and Trade Finance
Trade finance was invented by the Italian merchants of the Renaissance, and it is a cornerstone of the global economy to this day. However, it is costly, unwieldy and slow, with a single transaction often taking weeks to complete.
Blockchain technology uses digitised ledgers of title and assists with execution and settlement, thereby reducing costs, streamlining the cash cycle and improving transparency. But as the use of blockchain technology increases, sanctions risks will come into sharper focus for the parties involved.
The Impact of Economic Sanctions
The jurisdiction-based sanctions administered by the U.S. Treasury Department’s Office of Foreign Assets Control (OFAC) generally prohibit “U.S. persons” from directly or indirectly engaging in transactions involving individuals, entities, governments or countries that are the target of OFAC sanctions, unless authorised under an OFAC license or exemption. OFAC also prohibits U.S. persons from approving, facilitating, financing or guaranteeing transactions between non‑S. persons and sanctions targets where the transaction would be prohibited if performed by a U.S. person.
Blockchain technology owned or developed in the United States or by U.S. persons will be subject to U.S. jurisdiction and may also be subject to U.S. export controls depending on the technology used. If the blockchain is owned or licensed by a U.S. person, OFAC may take the view that any transaction using the blockchain – or which involves the selling or licensing of the software – which involves a sanctions target, could trigger the facilitation prohibition.
One of the concepts underpinning blockchain technology is that information is verified by multiple users who agree that the content on the ledger is complete and accurate: the “shared truth.” The integrity of the information is then protected by the ledger protocol, which keeps track of all changes and ensures that all copies of the ledger must be consistent. For trade finance transactions, this means that a user will need to input into the blockchain ledger, relevant information from the bills of lading, letters of credit and other shipping documents.
Failure to enter in all information relevant to sanctions (even if not all of it is necessary for commercial reasons) may expose those involved in the transaction to OFAC or other sanctions risks. For example, if the ledger did not contain information that the goods were to be transshipped through a sanctioned country or the origin of the goods, then others processing the transaction may unknowingly process or participate in a transaction in breach of sanctions.
There is also a risk that sanctions might deliberately be evaded if, through collusion between the exporter or importer or even the issuing bank, information is included in the ledger that does not accurately reflect the underlying transaction details where, for example, material information such as the origin of the goods or the ultimate consignee has been omitted. In such cases, those participating in the transaction such as the advising bank, may be exposed to facilitating a transaction that potentially violates sanctions and export controls.
One potential solution would be for the parties to agree on the information that needs to be entered into the ledger and who will be responsible for the accuracy of the data. Banks could agree that the “mandatory” information will include, for example, basic information such as the name and address of the exporter and the importer, the banks involved, the ports of loading, unloading and transit, the vessels and the insurers as well as the origin and description of the goods being shipped.
Keeping One Step Ahead
Given that OFAC sanctions are subject to change without notice and may include countries or activities that are currently not subject to sanctions, potential developers of blockchain technology need to consider a range of issues to ensure they are not unwittingly caught by sanctions. Here, we highlight four sanctions-specific functionalities that developers should consider with a view to mitigating the risks.
- Blockchain technology should incorporate sanctions-screening technologies so that information on the ledgers can be screened for any sanctions issues and the user of the system can be alerted any time a sanctions-related event is logged in the ledger.
- For U.S. banks, as well as other U.S. persons, it is important to have the ability to block the property or the property interest of a blocked person such as a Specially Designated National (SDN) in the possession or control of the U.S. bank.
- Given that trade finance is built around the concept of certainty, sanctions provisions should be built into blockchains, allowing for termination of the transaction where its consummation would give rise to a sanctions issue.
- Blockchain technology should include the ability for users to record data in accordance with their regulatory requirements and retrieve all of the data in the ledgers if required to produce the data to the relevant authorities, and in a manner consistent with data privacy or other restrictions that may be applicable.
Sanctions regimes in their current form cut against the vision of a global financial system underpinned by blockchain technology, a wide-open ledger that disintermediates traditional gatekeepers such as banks and trading houses, and with which governments and regulators cannot interfere.
Ultimately, blockchain advocates will have to submit to the reality of cross-border, extraterritorial regulation, including sanctions. An open and frank discussion on where the sanctions pitfalls lie in implementing blockchain solutions will help developers focus on these commercial and regulatory challenges.